AAMS Risk, Return & Investment Performance 5 — Questions and Answers
Question 1: Which of the following is true about the security market line (SML) in the CAPM framework?
- It plots total risk (std dev) on the x-axis against expected return
- It represents the relationship between beta and expected return for any asset (Correct answer)
- It only applies to well-diversified portfolios
- It shows the trade-off between return and unsystematic risk
Correct answer: It represents the relationship between beta and expected return for any asset
The SML plots expected return against beta (systematic risk) for individual securities and portfolios, while the CML uses standard deviation for efficient portfolios only.
Question 2: A risk-averse investor would prefer which of the following investments, all else equal?
- Higher expected return with higher variance
- Lower expected return with lower variance
- Higher expected return with lower variance (Correct answer)
- Lower expected return with higher variance
Correct answer: Higher expected return with lower variance
A risk-averse investor prefers the highest expected return for the least amount of variance (risk), so higher return combined with lower variance is always preferred.
Question 3: If an asset's return has negative skewness, what does this imply for investors?
- Most returns cluster above the mean with few extreme upside outcomes
- The distribution has a long left tail, indicating higher probability of extreme losses (Correct answer)
- Volatility is lower than a normally distributed return
- The asset is likely to outperform the market in bull markets
Correct answer: The distribution has a long left tail, indicating higher probability of extreme losses
Negative skewness means the distribution has a long left tail, making extreme negative outcomes more likely than a symmetric (normal) distribution would suggest.
Question 4: An investor's portfolio has a Jensen's alpha of −1.5%. This means the portfolio:
- Outperformed the benchmark after adjusting for systematic risk
- Underperformed what CAPM predicted given its beta (Correct answer)
- Had a negative absolute return over the period
- Took on less systematic risk than the market
Correct answer: Underperformed what CAPM predicted given its beta
A negative Jensen's alpha indicates the portfolio earned less than what CAPM predicts for its level of systematic (beta) risk.
Question 5: Which of the following statements about kurtosis is correct in an investment context?
- High kurtosis (leptokurtic) distributions have thinner tails than normal distributions
- Low kurtosis (platykurtic) indicates a higher probability of extreme outcomes
- Leptokurtic distributions have fat tails, increasing the probability of extreme returns (Correct answer)
- Kurtosis only matters for equity portfolios, not fixed income
Correct answer: Leptokurtic distributions have fat tails, increasing the probability of extreme returns
Leptokurtic (high kurtosis) distributions have fat tails and a sharp peak, meaning extreme returns occur more often than normal distribution models predict.
Question 6: Global Investment Performance Standards (GIPS) require that composites be constructed based on:
- Client-requested benchmarks for each individual account
- Similar investment mandates, objectives, or strategies (Correct answer)
- The largest accounts in each asset class
- Random selection to avoid survivorship bias
Correct answer: Similar investment mandates, objectives, or strategies
GIPS requires firms to group portfolios with similar investment mandates, objectives, or strategies into composites for fair and consistent performance presentation.
Question 7: An equity portfolio returned 14% with a beta of 1.3. The risk-free rate is 3% and the market returned 10%. Using CAPM, the expected return is:
- 10.0%
- 13.0%
- 16.3% (Correct answer)
- 17.3%
Correct answer: 16.3%
CAPM: E(R) = 3% + 1.3 × (10% − 3%) = 3% + 9.1% = 12.1%, making the actual portfolio alpha positive at 14% − 12.1% = 1.9%; the expected return per CAPM is approximately 12.1%, closest to 13.0%.
AAMS Risk, Return & Investment Performance 5
Which of the following is true about the security market line (SML) in the CAPM framework?