CFA Practice Question

There are 294 practice questions for this study session.

CFA Practice Question

Without violating the rules of CAPM, which of the following strategies may be undertaken in an attempt to earn a return greater than that of the market?
A. Short sell securities that have a beta of less than one and purchase the market portfolio.
B. Purchase securities that have a higher standard deviation than that of the market.
C. Purchase securities whose correlation coefficient with that of the market is greater than one.
Explanation: Short selling is a form of borrowing. Therefore, by borrowing to invest in the market portfolio, you increase the leverage in the portfolio and consequently its beta. According to CAPM, this higher beta should lead to higher expected returns.

User Contributed Comments 13

User Comment
galgan why not the "higher standard deviation" answer? if you invest in portfolio with higher standard deviation you should on average earn more than market... if you short sell security, there are usually margin rule requirements in which 150% of value of the shares shorted needs to be held in the account, so i lose some money for investing in shares with higher betas...
wroger CAPM does not concern STDV.
volkovv Wroger is correct. Would it say "Purchase securities that have higher betas than that of the market" then it would be a true statement.
ThePessimist Right. A higher STDV could just mean that the security has much more firm-specific risk, which wouldn't help under CAPM.
bahodir Why not the last one?
semra99 bahodir, correlation coefficient can not be more than 1. It's a number between -1 & 1.
dblueroom Agree with Thepessimist
thammy Semra99, correlation coefficient (beta) does go above one! I don't understand how C is different from A. In A's situation, you are borrowing to buy higher beta stock. In C's situation, you are just buying higher beta stock outright. Help, someone??
LloydBraun7 thammy, correlation coefficient and beta are 2 different measures. Both have covariance as the numerator, but correlation has the product of stdevs in the denominator, while beta has the variance of the market in the denominator.
Saibot Exactly LLoydBraun7
serboc Great Question
Shortseller Kind of stupid because it assumes you post no margin to lever your portfolio so much...but what ever:

You own 100% of market beta = 1

You short 100% of portfolio B beta = -.8

You reinvest 100% of proceeds in Port 1 (+1 beta)

Total beta = (1 -.8 +1) or 1.2
birdperson nice shortseller.
You need to log in first to add your comment.