BUSF_A01.qxd

Review questions

lManagers diversifying within the business may represent an agency cost to

the shareholders.

lThe arbitrage pricing model is similar to CAPM, but it relies on more para-

meters about the particular investment and the state of the world. It has been

shown to be quite effective and is likely to be taken more seriously, in the light

of the serious criticisms of CAPM.

Copeland, Weston and Shastri (2004) give a rigorous coverage of CAPM and APM and discuss

empirical tests of them. Arnold (2005) is also worth reading on the derivation of CAPM and

empirical tests of the model. For the very readable Dimson, Marsh and Staunton article on busi-

ness returns over time, cited in the chapter, see http://faculty.london.edu/edimson/Jacf1.pdf.

Fama and French (2004), also cited in the chapter, provide a readable review of the various tests

of CAPM that have taken place over the model’s lifetime.

Further

reading

7.1 Portfolio theory tends to define risky investments in terms of just two factors: expected

returns and variance (or standard deviation) of those expected returns.

What assumptions need to be made about investors and the expected investment

returns (one assumption in each case) to justify this ‘two-factor’ approach? Are these

assumptions justified in real life?

7.2 ‘The expected return from a portfolio of securities is the average of the expected

returns of the individual securities that make up the portfolio, weighted by the value of

the securities in the portfolio.’

‘The expected standard deviation of returns from a portfolio of securities is the average

of the standard deviations of returns of the individual securities that make up the port-

folio, weighted by the value of the securities in the portfolio.’

Are these statements correct?

7.3 What can be said about the portfolio that is represented by any point along the efficient

frontier of risky investment portfolios?

7.4 What is meant by ‘two-fund separation’?

7.5 ‘The capital asset pricing model tells us that a security with a beta of 2 will be expected

to yield a return twice that of a security whose beta is 1.’ Is this statement true?

7.6 What justification can there be for using the rate of return derived from capital (stock)

market returns as the discount rate to be applied in the appraisal of a real investment

project within a business?

REVIEW QUESTIONS

Suggested answers to
review questions appear
in Appendix 3.