Name: __________________________ Date: _____________



Consider the following probability distribution for stocks A and B:

Reference: 8-3

1.
The expected rates of return of stocks A and B are _____ and _____, respectively.
A.
13.2%; 9%.
B.
13%; 8.4%
C.
13.2%; 7.7%
D.
7.7%; 13.2%
E.
none of the above


2.
Beta is the measure of
A.
firm specific risk.
B.
diversifiable risk.
C.
market risk.
D.
unique risk.
E.
none of the above.


3.
Draw graphs that represent each of the following situations:
•     Investors face an efficient frontier of risky assets. There is no borrowing or lending allowed at a risk-free rate. Using indifference curves, show an example of the optimal portfolio choice for Investor A, who has a strong aversion to risk, and one for Investor B, who is much less risk-averse. Label points A and B clearly.
•     Investors face an efficient frontier of risky assets. Borrowing and lending at a risk-free rate are allowed. Using indifference curves, show an example of Investor C, who chooses to put 100% of his investment in the optimal risky portfolio. Show an example of Investor D, who chooses to put 75% of her investment in the optimal risky portfolio. Label points C and D clearly.
•     Investors face an efficient frontier of risky assets. Lending at a risk-free rate is allowed, and investors can borrow at a slightly higher rate. Using an indifference curve, show an example of Investor E, who chooses to borrow. Label this point E. On the same graph show where the investor's indifference curve would be if she could borrow at the lending rate. Label this point F.

Answer:


4.
The Capital Allocation Line provided by a risk-free security and N risky securities is
A.
the line that connects the risk-free rate and the global minimum-variance portfolio of the risky securities.
B.
the line that connects the risk-free rate and the portfolio of the risky securities that has the highest expected return on the efficient frontier.
C.
the line tangent to the efficient frontier of risky securities drawn from the risk-free rate.
D.
the horizontal line drawn from the risk-free rate.
E.
none of the above.


Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 10% and a standard deviation of 16%. B has an expected rate of return of 8% and a standard deviation of 12%.
Reference: 8-2

5.
The weights of A and B in the global minimum variance portfolio are _____ and _____, respectively.
A.
0.24; 0.76
B.
0.50; 0.50
C.
0.57; 0.43
D.
0.43; 0.57
E.
0.76; 0.24


6.
Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz?

A.
Only portfolio W cannot lie on the efficient frontier.
B.
Only portfolio X cannot lie on the efficient frontier.
C.
Only portfolio Y cannot lie on the efficient frontier.
D.
Only portfolio Z cannot lie on the efficient frontier.
E.
Cannot tell from the information given.


7.
The unsystematic risk of a specific security
A.
is likely to be higher in an increasing market.
B.
results from factors unique to the firm.
C.
depends on market volatility.
D.
cannot be diversified away.
E.
none of the above.


8.
Discuss how the investor can use the separation theorem and utility theory to produce an efficient portfolio suitable for the investor's level of risk tolerance.

Answer:


9.
Security X has expected return of 12% and standard deviation of 20%. Security Y has expected return of 15% and standard deviation of 27%. If the two securities have a correlation coefficient of 0.7, what is their covariance?
A.
0.038
B.
0.070
C.
0.018
D.
0.013
E.
0.054


10.
A statistic that measures how the returns of two risky assets move together is:
A.
variance.
B.
standard deviation.
C.
covariance.
D.
correlation.
E.
C and D.


Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 12% and a standard deviation of 17%. B has an expected rate of return of 9% and a standard deviation of 14%.
Reference: 8-4

11.
The risk-free portfolio that can be formed with the two securities will earn _____ rate of return.
A.
9.5%
B.
10.4%
C.
10.9%
D.
9.9%
E.
none of the above


12.
Security X has expected return of 14% and standard deviation of 22%. Security Y has expected return of 16% and standard deviation of 28%. If the two securities have a correlation coefficient of 0.8, what is their covariance?
A.
0.038
B.
0.049
C.
0.018
D.
0.013
E.
0.054


13.
The risk that can be diversified away is
A.
firm specific risk.
B.
beta.
C.
systematic risk.
D.
market risk.
E.
none of the above.


14.
The measure of risk in a Markowitz efficient frontier is:
A.
specific risk.
B.
standard deviation of returns.
C.
reinvestment risk.
D.
beta.
E.
none of the above.


15.
Given an optimal risky portfolio with expected return of 16% and standard deviation of 20% and a risk free rate of 4%, what is the slope of the best feasible CAL?
A.
0.60
B.
0.14
C.
0.08
D.
0.36
E.
0.36


Consider the following probability distribution for stocks A and B:

Reference: 8-1

16.
The expected rate of return and standard deviation of the global minimum variance portfolio, G, are __________ and __________, respectively.
A.
10.07%; 1.05%
B.
9.04%; 2.03%
C.
10.07%; 3.01%
D.
9.04%; 1.05%
E.
none of the above


Consider the following probability distribution for stocks A and B:

Reference: 8-3

17.
The standard deviations of stocks A and B are _____ and _____, respectively.
A.
1.56%; 1.99%
B.
2.45%; 1.68%
C.
3.22%; 2.01%
D.
1.54%; 1.11%
E.
none of the above


18.
As the number of securities in a portfolio is increased, what happens to the average portfolio standard deviation?
A.
It increases at an increasing rate.
B.
It increases at a decreasing rate.
C.
It decreases at an increasing rate.
D.
It decreases at a decreasing rate.
E.
It first decreases, then starts to increase as more securities are added.


19.
Theoretically, the standard deviation of a portfolio can be reduced to what level? Explain. Realistically, is it possible to reduce the standard deviation to this level? Explain.

Answer:


20.
Security X has expected return of 9% and standard deviation of 18%. Security Y has expected return of 12% and standard deviation of 21%. If the two securities have a correlation coefficient of -0.4, what is their covariance?
A.
0.0388
B.
0.0706
C.
0.0184
D.
-0.0133
E.
-0.1512


Consider the following probability distribution for stocks A and B:

Reference: 8-1

21.
Which of the following portfolio(s) is (are) on the efficient frontier?
A.
The portfolio with 20 percent in A and 80 percent in B.
B.
The portfolio with 15 percent in A and 85 percent in B.
C.
The portfolio with 26 percent in A and 74 percent in B.
D.
The portfolio with 10 percent in A and 90 percent in B.
E.
A and B are both on the efficient frontier.


22.
In words, the covariance considers the probability of each scenario happening and the interaction between
A.
securities' returns relative to their variances.
B.
securities' returns relative to their mean returns.
C.
securities' returns relative to other securities' returns.
D.
the level of return a security has in that scenario and the overall portfolio return.
E.
the variance of the security's return in that scenario and the overall portfolio variance.


23.
State Markowitz's mean-variance criterion. Give some numerical examples of how the criterion would be applied.

Answer:


24.
According to a 1991 study by Brinson, Singer and Beebower the policy that explained more than 90% of asset returns was
A.
security selection
B.
asset allocation
C.
good management
D.
market timing
E.
none of the above


25.
Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum variance portfolio has a standard deviation that is always
A.
greater than zero.
B.
equal to zero.
C.
equal to the sum of the securities' standard deviations.
D.
equal to -1.
E.
none of the above.


26.
Other things equal, diversification is most effective when
A.
securities' returns are uncorrelated.
B.
securities' returns are positively correlated.
C.
securities' returns are high.
D.
securities' returns are negatively correlated.
E.
B and C.


27.
An investor who wishes to form a portfolio that lies to the right of the optimal risky portfolio on the Capital Allocation Line must:
A.
lend some of her money at the risk-free rate and invest the remainder in the optimal risky portfolio.
B.
borrow some money at the risk-free rate and invest in the optimal risky portfolio.
C.
invest only in risky securities.
D.
such a portfolio cannot be formed.
E.
B and C


28.
Portfolio theory as described by Markowitz is most concerned with:
A.
the elimination of systematic risk.
B.
the effect of diversification on portfolio risk.
C.
the identification of unsystematic risk.
D.
active portfolio management to enhance returns.
E.
none of the above.


Consider the following probability distribution for stocks A and B:

Reference: 8-1

29.
The expected rates of return of stocks A and B are _____ and _____ , respectively.
A.
13.2%; 9%
B.
14%; 10%
C.
13.2%; 7.7%
D.
7.7%; 13.2%
E.
none of the above


Consider the following probability distribution for stocks A and B:

Reference: 8-3

30.
If you invest 35% of your money in A and 65% in B, what would be your portfolio's expected rate of return and standard deviation?
A.
9.9%; 3%
B.
9.9%; 1.1%
C.
10%; 1.7%
D.
10%; 3%
E.
none of the above


31.
The CAPM can easily be modified to represent a more realistic picture of the world by
A.
incorporating different rates for borrowing and lending.
B.
allowing non-systematic risk to be priced.
C.
assuming that investors do not use margin.
D.
A and B.
E.
A and C.


32.
The separation property refers to the conclusion that
A.
the determination of the best risky portfolio is objective and the choice of the best complete portfolio is subjective.
B.
the choice of the best complete portfolio is objective and the determination of the best risky portfolio is objective.
C.
the choice of inputs to be used to determine the efficient frontier is objective and the choice of the best CAL is subjective.
D.
the determination of the best CAL is objective and the choice of the inputs to be used to determine the efficient frontier is subjective.
E.
investors are separate beings and will therefore have different preferences regarding the risk-return tradeoff.


33.
Explain how the linear risk-return relationship as depicted by the basic version of the CAPM is unrealistic and how the assumptions behind this linear relationship can be relaxed, making the model more realistic.

Answer:


Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 10% and a standard deviation of 16%. B has an expected rate of return of 8% and a standard deviation of 12%.
Reference: 8-2

34.
The risk-free portfolio that can be formed with the two securities will earn _____ rate of return.
A.
8.5%
B.
9.0%
C.
8.9%
D.
9.9%
E.
none of the above


35.
The variance of a portfolio of risky securities
A.
is a weighted sum of the securities' variances.
B.
is the sum of the securities' variances.
C.
is the weighted sum of the securities' variances and covariances.
D.
is the sum of the securities' covariances.
E.
none of the above.


36.
When two risky securities that are positively correlated but not perfectly correlated are held in a portfolio,
A.
the portfolio standard deviation will be greater than the weighted average of the individual security standard deviations.
B.
the portfolio standard deviation will be less than the weighted average of the individual security standard deviations.
C.
the portfolio standard deviation will be equal to the weighted average of the individual security standard deviations.
D.
the portfolio standard deviation will always be equal to the securities' covariance.
E.
none of the above are true.


37.
The efficient frontier of risky assets is
A.
the portion of the investment opportunity set that lies above the global minimum variance portfolio.
B.
the portion of the investment opportunity set that represents the highest standard deviations.
C.
the portion of the investment opportunity set which includes the portfolios with the lowest standard deviation.
D.
the set of portfolios that have zero standard deviation.
E.
both A and B are true.


38.
The individual investor's optimal portfolio is designated by:
A.
The point of tangency with the indifference curve and the capital allocation line.
B.
The point of highest reward to variability ratio in the opportunity set.
C.
The point of tangency with the opportunity set and the capital allocation line.
D.
The point of the highest reward to variability ratio in the indifference curve.
E.
None of the above.


39.
Which statement about portfolio diversification is correct?
A.
Proper diversification can reduce or eliminate systematic risk.
B.
The risk-reducing benefits of diversification do not occur meaningfully until at least 50-60 individual securities have been purchased.
C.
Because diversification reduces a portfolio's total risk, it necessarily reduces the portfolio's expected return.
D.
Typically, as more securities are added to a portfolio, total risk would be expected to decrease at a decreasing rate.
E.
None of the above statements are correct.


Consider the following probability distribution for stocks A and B:

Reference: 8-1

40.
The standard deviations of stocks A and B are _____ and _____, respectively.
A.
1.5%; 1.9%
B.
2.5%; 1.1%
C.
3.2%; 2.0%
D.
1.5%; 1.1%
E.
none of the above



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