QUESTION 1 The literature is a little deficient in clearly explaining the relevance of utility theory to portfolio selection and the notions of indifference curves and efficient frontiers. The students should understand not merely that a particular point on a diagram represents something but why it does and why an investor may choose to prefer that point as opposed to othe possibilities An individual investor's choice between different portfolios will depend on personal preference(util ity theory). The portfolio with the maximum util ity is the one at the point of tangency of the opportunity set with the highest indifference curve. a risk averse investor will choose a portfolio which is at a point of tangency between his indifference curve and the efficient frontier QUESTION 2 When risk-free assets do not exist, the optimal portfolio selection will be found on the efficient frontier With the introduction of a risk-free asset we get a new efficient frontier which is drawn as the Capital Market Line(CML), with all points(except point M)on the old"efficient QUESTION 3 CAPM attempts to provide a means of understanding the relationship between expected return and systematic or non-diversifiable or unavo idable risk and evaluation of securities in the following context. In market equilibrium, a security is expected to provide a return commensurate with its unavoidable risk. Put simply, the greater the unavoidable risk of a security, the greater the return that investors will expect from that security QUESTION 4 Rr+ kA=0.05+075×(017-0.05 0.14or14% kB=05+[090×(0.17005 =0.158or15.8% kc=005+[40×(017-005 =0.2l8or21.8%July 2003 QUESTION 1 The literature is a little deficient in clearly explaining the relevance of utility theory to portfolio selection and the notions of indifference curves and efficient frontiers. The students should understand not merely that a particular point on a diagram represents something but why it does and why an investor may choose to prefer that point as opposed to other possibilities. An individual investor's choice between different portfolios will depend on personal preference (utility theory). The portfolio with the maximum utility is the one at the point of tangency of the opportunity set with the highest indifference curve. A risk averse investor will choose a portfolio which is at a point of tangency between his indifference curve and the efficient frontier. QUESTION 2 When risk-free assets do not exist, the optimal portfolio selection will be found on the efficient frontier. With the introduction of a risk-free asset, we get a new efficient frontier which is drawn as the Capital Market Line (CML), with all points (except point M) on the “old” efficient frontier now dominated by points on the "new" frontier. QUESTION 3 CAPM attempts to provide a means of understanding the relationship between expected return and systematic or non-diversifiable or unavoidable risk and evaluation of securities in the following context. In market equilibrium, a security is expected to provide a return commensurate with its unavoidable risk. Put simply, the greater the unavoidable risk of a security, the greater the return that investors will expect from that security. QUESTION 4  ( )  ( )  ( )  ( ) 0.218 or 21.8% k 0.05 1.40 0.17 - 0.05 0.158 or 15.8% k 0.05 0.90 0.17 - 0.05 0.14 or 14% k 0.05 0.75 0.17 - 0.05 k R b k - R C B A j F j m F = = +  = = +  = = +  = + 