Nt1310 Unit 7-1

7-1 a. A portfolio is made up of a group of individual assets held in combination. An asset that would be relatively risky if held in isolation may have little, or even no risk if held in a well-diversified portfolio.

b. The feasible, or attainable, set represents all portfolios that can be constructed from a given set of stocks. This set is only efficient for part of its combinations.

c. An efficient portfolio is that portfolio which provides the highest expected return for any degree of risk. Alternatively, the efficient portfolio is that which provides the lowest degree of risk for any expected return.

d. The efficient frontier is the set of efficient portfolios out of the full set of potential portfolios. On a graph, the efficient
Since Stock X is in equilibrium and plots on the Security Market Line (SML), and given the further assumption that and --and this assumption often does not hold--then this equation must hold:

This equation can be solved for the risk-free rate, kRF, which is the only unknown:

d. The SML is plotted below. Data on the risk-free security (bRF = 0, kRF = 8.6%) and Security X (bX = 0.56, = 10.6%) provide the two points through which the SML can be drawn. kM pro¬vides a third point.

e. In theory, you would be indifferent between the two stocks. Since they have the same beta, their relevant risks are identical, and in equilibrium they should provide the same returns. The two stocks would be represented by a single point on the SML. Stock Y, with the higher standard devia¬tion, has more diversifiable risk, but this risk will be eliminated in a well-diversified portfolio, so the market will compensate the investor only for bearing market or relevant risk. In practice, it is possible that Stock Y would have a slightly higher required return, but this pre¬mium for diversifiable risk would be small.

7-2

a. The regression graph is shown above. b will depend on students' freehand line. Using a calculator, we find b =
With regard to Condition 1, the single-asset portfolio, we can be sure that its probability distribution is less peaked than that for the 100-stock portfolio. Analytically, since b = 0.62 both for the single stock portfolio and for the 100-stock portfolio,

We can also say on the basis of the available information that σY is smaller than σM; Stock Y's market risk is only 62 percent of the "market," but it does have company-specific risk, while the market portfolio does not. However, we know from the given data that σY = 13.8%, while σM = 19.6%. Thus, we have drawn the distribution for the single stock portfolio more peaked than that of the market. The relative rates of return are not reasonable. The return for any stock should be

ki = kRF + (kM - kRF)bi.

Stock Y has b = 0.62, while the average stock (M) has b = 1.0; therefore,

kY = kRF + (kM - kRF)0.62 < kM = kRF + (kM -