I am having trouble understanding the concept of ‘zero beta portfolio’. Can someone help?
Any portfolio that does not have systematic risk or beta =0. Put it another way, does not vary with market portfolio. E.g., bank deposit, CD,… Mind you, the portfolio can still have non-systematic risk, e.g., market neutral hedge fund which both go long and short closely-related stocks can have zero beta, but still has a lot of non-systematic risks.
So how does that translate into high intercept on the y axis and flatter slope for the SML?
The intercept at the Y axis is the zero beta on the X axis. That’s the risk free rate with zero systemic risk. Anything further out to the right has positive beta and some systemic risk.
I think it is assumed that the zero-beta portfolio has a higher expected return than the risk-free asset. Because the expected return is higher, that shifts the y-intercept higher.
The result is that the SML is flatter than it would be with a higher intercept than if you used the RF Asset
What would be an example of a zero beta asset with a return > RF?
Zero-beta portfolio is used when you don’t have access to a risk-free asset to combine with market portfolio to create a SML (thus relaxing one of the key assumptions) , so you use the zero-beta instead of riskfree. I have just gone through my text and cannot find anywhere it says that the intercept (i.e., the return of the zero beta) has to be higher than risk-free. Do I miss sth here?
Yes u did, page 269 in the CFA book sir!
Sorry, I am reading a scanned copy of level I 2010 copy, and page 269 talks about different assumptions which I mentioned earlier. pg 286 talks about zero beta model and relaxing the assumptions. Cannot find any mentioning about high intercept on the y axis and flatter slope for the SML?
Ok on that page in the CFA book it says that we assume the zero beta asset to have a higher return than the RF asset, which makes that intercept higher, and the line flatter.
Well, still have not found the text (a bit slow today :-)), but what you quote does not contradict what I mentioned. IF we assume zero beta asset to have a higher return (does not have to be, if you put your money under the mattress, its real return is below zero), then the intercept is higher since the intercept is the return of the zero-beta portfolio. Since the intercept is higher, it makes the line flatter.
doesnt a zero beta portfolio have arbitrage opportunity? which would mean that the portfolio return is greater than the return of the risk free?
It has nothing to do with arbitrage in this context. The concept of zero-beta portfolio is a substitute in situations where you don’t have a risk free asset to derive at the SML line. E.g., investors in developing countries where gov bonds are as risky as corp bonds, thus no natural risk-free asset. Arbitrage fund can be a substitute for riskfree theoretically, I think, though it is hardly any arbitrage fund is risk-free in its real nature since it is hard to have absolute zero beta (in addition to its nonsystematic risk). In other context, a zero-beta asset can mean arbitrage fund, long-short fund, whatever assets which do not vary with market portfolio.
You seem to be really well prepared elfca…if you don’t mind me asking: what is your educational / work background… Also…how did you get a scanned version of 2010 curriculum ?
Hes L2 candidate I think lol
CFAMaven Thanks a lot. Just don’t want to brag about my background, I’d skip that. Passed level I some time ago. Have some downtime temporarily, so just try to help you guys out, like many other members who also have passed level I and work tirelessly to answer your questions in this forum without any selfish motives. Concerning, scanned version of 2010 curriculum: can’t say that either :-). Sorry.
Cool…I didn’t know you already passed, congrats!