Portfolio Management, LOS weight share 2.5 percent of the 365 Level I learning outcomes.
One formula prices every stock on the market. Four ratios judge every manager against it, each with a different denominator.
Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.
1. A stock has a beta of 1.4. The risk-free rate is 3.0% and the expected market return is 9.0%. According to CAPM, what is the stock's required return?
2. Manager A returns 15% with a beta of 1.3. Manager B returns 12% with a beta of 0.8. The risk-free rate is 3% and the market return is 10%. Which manager has the higher Jensen's alpha?
3. An investor is deciding between two funds to add to an already well-diversified portfolio. Which performance measure fits this decision?
Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.
The exam wants you to calculate an asset's required return using CAPM, calculate and interpret alpha, distinguish the Capital Market Line from the Security Market Line, and calculate and choose among the Sharpe ratio, the Treynor ratio, Jensen's alpha and the Information Ratio for judging risk-adjusted performance.
CAPM reads left to right exactly the way it should be understood: E(Ri) = Rf + beta-i x [E(Rm) - Rf]. You earn the risk-free rate, plus your share of the market's excess return, scaled by your beta. The most repeated arithmetic error on this module is multiplying beta by the full market return instead of the market risk premium, E(Rm) - Rf. The market risk premium has to be computed as its own separate line before beta ever touches it. Beta measures systematic risk only, never total volatility. A stock can carry a large total standard deviation while still having a low beta, if most of that volatility is company-specific rather than market-correlated. CAPM prices only the beta component, because unsystematic risk can be diversified away for free, and the market pays no premium for bearing a risk voluntarily.
Alpha is a stock's actual expected return minus its CAPM-required return, and its sign tells you the mispricing direction directly. Positive alpha means the stock plots above the Security Market Line, offering more return than its systematic risk demands, an undervalued buy signal. Negative alpha means it plots below the line, a sell signal. Alpha is not the same thing as beating the market in absolute terms. A high-beta stock can outperform the market index in raw return and still carry negative alpha, if its return falls short of what that beta level actually demanded.
The Capital Market Line and the Security Market Line look similar but answer different questions. The fastest way to tell them apart is to check the x-axis. The CML uses total risk, standard deviation, and applies only to efficient, fully diversified portfolios sitting on the efficient frontier. The SML uses systematic risk, beta, and applies to every asset, individual stocks and inefficient portfolios included. A single stock appears on the SML but never on the CML. Only the risk-free rate and the market risk premium shift the whole SML at once. A change in one stock's own beta does not shift the line; it just moves that stock along the line that is already there.
Four performance ratios each divide by a different measure of risk, and choosing the right one depends on how the portfolio is actually held. The Sharpe ratio divides excess return by total standard deviation. It is appropriate when the portfolio is the investor's entire holding, since there is no other position to absorb its unsystematic risk. The Treynor ratio divides the same excess return by beta instead. It is appropriate when the portfolio is one component inside a larger diversified holding, where only systematic risk still matters to the investor. Jensen's alpha subtracts the CAPM-required return from actual return, testing whether a manager beat what their own beta predicted. Always compute the CAPM figure first as a separate step before subtracting. The Information Ratio divides active return, portfolio return minus benchmark return, by tracking error, the standard deviation of that active return. It measures how consistently a manager beats their own benchmark rather than the risk-free rate.
A portfolio's raw return never determines its risk-adjusted ranking on its own. The exam consistently builds a high-return, high-risk option that loses to a lower-return, lower-risk one once the correct ratio is actually computed. Every ratio must be calculated in full before any ranking is chosen, never assumed from the return alone.
A stock has a beta of 1.6. The risk-free rate is 3.5 percent and the expected market return is 10 percent. What is the stock's required return under CAPM? Market risk premium = E(Rm) - Rf = 10% - 3.5% = 6.5%. Required return = Rf + beta x MRP = 3.5% + 1.6 x 6.5% = 3.5% + 10.4% = 13.9%.
Same inputs: beta 1.6, risk-free rate 3.5 percent, expected market return 10 percent. Compute the market risk premium as its own step first, then finish the CAPM calculation yourself.
Beta = 1.6, Rf = 3.5%, E(Rm) = 10%. Find the required return using CAPM.
CAPM's most repeated error is multiplying beta by the full expected market return instead of the market risk premium; compute E(Rm) - Rf as its own line first, then multiply by beta, then add the risk-free rate.
Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.
Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.
Required return equals the risk-free rate plus beta times the market risk premium, where the market risk premium is the expected market return minus the risk-free rate. The most common arithmetic error on the exam is multiplying beta by the full market return instead of the market risk premium.
A stock can have a large total standard deviation but a low beta, if most of that volatility is company-specific rather than market-correlated. CAPM prices only the beta component, because unsystematic risk can be diversified away for free and the market will not pay a premium for bearing it voluntarily.
Alpha is a stock's actual expected return minus its CAPM-required return. Positive alpha means the stock plots above the Security Market Line and is undervalued, a buy signal; negative alpha means it plots below the line and is overvalued, a sell signal.
The Capital Market Line uses total risk, standard deviation, on its axis and applies only to efficient portfolios on the efficient frontier. The Security Market Line uses systematic risk, beta, and applies to every asset, individual stocks and inefficient portfolios included. A single stock appears on the SML but never on the CML.
An increase in the risk-free rate shifts the entire Security Market Line upward, raising every required return at once. A change in one stock's own beta does not shift the line; it moves that stock along the existing line.
Sharpe divides excess return by total standard deviation, for a portfolio that is the investor's entire holding. Treynor divides excess return by beta, for a portfolio that is one component of a larger diversified holding. Jensen's alpha subtracts the CAPM-required return from actual return, testing whether a manager beat what their beta predicted. The Information Ratio divides active return, versus a benchmark, by tracking error, testing consistency of active management.
A portfolio with the highest raw return is not automatically the best performer once risk is accounted for. The exam consistently builds a high-return, high-risk portfolio that loses on a risk-adjusted basis to a lower-return, lower-risk one; the ratio must be calculated, never assumed from the return alone.
When Sharpe ratios are negative, adding more risk makes the ratio less negative, which looks like an improvement even though performance actually worsened. The mathematically higher (less negative) value still ranks first, but the curriculum explicitly flags this ranking as unreliable in that situation.
Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.
Read the CAPM formula in English before touching numbers. It stops the single most common exam error: multiplying beta by the full market return instead of the market risk premium.
Systematic Measures Line for beta, Complete-sigma Measures Line for total standard deviation. If the axis label in a question is standard deviation, it is the CML; if it is beta, it is the SML.
A stock plotting above the SML is giving more return than its systematic risk requires. Above the line is always the favorable direction.
Sharpe is for when the fund is the investor's whole portfolio. Treynor is for when it is one holding among several, so only its systematic risk matters to the investor.
Always calculate the CAPM-required return as its own separate step before subtracting it from actual return. Skipping the intermediate step is where arithmetic errors creep in.
Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.
Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.
An analyst estimates that Stock X has a beta of 1.4. The risk-free rate is 3.0% and the expected market return is 9.0%. According to CAPM, the required return for Stock X is closest to:
How sure are you?
Unit: portfolio-risk-and-return-part-ii
A stock has an expected return of 14%. The risk-free rate is 4% and the market risk premium is 7%. The stock's beta according to CAPM is closest to:
How sure are you?
Unit: portfolio-risk-and-return-part-ii
Stock Y has a beta of 0.7, risk-free rate of 2.5%, and expected market return of 8.5%. Stock Y's current expected return is 6.8%. Which of the following is most accurate?
How sure are you?
Unit: portfolio-risk-and-return-part-ii
Which of the following statements about the Security Market Line (SML) is most accurate?
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Unit: portfolio-risk-and-return-part-ii
A portfolio manager holds two assets: Asset A (beta = 1.2, weight = 60%) and Asset B (beta = 0.5, weight = 40%). The risk-free rate is 3% and the expected market return is 10%. The required return on the portfolio is closest to:
How sure are you?
Unit: portfolio-risk-and-return-part-ii
Which of the following is most likely a key assumption of the Capital Asset Pricing Model (CAPM)?
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Unit: portfolio-risk-and-return-part-ii
An analyst calculates that Stock Z has an alpha of -2.3%. According to CAPM, which of the following best describes Stock Z?
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Unit: portfolio-risk-and-return-part-ii
Why does CAPM hold that unsystematic (idiosyncratic) risk is most likely not compensated with higher expected return?
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Unit: portfolio-risk-and-return-part-ii
A stock has a beta of 1.4. The risk-free rate is 3% and the expected market return is 9%. The stock's ACTUAL realized return over the period was 12%. Combining the Capital Asset Pricing Model with the concept of Jensen's alpha, the stock's Jensen's alpha for the period is closest to:
How sure are you?
Unit: portfolio-risk-and-return-part-ii
An investor is choosing between the Sharpe ratio and the Treynor ratio to evaluate a manager's risk-adjusted performance. The manager's portfolio is the investor's ENTIRE investable wealth (not one holding within a larger diversified portfolio). Combining the risk measure each ratio uses with this specific context (a standalone, entire-wealth portfolio), the investor should most likely conclude that:
How sure are you?
Unit: portfolio-risk-and-return-part-ii
Answer the questions above, then press the button.