CFA Practice Question
Which of the following is incorrect?
A. CAPM implies that the only reason for differences in expected returns should be only systematic risk. Other characteristics like firm size or book to market should not matter.
B. If two assets are positively correlated, combining them into a portfolio cannot result in the portfolio standard deviation being less than the standard deviations of both assets.
C. If an investor is invested in a portfolio that lies within the efficient frontier, she can change her investments to have both higher expected returns and lower risk.
Explanation: Variance for a portfolio of assets A and B = Var(w1*A + w2*B) = w12 * Var (A) + w22 * Var (B) + 2 * w1 * w2 * cov(A, B)
Due to the 2nd powers of weights, the portfolio std dev can be lower than individual std devs. Note that in comparison, the weights for expected return are only 1st power.
User Contributed Comments 2
| User | Comment |
|---|---|
| GBolt93 | can someone explain C being correct? Isn't the definition of the efficient from that curve that provides lowest risk for each expected return? |
| tferik | For C - the portfolio is within the efficient frontier (below the line and not efficient) and therefore can move her portfolio up to the efficient frontier, which would increase her return and reduce her risk |