Question

8. (5) True or false or Uncertain. Explain briefly.

1. By the CAPM, stocks with the same beta have the same variance
2. If CAPM holds, α should be zero for all assets.
3. Optimal portfolios should exclude individual assets whose expected return and risk (measured by its standard deviation) are dominated by other available assets.
4. A stock with high standard deviation may contribute less to portfolio risk than a stock with lower standard deviation.
5. Diversification reduces the expected return on the portfolio as its risk decreases.

Answer 1

a: False: CAPM beta represents the systematic risk of stock and variance represent unsystematic risk or diversifiable risk. Hence both cant be compared

b: True; CAPM which is based on efficient market hypothesis states that expected alpha is zero for all securities

c: uncertain: Optimal portfolios are created by considering overall risk and correlation between each stocks and we cant say a stock has to be avoided because it has inferior risk or return

d: False; standard deviation represents risk and stock with high std dev contributes heavily to portfolio risk

e: False: A diversification can provide same portfolio return with lower risks.