Finance Short Answer Questions Assignment

Short Answer Questions1) What is the difference between efficient set and feasible set?Efficient set: is all of the portfolios on the efficient frontier, or those that generate thelargest return for a given risk level.Feasible set: is the entire region bounded by blue, but with integer constraints it isthe set of red dots. A closed feasible region of a linear programming problem withthree variables is a convex polyhedron.2) How does an investor select his/her portfolio from efficient set?3) Write down the CAPM and Fama-French model. Explain the notations used inthose two models.Capital Asset Pricing Model (CAPM): A model that describes the relationshipbetween risk and expected return and that is used in the pricing of risky securities. Thegeneral idea behind CAPM is that investors need to be compensated in two ways: timevalue of money and risk.Fama-French model:Is a model designed by Eugene Fama and Kenneth French to describe stock returns.Fama and French noted that stocks of smaller firms and stocks of firms with a highbook to market have had higher stock returns than predicted by single factor models.Page 1 of 34) Define the main idea of Arbitrage Pricing Theory (APT).•Arbitrage: Arises if an investor can construct a zero investment portfolio with a sureprofit.•Zero investment: Since no net investment outlay is required, an investor can createarbitrarily large positions to secure large levels of profit.•Efficient markets: With efficient markets, profitable arbitrage opportunities willquickly disappear.5) What is CAPM important to an investor?6) Write five factors that can be used in APT.7) Define systematic and unsystematic risk.Systematic risk: Also known as "market risk" or "un-diversifiable risk", is theuncertainty inherent to the entire market or entire market segment. Also referred to asvolatility, systematic risk consists of the day-to-day fluctuations in a stock’s price.Unsystematic risk: Also known as "specific risk," "diversifiable risk" or"residual risk," is the type of uncertainty that comes with the company or industry youinvest in. Unsystematic risk can be reduced through diversification.Page 2 of 38) Why cannot you diversify systematic risk?9) How is beta in CAPM related to risk and expected return?10) What is SML? What does it tell us about the price of a stock?Security market line (SML): is the graphical representation of the capital assetpricing model. It displays the expected rate of return of an individual security as afunction of systematic, non-diversifiable risk.

 

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