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Test Bank to accompany Modern Portfolio Theory and Investment Analysis, 9th Edition
MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS

9TH EDITION
ELTON, GRUBER, BROWN, & GOETZMANN
The following exam questions are organized according to the text's sections. Within each
section, questions follow the order of the text's chapters and are organized as multiple
choice, true-false with discussion, problems, and essays. The correct answers and the
corresponding chapter(s) are indicated below each question.
PART 3: MODELS OF EQUILIBRIUM IN THE CAPITAL MARKETS
Multiple Choice
1. The CAPM implies that:

a. investors may invest in assets with expected returns lower than the riskless
interest rate.
b. no investor should invest in the risk-free asset.
c. the only relevant measure of risk is standard deviation.
d. the expected return on an efficient portfolio may be lower than the riskless
interest rate.
Answer: A
Chapter: 13
2. The beta of an efficient portfolio:

a. must be 1 since an efficient portfolio is perfectly positively correlated with the
market portfolio.
b. is proportional to 1, depending on the proportion invested in the market
portfolio.
c. is equivalent to the portfolio's standard deviation, since standard deviation is the
measure of risk for an efficient portfolio.
d. is always less than 1.
Answer: B
Chapter: 13
3. Assume that the risk-free rate is 9% and that the market portfolio has an expected
return of 17%. Under equilibrium conditions as described by the CAPM, what would be
the expected return for a portfolio having no diversifiable risk and a beta of 0.75?
a. 17%
b. 9%
c. 20%
d. 15%
Part 3 - 1
Test Bank Modern Portfolio Theory and Investment Analysis, 9th Edition
Answer: D
Chapter: 13
4. Assume that the risk-free rate is 9% and that the market portfolio has an expected
return of 17%. What expected return would be consistent with the CAPM for a security
with a beta of 1.5?
a. 13%
b. 21%
c. 25.5%
d. 17%
Answer: B
Chapter: 13
5. Which statement of the following statements is true?

a. In equilibrium, every security and combination of securities lies on the Capital
Market Line.
b. In equilibrium, every security and combination of securities lies on the Security
Market Line.
c. Only efficient portfolios lie on the Security Market Line.
d. In equilibrium, every security and combination of securities lies lower than the
Capital Market Line.
Answer: B
Chapter: 13
6. Security A has a greater level of systematic risk than security B. The expected
equilibrium return for A must be greater than that for B because:
a. B's price will fall as investors realize that B offers lower returns.
b. if it is not, then A's price will fall and B's price will rise as investors sell A and buy B.
c. the Security Market Line is negatively sloped.
d. the standard deviation of A's return is greater than B's.
Answer: B
Chapter: 13
7. If the standard CAPM holds, a security with a high variance of return and a beta of
zero should be expected to earn:
a. a zero rate of return.
b. the market rate of return.
c. the risk-free rate of return.
d. higher rate of return
Answer: C
Chapter: 13
8. The existence of riskless lending and borrowing at the same rate and
Part 3 - 2 Copyright © 2014 John Wiley & Sons, Inc.

Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
homogeneous expectations means:

a. all investors hold the same portfolio of risky assets.
b. all investors will either borrow or lend.
c. all investors place at least some of their wealth in the riskless asset.
d. none of the above.
Answer: A
Chapter: 13
9. The standard CAPM implies:

a. investors are compensated for all risk they take.
b. investors are compensated for all market risk they take.
c. portfolio diversification does not matter.
d. high-return investments have higher variances than low-return investments.
Answer: B
Chapter: 13
For the following three questions, assume that: R m  15% , R A  13% , RF  5% ,  m  16% ,
the market portfolio is a tangency portfolio, and that A is an efficient portfolio on the
Capital Market Line.
10. What is the standard deviation of portfolio A?

a. 12.8%
b. 13.8%
c. 10.7%
d. 28.6%
Answer: A
Chapter: 13
11. What would be the expected rate of return of portfolio A if its standard deviation
was 32%?
a. 25%
b. 15%
c. 30%
d. 20%
Answer: A
Chapter: 13
12. What would be the expected return and standard deviation of a portfolio with
equal proportions invested in Treasury bills and the market portfolio?
a. 7.5%, 8%
b. 10%, 8%
c. 10%, 16%
Copyright © 2014 John Wiley & Sons, Inc. Part 3 - 3

d. 25%, 32%
Answer: B
Chapter: 13
13. Which statement of the following statements is true?

a. All portfolios that plot on the Security Market Line are efficient.
b. All portfolios that plot on the Security Market Line are inefficient.
c. Both efficient and inefficient portfolios plot on the Capital Market Line.
d. Only individual securities plot on the Capital Market Line.
Answer: A
Chapter: 13
14. In a CAPM framework, prohibiting short sales:

a. will prohibit investors from holding the market portfolio in equilibrium.
b. will make the security market line steeper.
c. will encourage investors to hold more riskless assets.
d. will not change the equilibrium.
Answer: D
Chapter: 14
15. In case of a simple CAPM being used to estimate a time series data:
a. the mean of a residual risk should be equal to zero.
b. the regression coefficient should be equal to zero.
c. the difference between the market return and the riskfree rate of return should
be equal to zero.
d. the beta of the portfolio should be equal to zero.
Answer: B
Chapter: 15
16. A long-short investment strategy is used in the case where the target is being
tracked vastly differs from a diversified market portfolio. In such a situation, a _____ model
is being used.
a. multi-index
b. single-index
c. multi-asset pricing
d. value at risk
Answer: A
Chapter: 16
17. What is the expected return on asset A if it has a beta of 0.6, the expected
market portfolio return is 15%, and the risk-free rate is 6%?
a. 12.4%
b. 11.4%
c. 11.8%

d. 10.2%
Answer: B
Chapter 13
True-False
1. Assume that the assumptions underlying the standard CAPM hold. Indicate
whether each of the following statements is true or false.
a. A firm with a high variance will have a higher beta than a firm with a low
variance.
b. A portfolio is efficient if it has no unsystematic risk.
c. A firm that is highly correlated with the market will have a higher beta than a
firm that is less correlated.
d. If the variance of the market portfolio goes up, the betas of all securities will go
down.
e. A well-managed firm will have a lower beta than a poorly managed firm.
f. The market portfolio is efficient. Therefore, it contains only the best stocks in the
market.
g. A risk-seeking investor should hold the riskiest stocks in the market, and a risk-
averse investor should hold the safest stocks.
h. If the riskless rate increases, the slope of the capital market line will decrease.
Answer:
a. False
b. True
c. False
d. False
e. False
f. False
g. False
h. True
Chapter: 13
True-False With Discussion
1. Discuss whether the following statement is true or false:

If there were no riskless assets in the economy, then there would be no security market
line.
Answer: False
The security market line describes the expected return for all assets and portfolios in the
economy. The expected return of an asset or a portfolio, whether efficient or not, can be
determined.
In a situation, where there is no lending or borrowing of riskfree securities, the security

market line will still hold existence. Here, the straight line will be described by any two
points. One convenient point is the market portfolio. A second convenient portfolio is

where the straight line cuts the vertical axis (where Beta equals zero).
The equation of the straight line will be Expected return  a  b (  ) and will hold for a
portfolio with zero Beta. R Z will be the expected return on this portfolio. Solving the
equation further, we will get the final equation for the expected return on any security or
 
portfolio as R i  R Z  R M  R Z  i .
Chapter: 14

Under the assumption of the standard CAPM, an investor who is very risk averse will only
invest in the riskless asset and risky assets with very low variances.
Answer: True
Low-beta stocks are a result of low standard deviation, which means a low risk of non
performance of an asset. Low risk of an asset gives lower returns on the asset due to the
linear correlation between a security or portfolio’s returns and Beta. Hence, an investor
who wishes to minimize default risk and is ready to get lower returns on his portfolio,
should predominantly buy low variance stocks.
Chapter: 13

If the post-tax form of the CAPM holds, then a tax-free institution should hold the market
portfolio.
Answer: True
If returns are determined by the equilibrium model as shown in the equation
E Ri   RF   i E RM   RF     M  RF     i  RF  , it should be possible to derive
optimal portfolios for any investor as a function of the tax rates paid on capital gains
and dividends. Individuals hold widely diversified portfolios that resemble the market
portfolio. However, since tax-free institutions have a competitive advantage when they
hold dividend stocks, their portfolios will resemble the market portfolio but will be tilted in
favor of dividends stocks.
Chapter: 14


Under the assumption of a CAPM with no riskless lending or borrowing, every investor
holds the same portfolio of risky assets.
Answer: True
In a situation where there is no riskless lending or borrowing, and all investors have
homogeneous expectations, they must all face the same efficient frontier. In equilibrium,
if securities or portfolios happened to lie on a straight line in expected return Beta space,
all combinations of securities or portfolios would lie on the same line. Hence, all investors
will hold the same portfolio of risky assets.
Chapter: 14

A very risk-averse investor should buy predominantly low-beta stocks.
Answer: False
A very risk-averse investor will buy low-beta stocks as well as stocks which are risk free in
nature. It is always desired to have a portfolio which is diversified and not leaning on
either of the sides.
Chapter: 13

It is possible for a stock to have an expected rate of return that is negative.
Answer: True
In a situation where the Beta of a stock is negative, it means that the market and the
stock prices are having a negative correlation. This implies that when the markets rate
increases, the stock rate moves down leading to a negative rate of return for a particular
period. Usually, this occurs when the stock has a high degree of negative correlation.
Chapter: 13
Problems
For questions 1-3 use the information from the following table
Security Return Standard Deviation Beta

A 16% 20% 1.2
B 12% 25% 0.8
Risk-free asset 4% ??? ???
1. Which of A and B has the least total risk? Which of A and B has the least
systematic risk?
Answer: A has least total risk; B has least systematic risk

Chapter 13

2. What is the value of systematic risk for a portfolio with 2/3 of

the funds invested in A and 1/3 of the funds invested in B?
Answer:
2 1
p   A   B  1.067
3 3
Chapter 13
3. What is the portfolio expected return and the portfolio beta if

you invest 35% in A, 45% in B and 20% in the risk-free asset?
Answer:
E P  0.35 * E A  0.45 * E B  0.20 * E rf  0.35 * 0.16  0.45 * 0.12  0.20 * 0.04  0.118  11.8%
 P  0.35 *  A  0.45 *  B  0.20 *  rf  0.35 *1.2  0.45 * 0.8  0.20 * 0.0  0.78
Chapter 13
4. You use the single-factor model Rit   i   i Rm t  eit and have obtained the
following estimates for stock A and stock B:
Stock   e
A 2% 1.3 30%
B 10% 1.2 40%
You also estimate that the expected return on the market portfolio is 16%, the standard
deviation of the market portfolio is 20%, and the riskless rate is 8%.
a. Based on the single-factor model, what are the expected returns and
standard deviations of stock A and stock B?
b. Based on the single-factor model, the Security Market Line, and the Capital
Market Line, state whether each of the following statements is completely
true, completely false, or uncertain. Explain your answers.
1) In any given year, stock B is certain to outperform stock A.
2) An investor would consider stock B to be riskier than stock A.
3) Stock A is undervalued.
4) If an investor had to select one investment to combine with the
riskless asset, the investor would prefer stock A to the market
portfolio.
Answer:
a. Based on the information given, the expected returns and the standard deviations
using the single-factor model for stock A and stock B are calculated as follows:

Ri  i   i R m
RA  2  1.3 16  22.80%
RB 10  1.2 16  29.20%
 i 2   i 2  m 2   ei 2
A  1.3   20  30

2 2 2
= 39.70%
B  1.2  20  40
2 2 2
= 46.65%
b.
Based on the single-factor model, the expected returns for stocks A and B are 22.8%
and 29.2% respectively.
Based on the security market line, the expected return on stocks A and B are:
Ri  RF   ( RM  RF )
RA  8  1.3(16  8)  18.40%
RB  8  1.2(16  8)  17.60%
Based on the capital market line, expected return on stocks A and B are:
RM  RF
Ri  RF  ( ) i
M
 16  8 
RA  8     39.70  23.88%
 20 
 16  8 
RB  8     46.65  26.66%
 20 
As per single-factor model:
1) False. Both stocks have different unsystematic returns. In the given scenario, the
unsystematic returns of stock B is higher than stock A. Therefore, stock B's returns are
higher. However, in a given period when stock A has higher unsystematic returns than B,
stock A will outperform B.
2) True. Stock B riskier compared to stock B as its standard deviation is higher.
3) False. Rate of return per unit of risk for stock A is lower than market. Therefore, stock A is
overvalued.
4) False. Stock A is overvalued as its rate of return per unit of risk is lower. Therefore, an
investor will benefit from buying the market portfolio.
As per security market line:

1) False. In the given scenario, stock B returns are lower than that of stock A.
2) False. Stock A riskier compared to stock B as it has a higher Beta.

3) Uncertain. We have computed the expected returns based on the SML equation.
However, it is not clearly indicated that the stock lies on the SML line. Therefore, we
cannot determine whether stock A is undervalued.
4) Uncertain. As stock A’s returns are positively correlated with the market returns, the
answer to this will depend on the amount of risk an investor is willing to take.
As per capital market line:

1) False. Both stocks have different standard deviations. In the given scenario, standard
deviation of stock B is higher than stock A. Therefore, stock B's returns are higher.
However, in a given period when stock A has higher standard deviation than B, stock A
will outperform B.
2) True, stock B has higher risk compared to Stock A as its standard deviation is higher
than A.
3) False. Rate of return per unit of risk for stock A is lower than market. Therefore, stock A is
overvalued.
4) False. Stock A is overvalued as its rate of return per unit of risk is lower. Therefore, an
investor will benefit from buying the market portfolio.
Chapter: 13
5. Consider the following data for assets A and B:

R A  12% ; R B  8% ;  A  10% ;  B  4% ;  AB  1.0
a. If only assets A and B are available, draw the efficient frontier.
b. If the riskless lending and borrowing rate is 10%, why is this a disequilibrium
situation and what is the arbitrage that will restore equilibrium?
Answer:
a. If only assets A and B are available, and both the assets have a perfect negative
correlation, the standard deviation of the portfolio will plot a straight line. Thus, a review of
the return on the portfolio of two assets as a function of the standard deviation will yield
two straight lines on the graph. The risk on portfolio of assets is always smaller when the
correlation coefficient is -1 than when it is +1. Hence, when two assets A and B are
perfectly negatively correlated, it is always possible for a combination of these two assets
to have a zero risk. Hence, we can draw an efficient frontier in the following way:

b. According to the CAPM model, the relationship between the expected return on any
two assets can be related simply to their difference in Beta. The higher the Beta for any
security, the higher must be its equilibrium return. In our situation, introducing a riskless
security offering a 10% return induces arbitrage opportunities as there is another risk-
bearing security, but with a lower return. In such a case, investors will follow the arbitrage
process and start short-selling asset B which offers an 8% return, and start buying the
riskfree asset, till the time when both the securities come under equilibrium on the security
market line.
Chapter: 13
6. If one accepts the Sharpe single-index model, and the simple form of the CAPM
holds, what is  i (the intercept term in the Sharpe single-index model) equal to?
Answer:
The Sharpe single-index model holds the equation of return on a security to be
 
as Ri  R f  ai  i R m  R f . Here, ai represents that component of return which is
independent to the return on market. Further, ai is broken into two parts ( ai   i  ei ),
wherein,  i denotes the expected value of ai and ei represents the uncertain amount of
ai , which has an expected value of zero.
As per CAPM, the equilibrium return of a security can be determined using the following
equation: R i  RF   i ( R M  RF ) .
If we assume that the CAPM holds, we can compare the two equations to determine
that Ri  R f  Ri   i  R f . This can be rewritten as R f  R f  i or  i  0 .
Chapter: 13

7. Consider the following data for stocks A and B:

R A  10% ; R B  19% ;  A  3% ;  B  5% ;  A  0.6 ;  B  1.4 ;  AB  0.4
a. Calculate the expected return, variance, and beta of a portfolio
constructed by investing 1/3 of your funds in stock A and 2/3 in stock B.
b. If the riskless rate of return were 5%, what percentage of money invested in
risky stocks should an investor place in each stock (assuming A and B are
the only risky assets available)?
c. If the security market line describes equilibrium, and stocks A and B are in
equilibrium, what is the return on the market portfolio and the riskless rate of
interest?
d. If an investor can lend and borrow at the riskless rate determined in part c,
but is restricted to holding only one of the two risky stocks in this problem,
which stock should be held?
Answer:
a. Expected Return:
R P  X R A  (1  X ) R B
1 2
R P  10  19
3 3
=16%
Beta of the portfolio:

 P  X A  (1  X ) B
1 2
 P   0.6  1.4
3 3
=1.13
Variance of the portfolio:

 p2  X a2 a2  X b2 b2  2 X 1 X 2 cov12
  1  2 2    2  2 2    1 2 
      3       5     2    0.4 3  5
2
p 
  3    
  3     3 3 
= 14.78%
b. If the riskless rate of return were 5%, the percentage of money invested in risky stocks
can be calculated as follows:
R A  RF  Z A A2  Z B AB
10  5  Z A 9  Z B 0.4  5  3
5 = 9 Z A + 6 Z B …. (1)

R B  RF  Z A AB  Z B B2
19  5  Z A 0.4  3  5  Z B 25
14 = 6 Z A + 25 Z B …. (2)
Solving equation (1) and (2), we get,
Z A  0.2169 and Z B  0.5079
Thus, the proportion to invest in each security is:
X A  30% and X B  70%
c. The security market line equation for security A is R A  RF   A ( R M  RF ) and for

security B is R B  RF   B ( R M  RF ) . Substituting the values given in the problem, we get,
10  RF  0.6 ( R M  RF ) and 19  RF 1.4 ( R M  RF ) .
From the above given equations, we get the value of market premium ( R M  RF ) of
11.25%. Substituting the value of market premium in the equation, we get the value of
risk free rate of return ( RF ) as 3.25% and the return on market portfolio ( R M ) as 14.5%.
d. We can determine the stock to be held by comparing the excess of returns to the risk
taken. Excess of returns can be calculated by:
( R i  RF )
i
Stock B gives a higher excess return to standard deviation of 3.15, as compared to 2.25 of
stock A. Hence, the investor should hold stock B.
Chapter: 13
8. Consider the following data for Dodger Corp. and the S&P 500:
Year Dodger Corp. Price S&P 500 Level

1979 40.00 150.00
1980 36.00 150.00
1981 34.20 145.50
1982 20.52 160.05
1983 22.57 163.25
1984 22.34 159.99
a. What is your estimate of beta for Dodger Corp.?

b. What portion of the firm's total variance is systematic, and what portion is

unsystematic?
c. What is the required rate of return for Dodger Corp. if the riskless rate is 7%
and the market risk premium is 8%?
Answer:
Ri = Ending value - Beginning value
Beginning Value
Yi A and the return on market = YM

Ri  1 RM  1
Pi PM
a.
Deviations Deviations
Dodger S&P Yi from from
YM
Corp. 500 Ri  1 RM  1 Average Average Stock Market
Year Price Level Pi PM (Dodger) (Market) Variance Variance Covariance
1979 40 150
1980 36 150 -10% 0% -0.79% -1.40% 0.0063% 0.01961% 0.01112%
1981 34.2 145.5 -5% -3% 4.21% -4.40% 0.1769% 0.19364% -0.18507%
1982 20.52 160.05 -40% 10% -30.79% 8.60% 9.4829% 0.73952% -2.64815%
1983 22.57 163.25 10% 2% 19.20% 0.60% 3.6849% 0.00359% 0.11496%
1984 22.34 159.99 -1% -2% 8.19% -3.40% 0.6702% 0.11542% -0.27814%
Average 3.50528% 0.26795% -0.74632%
a. The estimated Beta of the firm is equal to covariance (stock and market) ÷ market
variance. Hence, the Beta is = -2.78534.
b. To find the value of the firm’s systematic and unsystematic variance, we use the
following equation:
 i2  i2 m2   ei2
 i2 m2   2.78534 2  0.26795  2.07875
As 2.07875% is the systematic variance, the unsystematic variance can be found by the
following equation:
 ei2   i2  i2 m2
 ei2  3.50528  2.07875 1.42653
c. The expected rate of return on Dodger’s stock is:

Ri  RF  i ( R M  RF )
=7% + -2.78534(8%)
=-15.28%

Chapter: 13
9. An efficient portfolio has an expected return of 20%. The riskless rate is 5%, the
return on the market portfolio is 15%, and the standard deviation of the market portfolio is
20%. What is the efficient portfolio's beta, standard deviation, and correlation coefficient
with the market portfolio?
Answer:
From the given information, we are able to find the following values:
Beta of the efficient portfolio is:
R P  RF   P ( R M  RF )
20  5   P (15  5)
Hence, the security’s Beta is1.5.
For an efficient portfolio, the return on the portfolio can be found using the following
equation:
R M  RF
R e  RF  e
M
Here,  e is the standard deviation of the efficient portfolio.
Hence,  e 
20  5 20  30
15  5
To determine the correlation coefficient, we use the following formula:
 im 
Cov (im)
 (i )  (m)
Cov (im)    M2 1.5  400  600

Hence,
 im 
600
1
30  20
Chapter: 13
10. You believe that Beta Alpha Watch Company will be worth $100 per share one
year from now. How much are you willing to pay for one share today if the riskless rate is
8%, the expected return on the market is 18%, and the company's beta is 2?
Answer:
As the riskless rate, expected rate of return on market, and the company’s beta have
been provided, we can calculate the expected return on the firm’s security.
Ri  RF   ( RM  RF )

Ri  8  2 18  8  28%
We have been given the share price one year from now as $100.
Based on the security’s rate of return, we calculate a present value per share to be
$78.125 [$100/(1+0.28)1].
Chapter: 13
11. Consider the following data:
ABC XYZ Market

Price $20 $50 -
Dividend $0.40 $2 6%
Beta 1.5 1.0 1.0
Alpha -1.0% 2.0% -
The riskless rate is 10%, and the expected return on the market is 20%. Your portfolio
consists of 50,000 shares of ABC and 10,000 shares of XYZ.
a. Give the values of the following statistics for your portfolio: dividend yield;
expected prices for ABC and XYZ in one year; beta; and alpha.
b. Suppose you are in the 40% effective marginal tax bracket and you plan to
hold your portfolio more than one year. What is the expected after-tax
return on your portfolio? What is the expected after-tax return on the
market portfolio?
Answer:
a.
Dividend for period
Dividend yield =
Initial price for the period
0.40
Dividend yield of ABC stock is =  2%
20
2
And, dividend yield of XYZ stock is =  4%
50
2  1 
Hence, dividend yield on the portfolio =   2%     4%   2.67%
3  3 
Expected prices for ABC and XYZ in one year can be determined as follows:
The expected return on ABC shares is:

R ABC  RF   ABC ( R M  RF )
R ABC 10  1.5 (20 10)  25%

Assuming expected price as X, we get the following equation:
((X - 20) + 2)/20 = 0.25
Solving the equation, we get the expected price of ABC shares one year from now as
$23.

Similarly, we can determine expected price of XYZ shares as:
R XYZ  RF   XYZ ( R M  RF )
R XYZ 10 1(20 10)  20%
The expected price of the share XYZ is:

((X - 50) + 2)/20 = 0.20
Hence, the expected price of the share XYZ = $58
Also, the return on the total portfolio is determined as:

R P  X ABC R ABC  X XYZ R XYZ
2 1
R P   25   20  23.33%
3 3
Beta of the portfolio:

 P  X  ABC  1  X   XYZ
 P  X  ABC  1  X   XYZ
2 1
 P  1.5  1  1.33
3 3
Alpha of the portfolio:

N
 P   X i i
i 1
2 1
 P   1   2  0
3 3
b. The expected after-tax return on a portfolio is:
E Ri   RF   i E RM   RF     M  RF    i  RF 
E R ABC  RF   ABC E RM   RF    M  RF    ABC  RF 
E RABC  10  1.520  10  0.406 10  0.402 10  24.2%

E R XYZ   RF   XYZ E RM   RF     M  RF     XYZ  RF 
ERXYZ 10 120  10 0.406 10  0.404 1019.2%

R P  X ABC R ABC  X XYZ R XYZ
Hence, the after tax return on investor’s portfolio =

2 1
R P   27.4  19.2  24.667%
3 3
The expected after tax return on market portfolio=
RF   M ERM   RF     M  RF    M  RF 
Therefore, the expected after tax return on market portfolio will remain 20%
Chapter: 14
12. The expected return on the market portfolio is 20% and the riskless rate is 10%. XYZ
gold mining has a beta of -0.2. What is the expected return on a short sale of 100 shares
of XYZ, assuming you can get the proceeds of your short sale? What if you can't?
Answer:
The expected return on stock XYZ will be determined as follows:
R XYZ  RF   XYZ ( R M  RF )
R XYZ  10  0.2(20  10)
R XYZ = 8%.
The expected return on the security XYZ is lower than both the market portfolio and the
riskless rate of return. If an investor gets the proceeds from short selling 100 shares of
security XYZ, he can either invest in the market portfolio or at the riskless rate of return to
benefit from the short sale.
If the investor invests the proceeds in the market portfolio, the expected return would be
20%. Thus, the effective return from a short sale would be 12% (20% - 8%).
If the investor invests the proceeds in the risk free asset, the expected return would be
10%. Thus, the effective return from a short sale would be 2% (10% - 8%).
However, if the proceeds cannot be received, the return on the short sale will solely
depend on price movement. If all expectations actualize, the effective return in this
case will be -8%.
Chapter: 13
13. Consider the following data for funds A, B, C, and D:

R A  20% ; R B  15% ; R C  10% ; R D  18% ;  A  1.5 ;  B  1.0 ;  C  0.8 ;  D  1.2 .
Assume that the zero-beta form of the CAPM is a reasonable description of reality and
that funds A and B are accurately priced. Which funds' returns are not in equilibrium and
by how much? What is the arbitrage that would restore equilibrium?
Answer:
Assuming the zero-beta model, we get the rates of riskfree assets and the market
premium with the help of the equation Ri  RZ  ( Rm  RZ )  i . Substituting the values of

both the securities A and B in equilibrium, we get the value of RZ as 5% and market
premium as 10%.
On the basis of these values, we get the expected return on stock C under equilibrium as:
Ri  5  10  0.8 =13%. The return on stock C currently is 10%.
Similarly, we calculate the expected return on stock D by Ri  5  10  1.2  =17%. The
current rate of return on stock D is 18%.
Security C is expected to provide a higher return than the current projections, whereas to
Security D is expected to provide a lower return than the current projections. Therefore, to
restore the equilibrium, investors must hold a long position in D and a short position in C.
Chapter: 14
14. Plot the standard CAPM and the zero-beta CAPM on the same diagram. Be sure
to label all points.
Answer:
R
RF  R Z
M is the market portfolio having a Beta of 1. In case of a simple CAPM, RF is the point
where the security market line cuts the vertical axis (where Beta equals zero). In case of a
zero-beta CAPM, the riskless lending or borrowing activity is discontinued. R Z is assumed
to be the intersection of the vertical axis and the zero-Beta capital asset pricing line.
Hence, the point which intersects the vertical line in both the models is the same and has
a Beta of zero.
Chapter: 14
15. Consider the following data for securities A and B:

R A  20% ; R B  10% ;  A  1.5 ;  B  0.5 .
Assume that the zero-beta CAPM holds and that all securities are in equilibrium. Plot the
Security Market Line. Be sure to label all points.
Answer:
To develop a security market line where the zero-beta CAPM holds and all securities are
in equilibrium, all securities contained in M (the market portfolio) must have an expected
 
return given by R j  R Z   j R M  R Z . All portfolios composed solely of risky assets have

returns from the above mentioned equation. The line R Z BMA is the line that defines the
equation. This equation holds only for risky assets and for portfolios of risky assets.
RA A
M
RM
B
RB
RZ
0.5 1 1.5
Chapter: 14
Essays
1. Discuss the two mutual fund theorem. Show why it arises. (A diagram may help.)
Answer:
For investors to hold a very well diversified portfolio, they will have to perform riskless
borrowing and lending as well as invest in risky assets.
If all investors have consistent expectations of lending and borrowing and they face the
same lending and borrowing rate, then they will face a situation, wherein portfolio of risky
assets, Pi , held by one investor will be identical to the portfolio of risky assets held by any
other investor. If all investors hold the same risky portfolio, then, in equilibrium, it must be
the market portfolio. The market portfolio is a portfolio that comprises all risky assets
available. The proportion of each asset held in an investor's portfolio is same as the
proportion represented by the market value of the asset as compared to total market
value of all risky assets.
The portfolio of risky assets that any investor holds can be identified without regard to the
investor’s risk preferences. This portfolio lies at the tangency point between the original
efficient frontier of risky assets and a ray passing through the riskless return. This can be
depicted from the diagram shown below. This is depicted in the diagram where
Pi denotes investor ( i' s ) portfolio of risky assets. The investors satisfy their risk preferences
by combining portfolio Pi with riskless lending or borrowing. Hence, all investors will hold a
portfolio along the line connecting RF with Pi in the expected return standard deviation
spaces as depicted in the following figure:

Thus, the two mutual fund theorem states that all investors can construct an optimum
portfolio by combining a market fund with riskless lending or borrowing.
Chapter: 13
2. You have been hired as a consultant to advise a client on an appropriate

measure of risk to use in judging the client's stock investments. What do you tell your client
and why?
Answer:
Risk is the uncertainty of returns, or more specifically, the probability of loss on any
investment. Standard deviation and beta are two of the most commonly used variables
to measure risk. While standard deviation measures the historical volatility in the returns of
an asset, beta is more specific, and reflects the returns affected by the over-all
movement of the markets.
If the client’s portfolio is relatively diversified, majority of the risk in the portfolio will be
systematic (since diversification will minimize unsystematic risk). A good measure of risk in
this case would be to check for the excess returns over a benchmark, typically a risk-free
rate, generated for each unit of market risk (beta). Beta being the index of systematic
risk, the expected return on any two assets can be related to their difference in Beta. The
higher the Beta, the higher is the return on securities.
On the contrary, if the portfolio is concentrated, use of standard deviation to calculate

excess returns per unit of risk would give a better picture, since standard deviation also
captures the stock specific (unsystematic) risk in the portfolio.
Chapter: 13
3. Explain the essential features of the following three lines: the Security Market Line,
and the Capital Market Line. How is each used in discussions of security price behavior?
Suppose you know that portfolio P is an efficient portfolio. What does this tell you about its

position with respect to each of the lines?

Answer:
Capital Market Line: All investors hold combinations of two portfolios. They are the risky
assets in the market portfolio and a riskless security which are depicted using a single line.
This has been explained with the help of a diagram given below:
The straight line in the diagram is called the Capital Market Line (CML). All efficient
portfolios lie along the capital market line. However, not all securities or portfolios lie along
the capital market line. In fact, all portfolios of risky and riskless assets, except those that
are efficient, lie below the capital market line.
By analyzing the CML, we can learn about a portfolio’s market price of risk through the
 RM  R F 
equation Re  R F     e . Here, the market price of risk for all efficient portfolios is
 M 
RM  R F
denoted by . It is the extra return that can be gained by increasing the level of
M
risk (standard deviation) on an efficient portfolio by one unit. The expected return on an
efficient portfolio is: Expected return = Price of time + (Price of risk × Amount of risk).
Hence, a portfolio P, which is an efficient portfolio, will lie at the tangency point between
the original efficient frontier of risky assets and a ray passing through the riskless return on
the vertical axis along the Capital Market Line.
Security Market Line: In a graph, where the points of market portfolio (M) with a Beta of 1
and an intercept with a Beta of 0 are given, and when a line passes through both the
points, the line is called the Security Market Line (SML). The SML describes the expected
return for all assets and portfolios of assets in the economy. The expected return on any
asset, or portfolio, whether it is efficient or not, can be determined from the equation
Ri  RF   i ( RM  RF ) of SML. The relationship between the expected return on any two
assets can be related simply to their difference in Beta.

The higher Beta is for any security, the higher must be its equilibrium return. Furthermore,
the relationship between Beta and expected return is linear. The expected return on any
security is the riskless rate of interest plus the market price of risk times the amount of risk in
the security or portfolio.
It takes only two points to identify the security market line. Point M with a Beta of 1 and an
expected return of RM represents the market portfolio. The second point is the intercept
that occurs when the Beta is zero represented by RF . Therefore, if we assume that
portfolio P is efficient, it will lie along the straight line M and RF .
Chapter: 13
4. Explain how the zero Beta version of CAPM is derived.

Answer:
The second assumption of the CAPM is that investors can lend and borrow unlimited sums
of money at the riskless rate of interest. In the absence of such a situation, which is more
representative of the real world, an alternative capital asset pricing model is required.
The systematic risk (Beta) of a portfolio is an appropriate measure of risk in case of a large
diversified portfolio. This is because the unsystematic risk of a large diversified portfolio is
essentially zero. Thus, even if an individual asset had a great deal of unsystematic risk, it
would have little impact on portfolio risk and, therefore, unsystematic risk would not
require a higher return.
If securities or portfolios happen to lie on a straight line in expected return Beta space, all
combinations of securities or portfolios would lie on the straight line. A straight line can be
described by any two points. One convenient point is the market portfolio with a Beta of
1. The second convenient point is where the straight line cuts the vertical axis, where the
Beta equals zero. The equation of the straight line is:
Expected return = a  b (Beta)
For a portfolio with zero Beta, letting R Z be the expected return on a portfolio, we get,
R Z  a  b(0) or R Z  a

The equation must also hold for the market portfolio. If R M is the expected return on the
market and, recalling that the Beta for the market portfolio is one, we have
R M  R Z  b(1) or b  R M  R Z .
Putting the two equations together and letting R i be the expected return and i be the

Beta on an asset or portfolio, the equation for the expected return on any security or
portfolio becomes:
 
Ri  R Z  R M  R Z i
This is called the zero-Beta version of CAPM where there is no riskless lending or borrowing.
A graph depicting this model is plotted below.
Chapter: 14
5. Discuss possible bias inherent in estimating the true Beta value according to Lintner
and Douglas. What are the findings of Miller and Scholes on the basis of this evaluation?
Answer:
According to Miller and Scholes, during the CAPM equation estimation, if returns are
really generated by the simple form of the CAPM, then the time series equation used to
estimate Beta should be consistent with the CAPM. The CAPM in time series form
 
is Rit  1   i RFt   i RMt  RFt . But the market model equation for the CAPM used by
~ ~
~
Lintner and Douglas is Rit   i   i R M t . If RF is a constant over the estimation period, it is
not a problem. The estimate of  i should be equal to 1   i RFt . However, if RFt
fluctuates over time and if it is correlated with R M t , there will be a case of missing variable
bias and  i will be a biased estimate of the true  i .
Miller and Scholes prove that if RFt and RM t are negatively correlated, then this will have
the effect of biasing the intercept of the second-pass regression upward and its slope
downward and this could, in part, explain the inconsistencies found by Lintner and

Douglas. Miller and Scholes examine historical data and find a negative correlation. This is
not surprising, for the stock market usually declines when interest rates go up. They test for
the importance of this in explaining the Lintner findings.
Although they find the influence is in the correct direction, the order of magnitude of the
bias is so small that it would have negligible effects on the results.
Chapter: 15
6. Consider the following multi-index model: Rit  RFt   i1 I1t   i 2 I 2t  ...   i j I jt  eit
where:
Rit is the return on asset i in period t
RFt is the risk-free rate in period t
 i j is the sensitivity of asset i to factor j
I jt is the value of factor j in period t
eit is a random error term for asset i in period t
a. Assuming the APT holds, what is the expression for the expected return of
asset i?
b. How can the APT be used in decision making?
c. Outline, in list form, the assumptions underlying the APT.
Answer:
Arbitrage pricing theory (APT) is a new and different approach to determining asset
prices. It is based on the law of one price which means that two items that are the same
can’t sell at different prices.
From APT model, we can derive that pricing can be affected by influences beyond
simple averages and variances.
a. A two-index model describes returns as: Ri  ai  bi1I1  bi 2 I 2  ei . The only terms in the
equation that affect the systematic risk in a portfolio are bi1 and bi 2 , as the residual risk
tends to be zero.
The general equation of a plane, where all the investments and portfolios lie, in expected
return, bi1 , and bi 2 space, for a well diversified portfolio is: Ri  0  1bi1  2bi 2 . 1 is the
increase in expected return for a one-unit increase in bi1 .Thus 1 and 2 are returns for
bearing the risks associated with I1 and I 2 for each unit of bi1 and bi 2 respectively.
If we assume a portfolio with bi1 and bi 2 both equal to zero, the expected return on this
portfolio equals 0 . This is a zero- bij portfolio, and we denote its return as RF .
Substituting RF for 0 and examining a portfolio with a bi 2 of zero and a bi1 of one, we
see that, 1  R1  RF . Here, R1 is the return on a portfolio having a bi1 of one and a bi 2 of

zero. In general, i  R j  RF or  j is the expected excess return on a portfolio only subject

to risk of index j and having a unit measure of this risk.
The analysis in this section can be generalized to the J index case as:
Ri  ai  bi1 I1  bi 2 I 2  ...  biJ I J  ei
By such analogous arguments it can be shown that all securities and portfolios have
expected returns described by the APT model:
Ri  0  1bi1  2bi 2  ...  J biJ .
b. The APT model, allows us to recognize the importance of multiple factors in

determining the expected excess return on a specific index, any specific security, or a
portfolio. APT, if implemented properly, could be a useful tool in determining the factors
other than market which affect the price of the security. This model can also be used to
explain relative prices of different securities operating in the same industry and markets.
With respect to portfolio management, this model can help managers decompose the
factors affecting the returns of the securities to identify mispriced securities. Passive
managers believe that mispriced securities can’t be identified and thus try to hold a
portfolio that mimics some set of stocks. The most common way passive management is
practiced is to hold a portfolio of stocks that closely tracks a selected index. Active
management, on the contrary, involves making bets about some securities or set of
securities in the sense of designing a portfolio based on a belief that one or more
securities are mispriced.
c. Assumptions underlying the APT are as follows:
APT holds the assumption of homogeneous expectations.

The assumption of process generating security returns is followed in this model.
The APT also requires that the returns on any stock to be linearly related to a set of
indexes.
Chapter: 16
7. List set of equity and fixed income factors that were shown to have generated
historical premia. Define the value factor and its economic interpretation.
Answer
The following are the factors:
1. Term Structure Factor
2. Credit Risk Factor
3. Foreign Exchange Carry
4. Value Factor
5. Size Factor
6. Momentum Factor
7. Volatility Factor
8. Liquidity Factor
9. Inflation Factor

10. GDP Factor

11. Equity Risk Premium Factor
Value factor is constructed from a long position in stocks with a high book-to-market
ratio and a short position in stocks with an unusually low book-to-market ratio. One
economic interpretation of the value factor is that it represents compensation for firm
distress, since high book-to-market value reflect low market price. Other economic
interpretations are that it compensates for low growth opportunities by inflexible firms
with assets in place during periods of distress or time varying sensitivities of value stocks
that manifest themselves as changing betas in macroeconomic states. The
behavioral explanation for the value premium is over extrapolation of past growth
rates into the future.
Chapter 16

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“How do you feel this morning?” I asked solicitously of Frau von
Eckthum on meeting her a moment alone behind her larder; I hoped she, at
least, had not been working too hard.
“Oh, very well,” said she.
“Not too weary?”
“Not weary at all.”
“Ah—youth, youth,” said I, shaking my head playfully, for indeed she
looked singularly attractive that morning.
She smiled, and mounting the steps into her caravan began to do things
with a duster and to sing.
For a moment I wondered whether she too had been made brisk by early
contact with the Medway (of course in some remoter pool or bay), so
unusual in her was this flow of language; but the idea of such delicacy being
enveloped and perhaps buffeted by that rude volume of muddy water was, I
felt, an impossible one. Still, why should she feel brisk? Had she not walked
the day before the entire distance in the dust? Was it possible that she too, in
spite of her poetic exterior, was really inwardly leathery? I have my ideals
about women, and believe there is much of the poet concealed somewhere
about me; and there is a moonlight intangibleness about this lady, an
etherealism amounting at times almost to indistinctness, that made the
application to her of such an adjective as leathery one from which I shrank.
Yet if she were not, how could she—but I put these thoughts resolutely
aside, and began to prepare for our departure, moving about mechanically as
one in a bleak and chilly dream.
That is a hideous bridge, that one the English have built themselves
across the Medway. A great gray-painted iron structure, with the dusty
highroad running over it and the dirty river running under it. I hope never to
see it again, unless officially at the head of my battalion. On the other side
was a place called Paddock Wood, also, it seemed to me, a dreary thing as I
walked through it that morning at my horse’s side. The sun came out just
there, and the wind with its consequent dust increased. What an August,
thought I; what a climate; what a place. An August and a climate and a place
only to be found in the British Isles. In Storchwerder at that moment a
proper harvest mellowness prevailed. No doubt also in Switzerland, whither
we so nearly went, and certainly in Italy. Was this a reasonable way of
celebrating one’s silver wedding, plodding through Paddock Wood with no
one taking any notice of me, not even she who was the lawful partner of the
celebration? The only answer I got as I put the question to myself was a
mouthful of dust.
Nobody came to walk with me, and unless some one did my position was
a very isolated one, wedged in between the Ailsa and the Ilsa, unable to
leave the Elsa, who, like a wife, immediately strayed from the proper road if
I did. The back of the Ailsa prevented my seeing who was with whom in
front, but once at a sharp turning I did see, and what I saw was Frau von
Eckthum walking with Jellaby, and Edelgard—if you please—on his other
side. The young Socialist was slouching along with his hands in his pockets
and his bony shoulders up to his ears listening, apparently, to Frau von
Eckthum who actually seemed to be talking, for he kept on looking at her,
and laughing as though at the things she said. Edelgard, I noticed, joined in
the laughter as unconcernedly as if she had nothing in the world to reproach
herself with. Then the Elsa followed round the corner and the scene in front
was blotted out; but glancing back over my shoulder I saw how respectably
Lord Sigismund, true to his lineage, remained by the Ilsa’s horse’s head,
reflectively smoking his pipe and accompanied only by his dog.
Beyond Paddock Wood and its flat and dreary purlieus the road began to
ascend and to wind, growing narrower and less draughty, with glimpses of a
greener country and a hillier distance, in fact improving visibly as we neared
Sussex. All this time I had walked by myself, and I was still too tired after
the long march the day before to have any but dull objections. It would have
been natural to be acutely indignant at Edelgard’s persistent defiance, natural
to be infuriated at the cleverness with which she shifted the entire charge of
our caravan on to me while she, on the horizon, gesticulated with Jellaby. I
realized, it is true, that the others would not have let her lead the horse even
had she offered to, but she ought at least to have walked beside me and hear
me, if that were my mood, grumble. However, a reasonable man knows how
to wait. He does not, not being a woman, hasten and perhaps spoil a crisis by
rushing at it. And if no opportunity should present itself for weeks, would
there not be years in our flat in Storchwerder consisting solely of
opportunities?
Besides, my feet ached. I think there must have been some clumsy
darning of Edelgard’s in my socks that pressed on my toes and made them
feel as if the shoes were too short for them. And small stones kept on getting
inside them, finding out the one place they could get in at and leaping
through it with the greatest dexterity, dropping gradually by unpleasant
stages down to underneath my socks, where they remained causing me
discomfort till the next camp. These physical conditions, to which the
endless mechanical trudging behind the Ailsa’s varnished back must be
added, reduced me as I said before to a condition of dull and bovine
acquiescence. I ceased to make objections. I hardly thought. I just trudged.
At the top of the ascent, at a junction of four roads called Four Winds
(why, when they were four roads, the English themselves I suppose best
know), we met a motor.
It came scorching round a corner with an insolent shriek of its tooting
apparatus, but the shriek died away as it were on its lips when it saw what
was filling up the way. It hesitated, stopped, and then began respectfully to
back. Pass us it could not at that point, and charge into such vast objects as
the caravans was a task before which even bloodthirstiness quailed. I record
this as the one pleasing incident that morning, and when it was my turn to
walk by the thing I did so with squared shoulders and held-up head and a
muttered (yet perfectly distinct) “Road hogs”—which is the term Menzies-
Legh had applied to them the day before when relating how one had run over
a woman near where he lives, and had continued its career, leaving her to
suffer in the road, which she did for the space of two hours before the next
passer-by passed in time to see her die. And she was a quite young woman,
and a pretty one into the bargain.
(“I don’t see what that has to do with it,” said the foolish Jellaby when, in
answer to my questions, I extracted this information from Menzies-Legh.)
Therefore, remembering this shocking affair, and being as well a great
personal detester of these conveyances, the property invariably of the
insolent rich, who with us are chiefly Jews, I took care to be distinct as I
muttered “Road hogs.” The two occupants in goggles undoubtedly heard me,
for they started and even their goggles seemed to shrink back and be
ashamed of themselves, and I continued my way with a slight reviving of my
spirits, the slight reviving of which he is generally conscious who has had
the courage to say what he thinks of a bad thing.
The post whose finger we were following had Dundale inscribed on it,
and as we wound downward the scenery considerably improved. Woods on
our left sheltered us from the wind, and on our right were a number of pretty
hills. At the bottom—a bottom only reached after care and exertion, for
loose stones imperilled the safety of my horse’s knees, and I had besides to
spring about applying and regulating the brake—we found a farm with a
hop-kiln in the hollow on the left, and opposite it a convenient, indeed
attractive, field.
No other house was near. No populace. No iron bridge. No donkeys. No
barrel-organ. Stretches of corn, so ripe that though the sky had clouded over
they looked as if the sun were shining on them, alternated very pleasantly
with the green of the hop-fields, and portions of woods climbed up between
the folds of the hills. It was a sheltered spot, with a farm capable no doubt of
supplying food, but I feared that because it was only one o’clock my
pedantic companions, in defiance of the previous day’s experience, would
decline to camp. Taking therefore the law into my own hands I pulled up my
caravan in front of the farm gate. The Ilsa behind me was forced to pull up
too; and the Ailsa, in the very act of lumbering round the next corner, was
arrested by my loud and masterful Brrr.
“Anything wrong?” asked Lord Sigismund, running up from the back.
“What is it?” asked Menzies-Legh, coming toward me from the front.
Strange to say they listened to reason; and yet not strange, for I have
observed that whenever one makes up one’s mind beforehand and
unshakably other people give in. One must know what one wants—that is
the whole secret; and in a world of flux and shilly-shally the infrequent rock
is the only person who really gets it.
Jellaby (who seemed to think he was irresistible) volunteered to go to the
farmer and get permission to camp in the field, and I was pleased to see that
he made so doubtful an impression that the man came back with him before
granting anything, to find out whether the party belonging to this odd
emissary were respectable. I dare say he would have decided that we were
not had he only seen the others, for the gentlemen were in their shirt sleeves
again; but when he saw me, well and completely dressed, he had no further
hesitations. Readily he let us use the field, recommending a certain lower
portion of it on account of the nearness of the water, and then he prepared to
go back and, as he said, finish his dinner.
But we, who wanted dinner too, could not be content with nothing more
filling than a field, and began almost with one voice to talk to him of poultry.
He said he had none.
Of eggs.
He said he had none.
Of (anxiously) butter.
He said he had none. And he scratched his head and looked unintelligent
for a space, and then repeating that about finishing his dinner turned away.
I went with him.
“Take the caravans into the field and I will forage,” I called back, waving
my hand; for the idea of accompanying a man who was going to finish his
dinner exhilarated me into further masterfulness.
My rapid calculation was, as I kept step with him, he looking at me
sideways, that though it was very likely true he had not enough for ten it was
equally probable that he had plenty for one. Besides, he might be glad to let
an interesting stranger share the finishing of his no doubt lonely meal.
In the short transit from the lane to his back door (the front door was
choked with grass and weeds) I chatted agreeably and fluently about the
butter and eggs we desired to buy, adopting the “Come, come, my dear
fellow” tone, perhaps better described as the man to man form of appeal.
“Foreign?” said he, after I had thus flowed on, pausing on his doorstep as
though intending to part from me at that point.
“Yes, and proud of it,” said I, lifting my hat to my distant Fatherland.
“Ah,” said he. “No accountin’ for tastes.”
This was disappointing after I had thought we were getting on. Also it
was characteristically British. I would at once have resented it if with the
opening of the door the unfinished dinner had not, in the form of a most
appetizing odour, issued forth to within reach of my nostrils. To sit in a room
with shut windows at a table and dine, without preliminary labours, on food
that did not get cold between the plate and one’s mouth, seemed to me at that
moment a lot so blessed that tears almost came into my eyes.
“Do you never have—guests?” I asked, faltering but hurried, for he was
about to shut the door with me still on the wrong side of it.
He stared. Red-faced and over stout his very personal safety demanded
that he should not by himself finish that dinner.
“Guests?” he repeated stupidly. “No, I don’t have no guests.”
“Poor fellow,” said I.
“I don’t know about poor fellow,” said he, getting redder.
“Yes. Poor fellow. And poor fellow inasmuch as I suppose in this
secluded spot there are none to be had, and so you are prevented from
exercising the most privileged and noble of rites.”
“Oh, you’re one of them Social Democrats?”
“Social Democrats?” I echoed.
“Them chaps that go about talkin’ to us of rights, and wrongs too, till we
all get mad and discontented—which is pretty well all we ever do get,” he
added with a chuckle that was at the same time scornful. And he shut the
door.
Filled with the certitude that I had been misunderstood, and that if only
he could be made aware that he had one of the aristocracy of the first nation
in the world on his step willing to be his guest and that such a chance would
never in all human probability occur again he would be too delighted to
welcome me, I knocked vigorously.
“Let me in. I am hungry. You do not know who I am,” I called out.
“Well,” said he, opening the door a few inches after a period during
which I had continued knocking and he, as I could hear, had moved about
the room inside, “here’s a quarter of a pound of butter for you. I ain’t got no
more. It’s salt. I ain’t got no fresh. I send it away to the market as soon as it’s
made. It’ll be fourpence. Tell your party they can pay when they settle for
the field.”
And he thrust a bit of soft and oily butter lying on a piece of paper into
my hand and shut the door.
“Man,” I cried in desperation, rattling the handle, “you do not know who
I am. I am a gentleman—an officer—a nobleman——”
He bolted the door.
When I got back I found them encamped in a corner at the far end of the
field, as close into the shelter of a hedge as they could get, and my butter
was greeted with a shout (led by Jellaby) of laughter. He and the fledglings
at once started off on a fresh foraging expedition, on my advice in another
direction, but all they bore back with them was the promise, from another
farmer, of chickens next morning at six, and what is the good of chickens
next morning at six? It was my turn to shout, and so I did, but I seemed to
have little luck with my merriment, for the others were never merry at the
moment that I was, and I shouted alone.
Jellaby, pretending he did not know why I should, looked surprised and
said as usual, “Hullo, Baron, enjoying yourself?”
“Of course,” said I, smartly—“is not that what I have come to England
for?”
We dined that day on what was left of our bacon and some potatoes we
had over. An attempt which failed was made to fry the potatoes—“as a
pleasant change,” said Lord Sigismund good humouredly—but the wind was
so high that the fire could not be brought to frying pitch, so about three
o’clock we gave it up, and boiled them and ate them with butter and the
bacon, which was for some reason nobody understood half raw.
That was a bad day. I hope never to revisit Dundale. The field, which
began dry and short-grassed at the top of the slope, was every bit as deep and
damp by the time it got down to the corner we were obliged to camp in
because of the wind as the meadow by the Medway had been. We had the
hedge between us (theoretically) and the wind, but the wind took no notice
of the hedge. Also we had a black-looking brook of sluggish movement sunk
deep below some alders and brambles at our side, and infested, it appeared,
with a virulent species of fly or other animal, for while we were wondering
(at least I was) what we were going to do to pass the hours before bed time,
and what (if any) supper there would be, and reflecting (at least I was) on the
depressing size and greenness of the field and on the way the threatening
clouds hung lower and lower over our heads, the fledgling Jumps appeared,
struggling up from the brook through the blackberry bushes, and crying that
she had been stung by some beast or beasts unknown, flung herself down on
the grass and immediately began to swell.
Everybody was in consternation, and I must say so was I, for I have never
seen anything to equal the rapidity of her swelling. Her face and hands even
as she lay there became covered with large red, raised blotches, and judging
from her incoherent remarks the same thing was happening over the rest of
her. It occurred to me that if she could not soon be stopped from further
swelling the very worst thing might be anticipated, and I expressed my fears
to Menzies-Legh.
“Nonsense,” said he, quite sharply; but I overlooked it because he was
obviously in his heart thinking the same thing.
They got her into the Ilsa and put her, I was informed, to bed; and
presently, just as I was expecting to be scattered with the other gentlemen in
all directions in search of a doctor, Mrs. Menzies-Legh appeared in the
doorway and said that Jumps had been able to gasp out, between her wild
scratchings, that when anything stung her she always swelled, and the only
thing to do was to let her scratch undisturbed until such time as she should
contract to her ordinary size again.
Immensely relieved, for a search for a doctor in hedges and ditches would
surely have been a thing of little profit and much fatigue, I sat down in one
of the only three chairs that were at all comfortable and spent the rest of the
afternoon in fitful argument with Jellaby as he came and went, and in
sustained, and not, I trust, unsuccessful efforts to establish my friendship
with Lord Sigismund on such a footing that an invitation to meet his Serene
Aunt, the Princess of Grossburg-Niederhausen, would be the harmonious
result.
The ladies were busied devising methods for the more rapid relief of the
unhappy and still obstinately swollen fledgling.
There was no supper except ginger-biscuits.
“You can’t expect it,” said Edelgard, when I asked her (very distantly)
about it, “with sickness in the house.”
“What house?” I retorted, pardonably snappy.
I hope never to revisit Dundale.
CHAPTER X
L ET me earnestly urge any of my hearers who may be fired by my

example to follow it, never to go to Dundale. It is a desolate place, and a
hungry place; and a place, moreover, greatly subject to becoming
enveloped in a sort of universal gray cloud, emitting a steady though fine
drizzle and accounted for—which made it none the less wet—by persons
who knew everything, like Jellaby, as being a sea-mist.
I am no doubt very stupid, and therefore was unable to understand why
there should be a sea-mist when there was no sea.
“Well, we’re in Sussex now you know,” said Jellaby, on my saying
something of the sort to him.
“Indeed,” said I politely, as though that explained it; but of course it did
not.
Up to this point we had at least, since the first night, been dry. Now the
rain began, and caravaning in rain is an experience that must be met with
one’s entire stock of fortitude and philosophy. This stock, however large
originally, has a tendency to give out after drops have trickled down inside
one’s collar for some hours. At the other end, too, the wet ascends higher
and higher, for is not one wading about in long and soaking grass, trying to
perform one’s (so to speak) household duties? And if, when the ascending
wet and the descending wet meet, and the whole man is a mere and very
unhappy sponge, he can still use such words as healthy and jolly, then I say
that that man is either a philosopher indeed, worthy of and ripe for an
immediate tub, or he is a liar and a hypocrite. I heard both those adjectives
often that day, and silently divided their users into the proper categories. For
myself I preferred to say nothing, thus producing private flowers of stoicism
in response to the action of the rain.
For the first time I was glad to walk, glad to move on, glad of anything
that was not helping dripping ladies to pack up dripping breakfast things
beneath the dripping umbrella that with studious gallantry I endeavoured to
hold the while over my and their dripping heads. However healthy and jolly
the wet might be it undoubtedly made the company more silent than the dry,
and our resumed march was almost entirely without conversation. We moved
on in a southwesterly direction, the diseased fledgling still in bed and still, I
was credibly informed, scratching, through pine woods full of wet bracken
and deep gloom and drizzle, till at a place called Frant we turned off due
south in response to some unaccountable impulse of Mrs. Menzies-Legh’s,
whose unaccountable impulses were the capricious rudder which swayed us
hither and thither during the entire tour.
She used to study maps, and walk with one under her arm out of which
she read aloud the names of the places we were supposed to be at; and just as
we had settled down to believe it we would come to some flatly
contradictory signpost which talked of quite different places, places we had
been told were remote and in an altogether different direction.
“It doesn’t matter,” she would say, with a smile in which I, at least, never
joined, for I have my own opinions of petticoat government—“the great
thing is to go on.”
So we went on; and it was she who made us suddenly turn off southward
after Frant, leaving a fairly comfortable highroad for the vicissitudes of
narrow and hilly lanes.
“Lanes,” said she, “are infinitely prettier.”
I dare say. They are also generally hillier, and so narrow that once a
caravan is in one on it has to go whatever happens, trusting to luck not to
meet anything else on wheels till it reaches, after many anxieties, the haven
of another highroad. This lane ran deep between towering hedges and did
not leave off again for five miles, and none of you would believe how long it
took us to do those five miles because none of you know—how should you?
—what the getting of caravans up hills by means of tracing is. We had,
thanks to Mrs. Menzies-Legh’s desire for the pretty (unsatisfied I am glad to
say on that occasion, because the so-called sea-mist clung close round us
like a wet gray cloak)—we had got into an almost mountainous lane. We
were tracing the whole time, dragging each caravan up each hill in turn,
leaving it solitary at the top and returning with all three horses for the next
one left meanwhile at the bottom. I never saw such an endless succession of
hills. If tracing does not teach a man patience what, I would like to know,
will?
At first, on finding my horse removed and harnessed on to the Ailsa, I
thought I would get inside the Elsa and stretch myself on the yellow box and
wait there quietly smoking till the horse came back again; but I found
Edelgard inside, blocking it up and preparing to mend her stockings.
This was unpleasant, for I had hardly spoken to her, and then only with
the chilliest politeness, since her behaviour on the evening by the Medway;
yet, determined to be master in my own (so to speak) house, I would have
carried out my intention if Menzies-Legh’s voice, which I thought had gone
up the hill, had not been heard quite close outside asking where I was.
I warned my wife by means of a hasty enjoining finger to keep silence.
Will it be believed that she looked at me, said “Why should you not
help?” opened the window, and called out that I was there?
“Come and give us a hand, Baron,” said Menzies-Legh from outside. “It’s
a very stiff pull—we’ll have to push behind as well, and want what help
we’ve got.”
“Certainly,” said I, all apparent ready bustle; but I shot a very expressive
brief glance at Edelgard as I went out.
She, however, pretended to be absorbed in her sewing.
“You Socialists,” said I to Jellaby, next to whom I found I was expected
to push, “do not believe in marriage, do you?”
“We—don’t—believe—in—tyrants,” he panted, so short of breath that I
stared at him, I myself having quite a quantity of it; besides, what an answer!
I shrugged the shoulder nearest him and continued up in silence. At the
top of the hill he was so warm and breathless that he could not speak, and so
were the others, while I was perfectly cool and chatty.
“Why, gentlemen,” I remarked banteringly, as I stood in the midst of
these panters watching them wipe their heated brows, “you are scarcely what
is known as in training.”
“But you, Baron—undoubtedly are——” gasped Menzies-Legh. “You are
—absolutely unruffled.”
“Oh, yes,” I agreed modestly, “I am in good condition. We always are in
our army. Ready at any moment to——”
I stopped, for I had been on the verge of saying “eat the English,” when I
recollected that we may not inform the future mouthfuls of their fate.
“Ready to go in and win,” finished Lord Sigismund.
“To blow up Europe,” said Jellaby.
“To mobilize,” said Menzies-Legh. “And very right and proper.”
“Very wrong and improper,” said Jellaby. “You know,” he said, turning on
his host with all the combativeness of these men of peace (the only really
calm person is your thoroughly trained and equipped warrior)—“you know
very well you agree with me that war is the most unnecessary——”
“Come, come, my young gentlemen,” I interposed, broadening my chest,
“do not forget that you are in the presence of one of its representatives——”
“Let us fetch up the next caravan,” interrupted Menzies-Legh, thrusting
my horse’s bridle into my hand; and as I led it down the hill again my
anxiety to prevent its stumbling and costing me heaven knows how much in
the matter of mending its knees rendered me unable for the moment to
continue the crushing of Jellaby.
About four o’clock in the afternoon we found ourselves, drenched and
hungry, on the outskirts of a place called Wadhurst. It seemed wise to go no
nearer unless we were prepared to continue on through it, for already the
laurels of its villa residences dropped their rain on us over neat railings as we
passed. We therefore, too worn out to attempt to get right through the place
to the country beyond, selected the first possible field on the left of the
brown and puddle-strewn road, a field of yellow stubble which, soaking as it
was, was yet a degree less soaking than long grass, and though it had nothing
but a treeless hedge to divide us from the eyes of wanderers along the road it
had an unusually conveniently placed gate. The importance now of fields
and gates! The importance, indeed, of everything usually unimportant—
which is, in brief, the tragedy of caravaning.
This time the Menzies-Legh couple went to find the owner and crave
permission. So reduced were we—and could reduction go further?—that to
crave, hat in hand, for permission to occupy some wretched field for a few
hours, and to crave it often of illiterate, selfish, and grossly greedy persons
like my friend at Dundale, was not beneath any of our prides, while to obtain
it seemed the one boon worth having.
While they were gone we waited, a melancholy string of vehicles and
people in a world made up of mist and mud. Frau von Eckthum, who might
have cheered me, had been invisible nearly the whole day, ministering (no
doubt angelically) to the afflicted fledgling. Edelgard and the child Jane got
into the Elsa during the pause and began to teach each other languages. I
leaned against the gate, staring before me. Old James, a figure of dripping
patience, remained at his horse’s head. And Lord Sigismund and Jellaby, as
though they had not had enough exercise, walked up and down the road
talking.
Except the sound of their receding and advancing footsteps the stillness
was broken by nothing at all. It was a noiseless rain. It did not patter. And
yet, fine though it was, it streamed down the flanks of the horses, the sides of
the caravans, and actually penetrated, as I later on discovered, through the
green arras lining of the Elsa, making a long black streak from roof to floor.
I wonder what my friends at home would have said could they have seen
me then. No shelter; no refuge; no rest. These three negatives, I take it, sum
up fairly accurately a holiday in a caravan. You cannot get in, for if you do
either you find it full already of your wife, or, if it is moving, Jellaby
immediately springs up from nowhere and inquires at the window whether
you have noticed how your horse is sweating. At every camp there is nothing
but work—and oh, my friends, such work! Work undreamed of in your
ordered lives, and nothing, nothing but it, for must you not eat? And without
it there is no eating. And then when you have eaten, without the least pause,
the least interval for the meditation so good after meals, there begins that
frightful and accursed form of activity, most frightful and accursed of all
known forms, the washing up. How it came about that it was not from the
first left to the women I cannot understand; they are fitted by nature for such
labour, and do not feel it; but I, being in a minority, was powerless to
interfere. Nor did I always succeed in evading it. If we camped early, the
daylight exposed my movements; and by the time it was done bed seemed
the only place to go to. Now an intelligent man does not desire to go to bed
at eight; yet in that cold weather—we were, they said, unusually unfortunate
in the weather—even if it was dry, what pleasure was there in sitting out-of-
doors? I had had enough during the day of out-of-doors; by the time evening
came, out-of-doors and fresh air were things abhorrent to me. And there
were only three comfortable chairs, low and easy, in which a man might
stretch himself and smoke, and these, without so much as a preliminary
offering of them to anybody else, were sat in by the ladies. It did seem a
turning of good old customs upside down when I saw Edelgard get into one
as a matter of course, so indifferent to what I might be thinking that she did
not even look my way. How vividly on such occasions did I remember my
easy chair at Storchwerder and how sacred it was, and how she never dared,
if I were in the house, approach it, nor I firmly believe ever dared, so good
was her training and so great her respect, approach it when I was out.
Well, our proverb—descriptive of a German gentleman about to start on
his (no doubt) well-deserved holiday travels—“He who loves his wife leaves
her at home,” is as wise now as the day it was written, and about this time I
began to see that by having made my bed in a manner that disregarded it I
was going to have to lie on it.
The Menzies-Leghs returned wreathed in smiles—I beg you to note the
reason, and all of wretchedness that it implies—because the owner of the
field’s wife had not been rude, and had together with the desired permission
sold them two pounds of sausages, the cold potatoes left from her dinner, a
jug of milk, a piece of butter, and some firewood. Also they had met a
baker’s cart and had bought loaves.
This, of course, as far as it went, was satisfactory, especially the potatoes
that neither wanted peeling nor patience while they grew soft, but I submit
that it was only a further proof of our extreme lowness in the scale of well-
cared-for humanity. Here in my own home, with these events in what
Menzies-Legh and Jellaby would have called the blue distance, how strange
it seems that just sausages and cold potatoes should ever have been able to
move me to exultation.
We at once got into the field, hugging the hedge, and in the shelter of the
Ilsa (which entered last) made our fire. I was deputed (owing to the
unfortunate circumstance of my being the only person who had brought one)
to hold my umbrella over the frying pan while Jellaby fried the sausages on
one of the stoves. It was not what I would have chosen, for while protecting
the sausages I was also, in spite of every effort to the contrary, protecting
Jellaby; and what an anomalous position for a gentleman of birth and
breeding and filled with the aristocratic opinions, and perhaps (for I am a fair
man) prejudices, incident to being born and bred—well born of course I
mean, not recognizing any other form of birth—what a position, to stand
there keeping the back of a British Socialist dry!
But there is no escaping these anomalies if you caravan; they crop up
continually; and however much you try to dam them out, the waters of
awkwardly familiar situations constantly break through and set all your finer
feelings on edge. Fain would I have let the rain work its will on Jellaby’s
back, but what about the sausages? As they turned and twisted in the pan,
obedient to his guiding fork, I could not find it in me to let a drop of rain mar
that melodious fizzling. So I stood there doing my best, glad at least I was
spared being compromised owing to the absence of my friends, while the
two other gentlemen warmed up the potatoes over the fire preparatory to
converting them into purée, and the ladies in the caravans were employed,
judging by the fragrance, in making coffee.
In spite of the rain a small crowd had collected and was leaning on the
gate. Their faces were divided between wonder and pity; but this was an
expression we had now got used to, for except on fine days every face we
met at once assumed it, unless the face belonged to a little boy, when it was
covered instead with what seemed to be glee and was certainly animation,
the animation being apparently not infrequently inspired by a train of
thought which led up to, after we had passed, a calling out and a throwing of
stones.
“You’ll see these turn brown soon,” said Jellaby, crouching over his
sausages and pursuing them untiringly round and round the pan with a fork.
“Yes,” said I; “and a pleasant sight too when one is hungry.”
“By Jove, yes,” said he; “caravaning makes one appreciate things, doesn’t
it?”
“Yes,” said I, “whenever there are any.”
In silence he continued to pursue with his fork.
“They are very pink,” said I, after some minutes.
“Yes,” said he.
“Do you think so much—such unceasing—exercise is good for them?”
“Well, but I must get them brown all round.”
“They are, however, still altogether pink.”
“Patience, my dear Baron. You’ll soon see.”
I watched him in a further silence of some minutes.
“Do you, Jellaby,” I then inquired, “really understand how best to treat a
sausage?”
“Oh, yes; they’re bound to turn brown soon.”
“But see how obstinately they continue pink. Would it not be wise,
considering the lateness, to call my wife and desire her to cook them?”
“What! The Baroness in this wet stubble?” said he, with such energy that
I deemed the moment come for the striking of the blow that had been so long
impending.
“Do you, Jellaby,” I then inquired, “really understand how best to treat a sausage?”
“When a lady,” I said with great distinctness, “has cooked for fourteen
years without interruption—ever since, that is, she was sixteen—one may
safely at thirty leave it always in her hands.”
“Monstrous,” said he.
At first I thought he was in some way alluding to her age, and to the fact
that he had been deceived into supposing her young.
“What is monstrous?” I inquired, as he did not add anything.
“Why should she cook for us? Why should she come out in the wet to
cook for us? Why should any woman cook for fourteen years without
interruption?”
“She did it joyfully, Jellaby, for the comfort and sustenance of her
husband, as every virtuous woman ought.”
“I think,” said he, “it would choke me.”
“What would choke you?”
“Food produced by the unceasing labour of my wife. Why should she be
treated as a servant when she gets neither wages nor the privilege of giving
notice and going away?”
“No wages? Her wages, young gentleman, are the knowledge that she has
done her duty to her husband.”
“Thin, thin,” he murmured, digging his fork into the nearest sausage.
“And as for going away, I must say I am surprised you should connect
such a thought with any respectable lady.”
Indeed, what he said was so ridiculous, and so young, and so on the face
of it unmarried that in my displeasure I moved the umbrella for a moment far
enough to one side to allow the larger drops collected on its metal tips to fall
on to his bent and practically collarless (he wore a flannel shirt with some
loose apology for a collar of the same material) neck.
“Hullo,” he said, “you’re letting the sausages get wet.”
“You talk, Jellaby,” I resumed, obliged to hold the umbrella on its original
position again and forcing myself to speak calmly, “in great ignorance. What
can you know of marriage? Whereas I am very fully qualified to speak, for I
have had, as you may not perhaps know, the families scheduled in the Gotha
Almanach being unlikely to come within the range of your acquaintance, two
wives.”
I must of course have been mistaken, but I did fancy I heard him say,
partly concealing it under his breath, “God help them,” and naturally greatly
startled I said very stiffly, “I beg your pardon?”
But he only mumbled unintelligibly over his pan, so that no doubt I had
done him an injustice; and the sausages being, as he said (not without a note
of defiance in his voice), ready, which meant that for some reason or other
they had one and all come out of their skins (which lay still pink in limp and
lifeless groups about the pan), and were now mere masses of minced meat,
he rose up from his crouching attitude, ladled them by means of a spoon into
a dish, requested my umbrella’s continued company, and proceeded to make
the round of caravans, holding them up at each window in turn while the
ladies helped themselves from within.
“And us?” I said at last, for when he had been to the third he began to
return once more to the first—“and us?”
“Us will get some presently,” he replied—I cannot think grammatically—
holding up the already sadly reduced dish at the Ilsa’s window.
Frau von Eckthum, however, smiled and shook her head, and very luckily
the sick fledgling, so it appeared, still turned with loathing from all
nourishment. Lord Sigismund was following us round with the potato puree,
and in return for being waited on in this manner, a manner that can only be
described as hand and foot, Edelgard deigned to give us cups of coffee
through her window and Mrs. Menzies-Legh slices of buttered bread through
hers.
Perhaps my friends will have noted the curious insistence and patience
with which we drank coffee. I can hear them say, “Why this continuous
coffee?” I can hear them also inquire, “Where was the wine, then, that
beverage for gentlemen, or the beer, that beverage for the man of muscle and
marrow?”
The answer to that is, Nowhere. None of them drank anything more
convivial than water or that strange liquid, seemingly so alert and full of
promise, ginger-beer, and to drink alone was not quite what I cared for.
There was Frau von Eckthum, for instance, looking on, and she had very
early in the tour expressed surprise that anybody should ever want to drink
what she called intoxicants.
“My dear lady,” I had protested—tenderly, though—“you would not have
a man drink milk?”
“Why not?” said she; but even when she is stupid she does not for an
instant cease to be attractive.
On the march I often could make up for abstinences in between by going
inside the inns outside which the gritless others lunched on bananas and
milk, and privately drinking an honest mug of beer.
You, my friends, will naturally inquire, “Why privately?”
Well, I was in the minority, a position that tends to take the kick, at least
the open kick, out of a man—in fact, since my wife’s desertion I occupied
the entire minority all by myself; then I am a considerate man, and do not
like to go against the grain (other people’s grain), remembering how much I
feel it when other people go against mine; and finally (and this you will not
understand, for I know you do not like her), there was always Frau von
Eckthum looking on.
CHAPTER XI
T HAT night the rain changed its character, threw off the pretence of being
only a mist, and poured in loud cracking drops on to the roof of the
caravan. It made such a noise that it actually woke me, and lighting a
match I discovered that it was three o’clock and that why I had had an
unpleasant dream—I thought I was having a bath—was that the wet was
coming through the boarding and descending in slow and regular splashings
on my head.
This was melancholy. At three o’clock a man has little initiative, and I
was unable to think of putting my pillow at the bottom of the bed where
there was no wet, though in the morning, when I found Edelgard had done
so, it instantly occurred to me. But after all if I had thought of it one of my
ends was bound in any case to get wet, and though my head would have
been dry my feet (if doctors are to be believed far more sensitive organs)
would have got the splashings. Besides, I was not altogether helpless in the
face of this new calamity: after shouting to Edelgard to tell her I was awake
and, although presumably indoors, yet somehow in the rain—for indeed it
surprised me—and receiving no answer, either because she did not hear,
owing to the terrific noise on the roof, or because she would not hear, or
because she was asleep, I rose and fetched my sponge bag (a new and roomy
one), emptied it of its contents, and placed my head inside it in their stead.
I submit this was resourcefulness. A sponge bag is but a little thing, and
to remember it is also but a little thing, but it is little things such as these that
have won the decisive battles of the world and are the finger-posts to the
qualities in a man that would win more decisive battles if only he were given
a chance. Many a great general, many a great victory, have been lost to our
Empire owing to its inability to see the promise contained in some of its
majors and its consequent dilatoriness in properly promoting them.
How the rain rattled. Even through the muffling sponge bag I could hear
it. The thought of Jellaby in his watery tent on such a night, gradually, as the
hours went on, ceasing to lie and beginning to float, would have amused me
if it had not been that poor Lord Sigismund, nolens volens, must needs float
too.

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MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS

ELTON, GRUBER, BROWN, & GOETZMANN

PART 3: MODELS OF EQUILIBRIUM IN THE CAPITAL MARKETS

1. The CAPM implies that:

2. The beta of an efficient portfolio:

5. Which statement of the following statements is true?

Part 3 - 2 Copyright © 2014 John Wiley & Sons, Inc.

homogeneous expectations means:

9. The standard CAPM implies:

10. What is the standard deviation of portfolio A?

Copyright © 2014 John Wiley & Sons, Inc. Part 3 - 3

13. Which statement of the following statements is true?

14. In a CAPM framework, prohibiting short sales:

Part 3 - 4 Copyright © 2014 John Wiley & Sons, Inc.

True-False With Discussion

1. Discuss whether the following statement is true or false:

In a situation, where there is no lending or borrowing of riskfree securities, the security

Copyright © 2014 John Wiley & Sons, Inc. Part 3 - 5

2. Discuss whether the following statement is true or false:

3. Discuss whether the following statement is true or false:

Part 3 - 6 Copyright © 2014 John Wiley & Sons, Inc.

4. Discuss whether the following statement is true or false:

5. Discuss whether the following statement is true or false:

6. Discuss whether the following statement is true or false:

Security Return Standard Deviation Beta

Answer: A has least total risk; B has least systematic risk

Copyright © 2014 John Wiley & Sons, Inc. Part 3 - 7

2. What is the value of systematic risk for a portfolio with 2/3 of

3. What is the portfolio expected return and the portfolio beta if

Part 3 - 8 Copyright © 2014 John Wiley & Sons, Inc.

A  1.3   20  30

As per security market line:

Copyright © 2014 John Wiley & Sons, Inc. Part 3 - 9

As per capital market line:

5. Consider the following data for assets A and B:

Part 3 - 10 Copyright © 2014 John Wiley & Sons, Inc.

Copyright © 2014 John Wiley & Sons, Inc. Part 3 - 11

7. Consider the following data for stocks A and B:

Beta of the portfolio:

Variance of the portfolio:

Part 3 - 12 Copyright © 2014 John Wiley & Sons, Inc.

Solving equation (1) and (2), we get,

Z A  0.2169 and Z B  0.5079

Thus, the proportion to invest in each security is:

X A  30% and X B  70%

c. The security market line equation for security A is R A  RF   A ( R M  RF ) and for

Year Dodger Corp. Price S&P 500 Level

a. What is your estimate of beta for Dodger Corp.?

Copyright © 2014 John Wiley & Sons, Inc. Part 3 - 13

Yi A and the return on market = YM

 ei2  3.50528  2.07875 1.42653

c. The expected rate of return on Dodger’s stock is:

Part 3 - 14 Copyright © 2014 John Wiley & Sons, Inc.