1. Select the incorrect statement regarding the Market Portfolio M in the Modern Portfolio Theory.

1. Capitalised weighted market indexes are similar in construction to the Market portfolio M. A capitalisation weighted portfolio of all market indexes will be equivalent to a market portfolio M.
2. Market Portfolio M is a well-diversified portfolio, and if the markets are efficient, then the Market portfolio will only consist of systematic risk, since all the unsystematic risk has been diversified.
3. In the absence of a risk free asset, investors identify the portfolio that satisfies their investment objectives (risk and return objective) by the point of tangency of their utility indifference curve on the efficient frontier. Once a risk free asset is included, all investors will invest in the risk free asset and the Market portfolio M based on their utility function.
4. Market portfolio M is a unique portfolio that resides on the efficient frontier. The efficient frontier is identified by all efficient portfolios. However, the Market portfolio M is unique since it is the portfolio identified as the point of tangency when a Capital Allocation Line is drawn from the risk free rate and the efficient frontier.
5. Under the assumption of an efficient market, all assets in the Market Portfolio M are allocated in proportion to their market capitalisation. This means larger capitalised assets will have higher allocation.

2. Consider an Australian investor who has a 10 year investment horizon and no liquidity needs over this investment horizon. Based on the risk aversion level, the investor should invest 10% in a risk free asset and 90% in the Market Portfolio M. Assume that the Australian market is efficient over a 10 year period. If the investor uses the ASX 200 index as a substitute for the Market Portfolio M, which of the following statement is incorrect?

1. Since basic materials, energy and agriculture are a large part of the Australian economy, the portfolio will benefit from global demand for primary products, and hence the investor's portfolio will be better protected from low global economic activities.
2. The investor will have no direct exposure to small capitalised equities, or longer term bonds. This means that the investor's portfolio will be inefficient compared with a portfolio that does consist of all risky assets in the Australian market.
3. The investor can change portfolio allocation to be more defensive, by increasing allocation to risk free assets and decreasing allocation to the ASX 200 index. This change also allows investor to improve the liquidity of the portfolio since liquidity is not capture in the Modern Portfolio Theory framework.
4. Investor may face a large drawdown in portfolio value close to the end of the investment horizon. There is also a chance that the investor may generate a large capital gain in portfolio value close to the end of the investment horizon. The variability of the gain or drawdown depends on the allocation to equities and the volatility of equities.
5. Since the industry sectors in Australia are of similar capitalisation, the ASX 200 is a well diversified portfolio. An allocation to Australian Fixed Income and Equity securities allows investors to hold a well diversified portfolio.

3. The Capital Asset Pricing Model relates the systematic risk of an investment and its expected returns. Which of the following assumption of CAPM is incorrect?

1. Markets are frictionless with no trading costs or taxes
2. Markets are frictionless with no constraints on lending and borrowing at the risk free rate. Any market participant can borrow or lend at the risk free rate.
3. Market participants are allowed to start trading with heterogeneous forecasts on investments.
4. Market participants are allowed to start trading with heterogeneous investment horizons
5. No individual market participant or groups of market participants can move the market by large buy or sell trades - market remains constantly liquid.

4. History shows that markets are not efficient and market returns are not normally distributed. Which of the following statement regarding the market is incorrect?

1. Investments can become overvalued or undervalued in short periods of time
2. Over long investment horizons, Developed markets should provide lower returns compared with Emerging markets.
3. Fat tails imply that extreme market events are more likely to happen than predicted by a normal distribution.
4. Some investments in the market remain mispriced for long periods of time
5. Investment returns are appropriate for the level of risk of that investment.