CHAPTER 11

RETURN AND RISK: THE CAPITAL ASSET PRICING MODEL (CAPM)

Answers to Concepts Review and Critical Thinking Questions

1. Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns.

2. a. systematic

b. unsystematic

c. both; probably mostly systematic

d. unsystematic

e. unsystematic

f. systematic

3. No to both questions. The portfolio expected return is a weighted average of the asset’s returns, so it must be less than the largest asset return and greater than the smallest asset return.

4. False. The variance of the individual assets is a measure of the total risk. The variance on a well-diversified portfolio is a function of systematic risk only.

5. Yes, the standard deviation can be less than that of every asset in the portfolio. However, p cannot be less than the smallest beta because p is a weighted average of the individual asset betas.

6. Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a diversification instrument.

7. The covariance is a more appropriate measure of a security’s risk in a well-diversified portfolio because the covariance reflects the effect of the security on the variance of the portfolio. Investors are concerned with the variance of their portfolios and not the variance of the individual securities. Since covariance measures the impact of an individual security on...