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ECN226 Capital Markets 1 – 2015
Questions and Answers
Question 1
a) The capital market line (CML), in the capital asset pricing model (CAPM), depicts the trade-off
between risk and return for efficient portfolios. It is a theoretical concept that represents all the
portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets.
Under CAPM, all investors will choose a position on the capital market line, in equilibrium, by
borrowing or lending at the risk-free rate, since this maximizes return for a given level of risk.
The “uninformed” investors who do not engage in security analysis and holds the market portfolio,
whereas the other optimizes using the Markowitz algorithm with input from security analysis. The
uninformed investor does not know what input the informed investor uses to make portfolio
purchases. The uninformed investor knows, however, that if the other investor is informed, the
market portfolio proportions will be optimal. Therefore, every investor (both the informed and
uninformed) holds a portfolio of risk yassets in proportions that duplicate the representation of the
assets in the market portfolio. The market portfolio therefore lies on the optimal CAL and the Capital
Market Line corresponds to the best CAL.
b)
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The slope of the Capital Allocation Line is the reward-to-variability ratio. It measures how an
increase in the standard deviation (and therefore the reward-to-variability ratio) must be matched
with an increase in the expected return. The steeper the line, the greater the return must be in order
for an investor to hold greater risk. This would occur if the investor is more risk-adverse.
c) The efficient market hypothesis posits that security prices fully reflect all available information, so
it is impossible to make economic profits by trading on that information. It theorises that investors
will spend time and resources to gather and process information only if this activity is likely to
generate higher investment returns. Competition among analysis ensures that stock prices ought to
reflect available information.
Testing the EMT does not make much sense as the conditions in the financial markets are much
more complex than the simplified conditions of perfect competition, zero transaction costs and free
information used in the formulation of the EMH. There are a number of market anomalies which are
price and/or rate of return distortions which contradict the efficient-market hypothesis. Some
examples of these are calendar effects, a lack of market transparency, and the “small-cap effect”. All
of these mean that real-life markets deviate considerably from those assumed by the EMT. Further,
it is difficult to test whether prices deviate from their “fundamental” prices because “fundamental”
prices are a theoretical construct. These cannot be measured, and therefore deviations from these
fundamental prices also cannot be measured.
d) The capital market line equation can be written as follows:
𝐸[𝑅 ] − 𝑅
𝐸[𝑅 ] = 𝑅 + 𝑆𝐷
𝑆𝐷
The Security Market Line equation can be written as follows:
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Discounted prices compared to all other websites
ECN226 Capital Markets 1 – 2015
Questions and Answers
Question 1
a) The capital market line (CML), in the capital asset pricing model (CAPM), depicts the trade-off
between risk and return for efficient portfolios. It is a theoretical concept that represents all the
portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets.
Under CAPM, all investors will choose a position on the capital market line, in equilibrium, by
borrowing or lending at the risk-free rate, since this maximizes return for a given level of risk.
The “uninformed” investors who do not engage in security analysis and holds the market portfolio,
whereas the other optimizes using the Markowitz algorithm with input from security analysis. The
uninformed investor does not know what input the informed investor uses to make portfolio
purchases. The uninformed investor knows, however, that if the other investor is informed, the
market portfolio proportions will be optimal. Therefore, every investor (both the informed and
uninformed) holds a portfolio of risk yassets in proportions that duplicate the representation of the
assets in the market portfolio. The market portfolio therefore lies on the optimal CAL and the Capital
Market Line corresponds to the best CAL.
b)
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
The slope of the Capital Allocation Line is the reward-to-variability ratio. It measures how an
increase in the standard deviation (and therefore the reward-to-variability ratio) must be matched
with an increase in the expected return. The steeper the line, the greater the return must be in order
for an investor to hold greater risk. This would occur if the investor is more risk-adverse.
c) The efficient market hypothesis posits that security prices fully reflect all available information, so
it is impossible to make economic profits by trading on that information. It theorises that investors
will spend time and resources to gather and process information only if this activity is likely to
generate higher investment returns. Competition among analysis ensures that stock prices ought to
reflect available information.
Testing the EMT does not make much sense as the conditions in the financial markets are much
more complex than the simplified conditions of perfect competition, zero transaction costs and free
information used in the formulation of the EMH. There are a number of market anomalies which are
price and/or rate of return distortions which contradict the efficient-market hypothesis. Some
examples of these are calendar effects, a lack of market transparency, and the “small-cap effect”. All
of these mean that real-life markets deviate considerably from those assumed by the EMT. Further,
it is difficult to test whether prices deviate from their “fundamental” prices because “fundamental”
prices are a theoretical construct. These cannot be measured, and therefore deviations from these
fundamental prices also cannot be measured.
d) The capital market line equation can be written as follows:
𝐸[𝑅 ] − 𝑅
𝐸[𝑅 ] = 𝑅 + 𝑆𝐷
𝑆𝐷
The Security Market Line equation can be written as follows:
