SM Nahidul Islam

Dept. of Finance & Banking (2nd batch)

1. Describe the key assumptions underlying the CAPM.
Answer: There are ten key assumptions underlying the CAPM:
1. Investors evaluate portfolios by analyzing expected returns and standard deviations over a oneperiod time horizon.
2. Everything else equal, investors prefer portfolios with greater expected returns.
3. Everything else equal, investors prefer portfolios with lower standard deviations.
4. Assets are infinitely divisible.
5. Investors may borrow or lend at a single risk free interest rate.
6. Taxes and transaction costs are immaterial.
7. All investors have the same one-period time horizon.
8. All investors borrow and lend at the same risk free rate.
9. All investors have immediate and costless access to all relevant information.
10. Investors possess homogeneous expectations regarding the expected returns and risks of
securities.
2. Many of the underlying assumptions of the CAPM are violated to some degree in the real
world. Does that fact invalidate the model's conclusions? Explain.
Answer: The fact that the many of the CAPM assumptions are violated in the "real world" does not
necessarily invalidate the CAPM's primary conclusions. As the text discusses, simplifying assumptions
are required to provide the degree of abstraction necessary to develop an explanatory model of any
complex system. The "reasonableness" of a model's assumptions are of little concern. Instead, the true
test of a model is its ability to help interested parties understand and predict the process being modeled.
3. What is the separation theorem? What implications does it have for the optimal portfolio of
risky assets held by investors?
Answer: The separation theorem states that an investor's optimal risky portfolio can be determined
without reference to the investor's risk-return preferences.
Assuming that every investor has the same expectations regarding expected returns and risks for
available securities, and assuming that everyone faces the same riskfree rate, then the efficient set must be
the same for all investors. This implies that every investor will hold the same risky portfolio. (That risky
portfolio is represented by the point of tangency between a ray emanating from the risk free asset and
extending into risk-return space and tangent to the curved Markowitz efficient set.) The only difference
in portfolios held by investors will be with respect to the amount of risk free lending or borrowing
undertaken, which will depend on the investors' individual risk-return preferences.
4. What constitutes the market portfolio? What problems does one confront in specifying the
composition of the true market portfolio? How have researchers and practitioners circumvented
these problems?
Answer: The market portfolio consists of all securities where the proportion invested in each security
equals the market value of the security (price per unit times the number of units of the security
outstanding) divided by the sum of the market values of all securities.
Specifying the "true" market portfolio is virtually impossible. One must be able to identify and
value all assets held by investors. These assets range from easily enumerated and valued assets such as
publicly-traded U.S. common stocks to difficult-to-value assets such as foreign real estate.
To overcome these difficulties, researchers and practitioners have restricted their definition of the

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
market portfolio to a relatively small subset of easily identifiable and valued securities, such as the stocks
constituting the S&P 500.
5. In the equilibrium world of the CAPM, is it possible for a security not to be part of the market
portfolio? Explain
Answer: The market portfolio is composed of all assets held by investors. Each asset is weighted by the
proportion of its market value relative to the market value of all assets.
As derived from the separation theorem, all investors will hold the same risky portfolio. Thus in
equilibrium every security must be included in the market portfolio. If a security were not included in the
market portfolio, no investor would own it and its equilibrium market price (and hence its market value)
would be zero.
6. Describe the price adjustment process that equilibrates the market's supply and demand for
securities. What conditions will prevail under such equilibrium?
Answer: If investors wish to hold more units of a security than are available, then they will bid up the
price of the security, thereby reducing its expected return. The lower expected return will cause investors
to reduce their desired holdings of the security.
Conversely, if investors wish to hold fewer units of a security than are available, then they will bid
down the security's price, thereby increasing its expected return. The higher expected return will cause
investors to wish to hold more units of the security.
This process will drive the price of the security toward its equilibrium value at which point the
number of units investors wish to hold will equal the number of units outstanding. This equilibrating
process will produce market clearing prices for all securities. Further, the risk free rate will move to a
level where the total amount of money borrowed will equal the supply of money available for lending.
7. Explain the significance of the capital market line.
Answer: The Capital Market Line (CML) represents the efficient set in the world of the CAPM. All
investors will hold a portfolio lying on the CML. An investor's portfolio will be composed of the market
portfolio combined with either riskfree borrowing or lending, depending on the investor's level of risk
aversion.
The vertical intercept of the CML is the riskfree rate, often referred to as the reward for waiting.
The slope of the CML is often referred to as the reward for bearing risk. Thus the CML represents how
the securities markets value time and risk.
8. Distinguish between the capital market line and the security market line.
Answer: The differences between capital market line and the security market line are given below:
Capital Market Line (CML)
1. CML is a line intersecting returns on norisk investments and returns on the entire
market.
2. Capital market line measures risk by
standard deviation, or total risk
3. CML graphs
portfolios

only

defines

Security Market Line (SML)

SML is a graphical representation of the
markets risk and return at a given time.
Security market line measures risk by beta to
find the securitys risk contribution to portfolio.

efficient The Security Market Line graphs define both

efficient and non-efficient portfolios.

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
4. The market portfolio and risk free assets All security factors are determined by the
are determined by the CML
SML.
SML =

Figure: Capital Market Line

Figure: Security Market line

9. Explain the significance of the slope of the SML. How might the slope of the SML change
over time?
Answer: The slope of the SML indicates the level of aggregate investor risk aversion. That is, it indicates
how much compensation investors as a group demand for bearing the risk associated with holding the
market portfolio.
As investors in aggregate become more (less) risk averse, the slope of the SML will rise (decline).
That is, investors will demand a higher (lower) incremental expected return over the riskfree rate for
bearing the risk associated with the market portfolio.
10. Why should the expected return for a security be directly related to the security's
covariance with the market portfolio?
Answer: According to the CAPM, all investors will hold the market portfolio combined with riskfree
borrowing or lending. Therefore all investors will be concerned with the risk (or standard deviation) of
the market portfolio. The standard deviation of the market portfolio can be shown to be a function of the
covariance with it of each of the securities that make up the market portfolio. Therefore the contribution
that each security makes to the market portfolio's risk will be directly related to its covariance with the
market portfolio. Risk averse investors will demand higher returns from securities exhibiting higher
covariances with the market portfolio.
11. The risk of a well-diversified portfolio to an investor is measured by the standard deviation
of the portfolio's returns. Why shouldn't the risk of an individual security be calculated in the
same manner?
Answer: With respect to risk, the investor ultimately is concerned with the standard deviation of his or
her portfolio. Therefore, in evaluating a well-diversified portfolio, the relevant measure of risk is standard
deviation. However, the contribution of an individual security to a portfolio's standard deviation is not the
standard deviation of the security. That is, a portfolio's standard deviation is not simply the weighted
average of the standard deviations of the component securities. The appropriate measure of a security's

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
risk is the contribution that it makes to the standard deviation of a well-diversified portfolio. That
contribution is reflected in the security's covariance with the portfolio.

Formula
1.Capital Market Line (CML):
rp
= rf + [( r M - rf)/M]p
2.Expected return of the market portfolio:
= (XA r A ) + (XB r B )
rM
3.Standard deviation of the market portfolio :
1/ 2
M X A A2 X B B2 2 X A X B AB A B
4. The SML expressed in its covariance (as opposed to beta) form is given by:
r M rf

r i rf

iM

M2