Doç.Dr.Fatma Dilvin TAŞKIN – Yaşar...

Chapter 06Efficient Diversification

Multiple Choice Questions

1. Risk that can be eliminated through diversification is called ______ risk.

A. unique

B. firm-specific

C. diversifiable

D. all of these options

2. The _______ decision should take precedence over the _____ decision.

A. asset allocation; stock selection

B. bond selection; mutual fund selection

C. stock selection; asset allocation

D. stock selection; mutual fund selection

3. Many current and retired Enron Corp. employees had their 401k retirement accounts

wiped out when Enron collapsed because ________.

A. they had to pay huge fines for obstruction of justice

B. their 401k accounts were held outside the company

C. their 401k accounts were not well diversified

D. none of these options

© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,

forwarded, distributed, or posted on a website, in whole or part.

4. Based on the outcomes in the following table, choose which of the statements below is (are) correct?

I. The covariance of security A and security B is zero.II. The correlation coefficient between securities A and C is negative.III. The correlation coefficient between securities B and C is positive.

A. I only

B. I and II only

C. II and III only

D. I, II, and III

5. Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B

has an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would prefer a portfolio using the risk-free asset and ______.

A. asset A

B. asset B

C. no risky asset

D. The answer cannot be determined from the data given.

6. Adding additional risky assets to the investment opportunity set will generally move

the efficient frontier _____ and to the ______.

A. up; right

B. up; left

C. down; right

D. down; left



7. An investor's degree of risk aversion will determine his or her ______.

A. optimal risky portfolio

B. risk-free rate

C. optimal mix of the risk-free asset and risky asset

D. capital allocation line

8. The ________ is equal to the square root of the systematic variance divided by the total

variance.

A. covariance

B. correlation coefficient

C. standard deviation

D. reward-to-variability ratio

9. Which of the following statistics cannot be negative?

A. Covariance

B. Variance

C. E(r)

D. Correlation coefficient

10. Asset A has an expected return of 20% and a standard deviation of 25%. The risk-free

rate is 10%. What is the reward-to-variability ratio?

A. .40

B. .50

C. .75

D. .80



11. The correlation coefficient between two assets equals _________.

A. their covariance divided by the product of their variances

B. the product of their variances divided by their covariance

C. the sum of their expected returns divided by their covariance

D. their covariance divided by the product of their standard deviations

12. Diversification is most effective when security returns are _________.

A. high

B. negatively correlated

C. positively correlated

D. uncorrelated

13. The expected rate of return of a portfolio of risky securities is _________.

A. the sum of the securities' covariances

B. the sum of the securities' variances

C. the weighted sum of the securities' expected returns

D. the weighted sum of the securities' variances

14. Beta is a measure of security responsiveness to _________.

A. firm-specific risk

B. diversifiable risk

C. market risk

D. unique risk



15. The risk that can be diversified away is __________.

A. beta

B. firm-specific risk

C. market risk

D. systematic risk

16. Approximately how many securities does it take to diversify almost all of the unique

risk from a portfolio?

A. 2B. 6C. 8D. 2

0 17. 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. equal to the sum of the securities' standard deviations

B. equal to -1

C. equal to 0

D. greater than 0

18. Market risk is also called __________ and _________.

A. systematic risk; diversifiable risk

B. systematic risk; nondiversifiable risk

C. unique risk; nondiversifiable risk

D. unique risk; diversifiable risk



19. Firm-specific risk is also called __________ and __________.





20. Which one of the following stock return statistics fluctuates the most over time?

A. Covariance of returns

B. Variance of returns

C. Average return


21. Harry Markowitz is best known for his Nobel Prize-winning work on _____________.

A. strategies for active securities trading

B. techniques used to identify efficient portfolios of risky assets

C. techniques used to measure the systematic risk of securities

D. techniques used in valuing securities options

22. Suppose that a stock portfolio and a bond portfolio have a zero correlation. This

means that ______.

A. the returns on the stock and bond portfolios tend to move inversely

B. the returns on the stock and bond portfolios tend to vary independently of each other

C. the returns on the stock and bond portfolios tend to move together

D. the covariance of the stock and bond portfolios will be positive



23. You put half of your money in a stock portfolio that has an expected return of 14% and a standard deviation of 24%. You put the rest of your money in a risky bond portfolio that has an expected return of 6% and a standard deviation of 12%. The stock and bond portfolios have a correlation of .55. The standard deviation of the resulting portfolio will be ________________.

A. more than 18% but less than 24%

B. equal to 18%

C. more than 12% but less than 18%

D. equal to 12%

24. On a standard expected return versus standard deviation graph, investors will prefer

portfolios that lie to the _____________ of the current investment opportunity set.

A. left and above

B. left and below

C. right and above

D. right and below

25. The term complete portfolio refers to a portfolio consisting of _________________.

A. the risk-free asset combined with at least one risky asset

B. the market portfolio combined with the minimum-variance portfolio

C. securities from domestic markets combined with securities from foreign markets

D. common stocks combined with bonds

26. Rational risk-averse investors will always prefer portfolios _____________.

A. located on the efficient frontier to those located on the capital market line

B. located on the capital market line to those located on the efficient frontier

C. at or near the minimum-variance point on the efficient frontier

D. that are risk-free to all other asset choices



27. The optimal risky portfolio can be identified by finding:

I. The minimum-variance point on the efficient frontierII. The maximum-return point on the efficient frontier and the minimum-variance point on the efficient frontierIII. The tangency point of the capital market line and the efficient frontierIV. The line with the steepest slope that connects the risk-free rate to the efficient frontier

A. I and II only

B. II and III only

C. III and IV only

D. I and IV only

28. The _________ reward-to-variability ratio is found on the ________ capital market line.

A. lowest; steepest

B. highest; flattest

C. highest; steepest

D. lowest; flattest

29. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of

return of 24%, while stock B has a standard deviation of return of 18%. Stock A comprises 60% of the portfolio, while stock B comprises 40% of the portfolio. If the variance of return on the portfolio is .0380, the correlation coefficient between the returns on A and B is _________.

A. .583

B. .225

C. .327

D. .128



30. The standard deviation of return on investment A is .10, while the standard deviation of return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation coefficient between the returns on A and B is _________.

A. .12

B. .36

C. .60

D. .77

31. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of

return of 35%, while stock B has a standard deviation of return of 15%. The correlation coefficient between the returns on A and B is .45. Stock A comprises 40% of the portfolio, while stock B comprises 60% of the portfolio. The standard deviation of the return on this portfolio is _________.

A. 23%

B. 19.76%

C. 18.45%

D. 17.67%

32. The standard deviation of return on investment A is .10, while the standard deviation

of return on investment B is .04. If the correlation coefficient between the returns on A and B is -.50, the covariance of returns on A and B is _________.

A. -.0447

B. -.0020

C. .0020

D. .0447



33. Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of return of 16% and a standard deviation of return of 20%. B has an expected rate of return of 10% and a standard deviation of return of 30%. The weight of security B in the minimum-variance portfolio is _________.

A. 10%

B. 20%

C. 40%

D. 60%

34. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an

expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is .50. The risk-free rate of return is 10%. The proportion of the optimal risky portfolio that should be invested in stock A is _________.

A. 0%

B. 40%

C. 60%

D. 100%


expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is .50. The risk-free rate of return is 10%. The expected return on the optimal risky portfolio is _________.

A. 14%

B. 15.6%

C. 16.4%

D. 18%



36. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is .50. The risk-free rate of return is 10%. The standard deviation of return on the optimal risky portfolio is _________.

A. 0%

B. 5%

C. 7%

D. 20%


expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The proportion of the optimal risky portfolio that should be invested in stock B is approximately _________.

A. 29%

B. 44%

C. 56%

D. 71%


expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The expected return on the optimal risky portfolio is approximately _________. (Hint: Find weights first.)

A. 14%

B. 16%

C. 18%

D. 19%



39. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The standard deviation of the returns on the optimal risky portfolio is _________.

A. 25.5%

B. 22.3%

C. 21.4%

D. 20.7%

40. An investor can design a risky portfolio based on two stocks, A and B. The standard

deviation of return on stock A is 24%, while the standard deviation on stock B is 14%. The correlation coefficient between the returns on A and B is .35. The expected return on stock A is 25%, while on stock B it is 11%. The proportion of the minimum-variance portfolio that would be invested in stock B is approximately _________.

A. 45%

B. 67%

C. 85%

D. 92%

41. An investor can design a risky portfolio based on two stocks, A and B. The standard

deviation of return on stock A is 20%, while the standard deviation on stock B is 15%. The correlation coefficient between the returns on A and B is 0%. The expected return on the minimum-variance portfolio is approximately _________.

A. 10%

B. 13.6%

C. 15%

D. 19.41%



42. An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20%, while the standard deviation on stock B is 15%. The correlation coefficient between the returns on A and B is 0%. The standard deviation of return on the minimum-variance portfolio is _________.

A. 0%

B. 6%

C. 12%

D. 17%

43. A measure of the riskiness of an asset held in isolation is ____________.

A. beta

B. standard deviation

C. covariance

D. alpha

44. Semitool Corp. has an expected excess return of 6% for next year. However, for every

unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it turns out that the economy and the stock market do better than expected by 1.5% and Semitool's products experience more rapid growth than anticipated, pushing up the stock price by another 1%. Based on this information, what was Semitool's actual excess return?

A. 7%

B. 8.5%

C. 8.8%

D. 9.25%



45. The part of a stock's return that is systematic is a function of which of the following variables?

I. Volatility in excess returns of the stock marketII. The sensitivity of the stock's returns to changes in the stock marketIII. The variance in the stock's returns that is unrelated to the overall stock market

A. I only

B. I and II only

C. II and III only

D. I, II, and III

46. Stock A has a beta of 1.2, and stock B has a beta of 1. The returns of stock A are

______ sensitive to changes in the market than are the returns of stock B.

A. 20% more

B. slightly more

C. 20% less

D. slightly less

47. Which risk can be partially or fully diversified away as additional securities are added

to a portfolio?

I. Total riskII. Systematic riskIII. Firm-specific risk

A. I only

B. I and II only

C. I, II, and III

D. I and III



48. According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of __________ and __________.

A. identifying all investor imposed constraints; identifying the set of securities that conform to the investor's constraints and offer the best risk-return trade-offs

B. identifying the investor's degree of risk aversion; choosing securities from industry groups that are consistent with the investor's risk profile

C. identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion

D. choosing which risky assets an investor prefers according to the investor's risk-aversion level; minimizing the CAL by lending at the risk-free rate

49. You are constructing a scatter plot of excess returns for stock A versus the market

index. If the correlation coefficient between stock A and the index is -1, you will find that the points of the scatter diagram ___________ and the line of best fit has a ______________.

A. all fall on the line of best fit; positive slope

B. all fall on the line of best fit; negative slope

C. are widely scattered around the line; positive slope

D. are widely scattered around the line; negative slope

50. The term excess return refers to ______________.

A. returns earned illegally by means of insider trading

B. the difference between the rate of return earned and the risk-free rate

C. the difference between the rate of return earned on a particular security and the rate of return earned on other securities of equivalent risk

D. the portion of the return on a security that represents tax liability and therefore cannot be reinvested

51. You are recalculating the risk of ACE stock in relation to the market index, and you

find that the ratio of the systematic variance to the total variance has risen. You must also find that the ____________.

A. covariance between ACE and the market has fallen

B. correlation coefficient between ACE and the market has fallen

C. correlation coefficient between ACE and the market has risen

D. unsystematic risk of ACE has risen



52. A stock has a correlation with the market of .45. The standard deviation of the market is 21%, and the standard deviation of the stock is 35%. What is the stock's beta?

A. 1B. .7

5C. .6

0D. .5

5 53. The values of beta coefficients of securities are __________.

A. always positive

B. always negative

C. always between positive 1 and negative 1

D. usually positive but are not restricted in any particular way

54. A security's beta coefficient will be negative if ____________.

A. its returns are negatively correlated with market-index returns

B. its returns are positively correlated with market-index returns

C. its stock price has historically been very stable

D. market demand for the firm's shares is very low

55. The market value weighted-average beta of firms included in the market index will

always be _____________.

A. 0B. between 0

and 1C. 1D. none of these options (There is no particular rule concerning the average beta of

firms included in the market index.)



56. Diversification can reduce or eliminate __________ risk.

A. all

B. systematic

C. nonsystematic

D. only an insignificant

57. To construct a riskless portfolio using two risky stocks, one would need to find two

stocks with a correlation coefficient of ________.

A. 1B. .

5C. 0D. -

1 58. Some diversification benefits can be achieved by combining securities in a portfolio as

long as the correlation between the securities is _____________.

A. 1B. less than

1C. between 0

and 1D. less than or equal

to 0 59. If an investor does not diversify his portfolio and instead puts all of his money in one

stock, the appropriate measure of security risk for that investor is the ________.

A. stock's standard deviation

B. variance of the market

C. stock's beta

D. covariance with the market index



60. Which of the following provides the best example of a systematic-risk event?

A. A strike by union workers hurts a firm's quarterly earnings.

B. Mad Cow disease in Montana hurts local ranchers and buyers of beef.

C. The Federal Reserve increases interest rates 50 basis points.

D. A senior executive at a firm embezzles $10 million and escapes to South America.

61. Which of the following statements is (are) true regarding time diversification?

I. The standard deviation of the average annual rate of return over several years will be smaller than the 1-year standard deviation.II. For a longer time horizon, uncertainty compounds over a greater number of years.III. Time diversification does not reduce risk.

A. I only

B. II only

C. II and III only

D. I, II, and III

62. You find that the annual Sharpe ratio for stock A returns is equal to 1.8. For a 3-year

holding period, the Sharpe ratio would equal _______.

A. 1.8

B. 2.48

C. 3.12

D. 5.49



63.

The beta of this stock is ____.

A. .12

B. .35

C. 1.32

D. 4.05

64.

This stock has greater systematic risk than a stock with a beta of ___.

A. .50

B. 1.5

C. 2D. 3



65.

The characteristic line for this stock is Rstock = ___ + ___ Rmarket.

A. .35; .12

B. 4.05; 1.32

C. 15.44; .97

D. .26; 1.36

66.

_______________ percent of the variance is explained by this regression.

A. 12

B. 35

C. 4.05

D. 80



67.

The stock is ______ riskier than the typical stock.

A. 32%

B. 15.44%

C. 12%

D. 38%

68. Decreasing the number of stocks in a portfolio from 50 to 10 would likely

________________.

A. increase the systematic risk of the portfolio

B. increase the unsystematic risk of the portfolio

C. increase the return of the portfolio

D. decrease the variation in returns the investor faces in any one year

69. If you want to know the portfolio standard deviation for a three-stock portfolio, you

will have to ______.

A. calculate two covariances and one trivariance

B. calculate only two covariances

C. calculate three covariances

D. average the variances of the individual stocks



70. Which of the following correlation coefficients will produce the least diversification benefit?

A. -.6

B. -.3

C. 0D. .

8 71. Which of the following correlation coefficients will produce the most diversification

benefits?

A. -.6

B. -.9

C. 0D. .

4 72. What is the most likely correlation coefficient between a stock-index mutual fund and

the S&P 500?

A. -1

B. 0C. 1D. .

5 73. Investing in two assets with a correlation coefficient of -.5 will reduce what kind of

risk?

A. Market risk

B. Nondiversifiable risk

C. Systematic risk

D. Unique risk



74. Investing in two assets with a correlation coefficient of 1 will reduce which kind of risk?

A. Market risk

B. Unique risk

C. Unsystematic risk

D. None of these options (With a correlation of 1, no risk will be reduced.)

75. A portfolio of stocks fluctuates when the Treasury yields change. Since this risk cannot

be eliminated through diversification, it is called __________.


B. systematic risk

C. unique risk

D. none of the options

76. As you lengthen the time horizon of your investment period and decide to invest for

multiple years, you will find that:

I. The average risk per year may be smaller over longer investment horizons.II. The overall risk of your investment will compound over time.III. Your overall risk on the investment will fall.

A. I only

B. I and II only

C. III only

D. I, II, and III



77. You are considering adding a new security to your portfolio. To decide whether you should add the security, you need to know the security's:

I. Expected returnII. Standard deviationIII. Correlation with your portfolio

A. I only

B. I and II only

C. I and III only

D. I, II, and III

78. Which of the following is a correct expression concerning the formula for the standard

deviation of returns of a two-asset portfolio where the correlation coefficient is positive?

A. σ2rp < (W12σ12 + W22σ22)

B. σ2rp = (W12σ12 + W22σ22)

C. σ2rp = (W12σ12 - W22σ22)

D. σ2rp > (W12σ12 + W22σ22)

79. What is the standard deviation of a portfolio of two stocks given the following data:

Stock A has a standard deviation of 18%. Stock B has a standard deviation of 14%. The portfolio contains 40% of stock A, and the correlation coefficient between the two stocks is -.23.

A. 9.7%

B. 12.2%

C. 14%

D. 15.6%



80. What is the standard deviation of a portfolio of two stocks given the following data: Stock A has a standard deviation of 30%. Stock B has a standard deviation of 18%. The portfolio contains 60% of stock A, and the correlation coefficient between the two stocks is -1.

A. 0%

B. 10.8%

C. 18%

D. 24%

81. The expected return of a portfolio is 8.9%, and the risk-free rate is 3.5%. If the

portfolio standard deviation is 12%, what is the reward-to-variability ratio of the portfolio?

A. 0B. .4

5C. .7

4D. 1.3

5 82. A project has a 60% chance of doubling your investment in 1 year and a 40% chance

of losing half your money. What is the standard deviation of this investment?

A. 25%

B. 50%

C. 62%

D. 73%

83. A project has a 50% chance of doubling your investment in 1 year and a 50% chance

of losing half your money. What is the expected return on this investment project?

A. 0%

B. 25%

C. 50%

D. 75%



84. The figures below show plots of monthly excess returns for two stocks plotted against excess returns for a market index.

Which stock is likely to further reduce risk for an investor currently holding her portfolio in a well-diversified portfolio of common stock?

A. Stock A

B. Stock B

C. There is no difference between A or B.

D. The answer cannot be determined from the information given.

85. The figures below show plots of monthly excess returns for two stocks plotted against

excess returns for a market index.

Which stock is riskier to a nondiversified investor who puts all his money in only one of these stocks?

A. Stock A is riskier.

B. Stock B is riskier.

C. Both stocks are equally risky.






Chapter 06 Efficient Diversification Answer Key

Multiple Choice Questions

1. Risk that can be eliminated through diversification is called ______ risk.

A. unique

B. firm-specific

C. diversifiable

D. all of these options

AACSB: Analytic

Blooms: RememberDifficulty: 1 Easy

Learning Objective: 06-01 Show how covariance and correlation affect the power of diversification to reduce portfolio risk.

Topic: Diversification and Portfolio Risk

2. The _______ decision should take precedence over the _____ decision.

A. asset allocation; stock selection

B. bond selection; mutual fund selection

C. stock selection; asset allocation

D. stock selection; mutual fund selection

AACSB: Analytic

Blooms: RememberDifficulty: 2 Medium

Learning Objective: 06-02 Calculate mean; variance; and covariance using either historical data or scenario analysis.

Topic: Asset Allocation with Two Risky Assets



3. Many current and retired Enron Corp. employees had their 401k retirement accounts wiped out when Enron collapsed because ________.

A. they had to pay huge fines for obstruction of justice

B. their 401k accounts were held outside the company

C. their 401k accounts were not well diversified

D. none of these options

AACSB: Reflective Thinking

Blooms: UnderstandDifficulty: 1 Easy



4. Based on the outcomes in the following table, choose which of the statements below is (are) correct?

I. The covariance of security A and security B is zero.II. The correlation coefficient between securities A and C is negative.III. The correlation coefficient between securities B and C is positive.

A. I only

B. I and II only

C. II and III only

D. I, II, and III


Blooms: UnderstandDifficulty: 3 Hard





5. Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would prefer a portfolio using the risk-free asset and ______.

A. asset A

B. asset B

C. no risky asset

D. The answer cannot be determined from the data given.


Blooms: UnderstandDifficulty: 2 Medium



6. Adding additional risky assets to the investment opportunity set will generally move the efficient frontier _____ and to the ______.

A. up; right

B. up; left

C. down; right

D. down; left

AACSB: Analytic


Learning Objective: 06-05 Use index models to analyze the risk and return characteristics of securities and portfolios.

Topic: Efficient Diversification with Many Risky Assets

7. An investor's degree of risk aversion will determine his or her ______.

A. optimal risky portfolio

B. risk-free rate

C. optimal mix of the risk-free asset and risky asset

D. capital allocation line

AACSB: Analytic


Learning Objective: 06-03 Construct efficient portfolios and use the Sharpe ratio to evaluate portfolio efficiency.Topic: The Optimal Risky Portfolio with a Risk-Free Asset



8. The ________ is equal to the square root of the systematic variance divided by the

total variance.

A. covariance

B. correlation coefficient

C. standard deviation

D. reward-to-variability ratio

AACSB: Analytic




9. Which of the following statistics cannot be negative?

A. Covariance

B. Variance

C. E(r)


AACSB: Analytic






10. Asset A has an expected return of 20% and a standard deviation of 25%. The risk-free rate is 10%. What is the reward-to-variability ratio?

A. .40

B. .50

C. .75

D. .80

AACSB: Analytic

Blooms: ApplyDifficulty: 2 Medium


11. The correlation coefficient between two assets equals _________.

A. their covariance divided by the product of their variances

B. the product of their variances divided by their covariance

C. the sum of their expected returns divided by their covariance

D. their covariance divided by the product of their standard deviations

AACSB: Analytic




12. Diversification is most effective when security returns are _________.

A. high

B. negatively correlated

C. positively correlated

D. uncorrelated

AACSB: Analytic






13. The expected rate of return of a portfolio of risky securities is _________.

A. the sum of the securities' covariances

B. the sum of the securities' variances

C. the weighted sum of the securities' expected returns

D. the weighted sum of the securities' variances

AACSB: Analytic




14. Beta is a measure of security responsiveness to _________.


B. diversifiable risk

C. market risk

D. unique risk

AACSB: Analytic



Topic: A Single-Index Stock Market

15. The risk that can be diversified away is __________.

A. beta

B. firm-specific risk

C. market risk

D. systematic risk

AACSB: Analytic

Blooms: Remember



Difficulty: 1 EasyLearning Objective: 06-01 Show how covariance and correlation affect the power of diversification to reduce

portfolio risk.Topic: Diversification and Portfolio Risk

16. Approximately how many securities does it take to diversify almost all of the

unique risk from a portfolio?

A. 2B. 6C. 8D. 2

0

AACSB: AnalyticBlooms: Remember

Difficulty: 1 EasyLearning Objective: 06-01 Show how covariance and correlation affect the power of diversification to reduce

portfolio risk.Topic: Diversification and Portfolio Risk

17. 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. equal to the sum of the securities' standard deviations

B. equal to -1

C. equal to 0

D. greater than 0

AACSB: Analytic




18. Market risk is also called __________ and _________.





AACSB: Analytic






19. Firm-specific risk is also called __________ and __________.





AACSB: Analytic




20. Which one of the following stock return statistics fluctuates the most over time?

A. Covariance of returns

B. Variance of returns

C. Average return


AACSB: Analytic




21. Harry Markowitz is best known for his Nobel Prize-winning work on _____________.

A. strategies for active securities trading

B. techniques used to identify efficient portfolios of risky assets

C. techniques used to measure the systematic risk of securities

D. techniques used in valuing securities options

AACSB: Analytic


Learning Objective: 06-05 Use index models to analyze the risk and return characteristics of securities and



portfolios.Topic: Efficient Diversification with Many Risky Assets

22. Suppose that a stock portfolio and a bond portfolio have a zero correlation. This

means that ______.

A. the returns on the stock and bond portfolios tend to move inversely

B. the returns on the stock and bond portfolios tend to vary independently of each other

C. the returns on the stock and bond portfolios tend to move together

D. the covariance of the stock and bond portfolios will be positive

AACSB: Analytic




23. You put half of your money in a stock portfolio that has an expected return of 14% and a standard deviation of 24%. You put the rest of your money in a risky bond portfolio that has an expected return of 6% and a standard deviation of 12%. The stock and bond portfolios have a correlation of .55. The standard deviation of the resulting portfolio will be ________________.

A. more than 18% but less than 24%

B. equal to 18%

C. more than 12% but less than 18%

D. equal to 12%

σ2p = .02592 = (.52)(.242) + (.52)(.122) + 2(.5)(.5)(.24)(.12).55 = .02592; σ = 16.1%

AACSB: Analytic

Blooms: ApplyDifficulty: 3 Hard





24. On a standard expected return versus standard deviation graph, investors will prefer portfolios that lie to the _____________ of the current investment opportunity set.

A. left and above

B. left and below

C. right and above

D. right and below

AACSB: Analytic




25. The term complete portfolio refers to a portfolio consisting of _________________.

A. the risk-free asset combined with at least one risky asset

B. the market portfolio combined with the minimum-variance portfolio

C. securities from domestic markets combined with securities from foreign markets

D. common stocks combined with bonds

AACSB: Analytic



26. Rational risk-averse investors will always prefer portfolios _____________.

A. located on the efficient frontier to those located on the capital market line

B. located on the capital market line to those located on the efficient frontier

C. at or near the minimum-variance point on the efficient frontier

D. that are risk-free to all other asset choices

AACSB: Analytic





27. The optimal risky portfolio can be identified by finding:

I. The minimum-variance point on the efficient frontierII. The maximum-return point on the efficient frontier and the minimum-variance point on the efficient frontierIII. The tangency point of the capital market line and the efficient frontierIV. The line with the steepest slope that connects the risk-free rate to the efficient frontier

A. I and II only

B. II and III only

C. III and IV only

D. I and IV only

AACSB: Analytic



28. The _________ reward-to-variability ratio is found on the ________ capital market

line.

A. lowest; steepest

B. highest; flattest

C. highest; steepest

D. lowest; flattest

AACSB: Analytic





29. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 24%, while stock B has a standard deviation of return of 18%. Stock A comprises 60% of the portfolio, while stock B comprises 40% of the portfolio. If the variance of return on the portfolio is .0380, the correlation coefficient between the returns on A and B is _________.

A. .583

B. .225

C. .327

D. .128

.0380 = (.62)(.242) + (.42)(.182) + 2(.6)(.4)(.24)(.18) ρ; ρ = .583

AACSB: Analytic

Blooms: RememberDifficulty: 3 Hard



30. The standard deviation of return on investment A is .10, while the standard deviation of return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation coefficient between the returns on A and B is _________.

A. .12

B. .36

C. .60

D. .77

Correlation =

AACSB: Analytic






31. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 35%, while stock B has a standard deviation of return of 15%. The correlation coefficient between the returns on A and B is .45. Stock A comprises 40% of the portfolio, while stock B comprises 60% of the portfolio. The standard deviation of the return on this portfolio is _________.

A. 23%

B. 19.76%

C. 18.45%

D. 17.67%

σ2p = (.402)(.352) + (.602)(.15)2 + (2)(.4)(.6)(.35)(.15)(.45)

σ2p = .039046

σp = 19.76%

AACSB: Analytic




32. The standard deviation of return on investment A is .10, while the standard deviation of return on investment B is .04. If the correlation coefficient between the returns on A and B is -.50, the covariance of returns on A and B is _________.

A. -.0447

B. -.0020

C. .0020

D. .0447

AACSB: Analytic






33. Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of return of 16% and a standard deviation of return of 20%. B has an expected rate of return of 10% and a standard deviation of return of 30%. The weight of security B in the minimum-variance portfolio is _________.

A. 10%

B. 20%

C. 40%

D. 60%

AACSB: Analytic






34. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is .50. The risk-free rate of return is 10%. The proportion of the optimal risky portfolio that should be invested in stock A is _________.

A. 0%

B. 40%

C. 60%

D. 100%

Since the numerator equals zero, WA = 0 without any further calculations.

AACSB: Analytic


Learning Objective: 06-04 Calculate the composition of the optimal risky portfolio.Topic: The Optimal Risky Portfolio with a Risk-Free Asset



35. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is .50. The risk-free rate of return is 10%. The expected return on the optimal risky portfolio is _________.

A. 14%

B. 15.6%

C. 16.4%

D. 18%

Wa = 0E(rp) = 1(.14) = .1400Since WA = 0 and WB = 1, the risky portfolio's expected return is the same as asset B's expected return.

AACSB: Analytic





36. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is .50. The risk-free rate of return is 10%. The standard deviation of return on the optimal risky portfolio is _________.

A. 0%

B. 5%

C. 7%

D. 20%

Wa = 0

Since WA = 0 and WB = 1, the risky portfolio's standard deviation is the same as asset B's standard deviation.

AACSB: Analytic





37. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The proportion of the optimal risky portfolio that should be invested in stock B is approximately _________.

A. 29%

B. 44%

C. 56%

D. 71%

WB = 71%

AACSB: Analytic





38. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The expected return on the optimal risky portfolio is approximately _________. (Hint: Find weights first.)

A. 14%

B. 16%

C. 18%

D. 19%

WB = 71% and WA = 29%E[rp] = (.29)(.21) + (.71)(.14) = 16.03%

AACSB: Analytic





39. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The standard deviation of the returns on the optimal risky portfolio is _________.

A. 25.5%

B. 22.3%

C. 21.4%

D. 20.7%

WB = 71% and WA = 29%σ2

rp = (.292)(.392) + (.712)(.202) + 2(.29)(.71)(.39)(.20).4σ2

rp = .045804σrp = 21.4%

AACSB: Analytic





40. An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 24%, while the standard deviation on stock B is 14%. The correlation coefficient between the returns on A and B is .35. The expected return on stock A is 25%, while on stock B it is 11%. The proportion of the minimum-variance portfolio that would be invested in stock B is approximately _________.

A. 45%

B. 67%

C. 85%

D. 92%

WB = ; COVAB = ρABσAσB = (.35)(.24)(.14) = .01176

WB =

AACSB: Analytic






41. An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20%, while the standard deviation on stock B is 15%. The correlation coefficient between the returns on A and B is 0%. The expected return on the minimum-variance portfolio is approximately _________.

A. 10%

B. 13.6%

C. 15%

D. 19.41%

AACSB: Analytic




42. An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20%, while the standard deviation on stock B is 15%. The correlation coefficient between the returns on A and B is 0%. The standard deviation of return on the minimum-variance portfolio is _________.

A. 0%

B. 6%

C. 12%

D. 17%

AACSB: Analytic

Blooms: Apply© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,


Difficulty: 3 HardLearning Objective: 06-02 Calculate mean; variance; and covariance using either historical data or scenario

analysis.Topic: Asset Allocation with Two Risky Assets

43. A measure of the riskiness of an asset held in isolation is ____________.

A. beta

B. standard deviation

C. covariance

D. alpha

AACSB: Analytic




44. Semitool Corp. has an expected excess return of 6% for next year. However, for every unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it turns out that the economy and the stock market do better than expected by 1.5% and Semitool's products experience more rapid growth than anticipated, pushing up the stock price by another 1%. Based on this information, what was Semitool's actual excess return?

A. 7%

B. 8.5%

C. 8.8%

D. 9.25%

6% + (1.5%)(1.2) + 1% = 8.8%

AACSB: Analytic






45. The part of a stock's return that is systematic is a function of which of the following variables?

I. Volatility in excess returns of the stock marketII. The sensitivity of the stock's returns to changes in the stock marketIII. The variance in the stock's returns that is unrelated to the overall stock market

A. I only

B. I and II only

C. II and III only

D. I, II, and III

AACSB: Analytic




46. Stock A has a beta of 1.2, and stock B has a beta of 1. The returns of stock A are ______ sensitive to changes in the market than are the returns of stock B.

A. 20% more

B. slightly more

C. 20% less

D. slightly less

AACSB: Analytic






47. Which risk can be partially or fully diversified away as additional securities are added to a portfolio?

I. Total riskII. Systematic riskIII. Firm-specific risk

A. I only

B. I and II only

C. I, II, and III

D. I and III

AACSB: Analytic




48. According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of __________ and __________.

A. identifying all investor imposed constraints; identifying the set of securities that conform to the investor's constraints and offer the best risk-return trade-offs

B. identifying the investor's degree of risk aversion; choosing securities from industry groups that are consistent with the investor's risk profile

C. identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion

D. choosing which risky assets an investor prefers according to the investor's risk-aversion level; minimizing the CAL by lending at the risk-free rate

AACSB: Analytic





49. You are constructing a scatter plot of excess returns for stock A versus the market index. If the correlation coefficient between stock A and the index is -1, you will find that the points of the scatter diagram ___________ and the line of best fit has a ______________.

A. all fall on the line of best fit; positive slope

B. all fall on the line of best fit; negative slope

C. are widely scattered around the line; positive slope

D. are widely scattered around the line; negative slope

AACSB: Analytic




50. The term excess return refers to ______________.

A. returns earned illegally by means of insider trading

B. the difference between the rate of return earned and the risk-free rate

C. the difference between the rate of return earned on a particular security and the rate of return earned on other securities of equivalent risk

D. the portion of the return on a security that represents tax liability and therefore cannot be reinvested

AACSB: Analytic



51. You are recalculating the risk of ACE stock in relation to the market index, and you

find that the ratio of the systematic variance to the total variance has risen. You must also find that the ____________.

A. covariance between ACE and the market has fallen

B. correlation coefficient between ACE and the market has fallen

C. correlation coefficient between ACE and the market has risen

D. unsystematic risk of ACE has risen

AACSB: Analytic






52. A stock has a correlation with the market of .45. The standard deviation of the market is 21%, and the standard deviation of the stock is 35%. What is the stock's beta?

A. 1B. .7

5C. .6

0D. .5

5

β =

AACSB: Analytic




53. The values of beta coefficients of securities are __________.

A. always positive

B. always negative

C. always between positive 1 and negative 1

D. usually positive but are not restricted in any particular way

AACSB: Analytic






54. A security's beta coefficient will be negative if ____________.

A. its returns are negatively correlated with market-index returns

B. its returns are positively correlated with market-index returns

C. its stock price has historically been very stable

D. market demand for the firm's shares is very low

AACSB: Analytic




55. The market value weighted-average beta of firms included in the market index will always be _____________.

A. 0B. between 0

and 1C. 1D. none of these options (There is no particular rule concerning the average beta of

firms included in the market index.)


Difficulty: 1 EasyLearning Objective: 06-05 Use index models to analyze the risk and return characteristics of securities and

portfolios.Topic: A Single-Index Stock Market

56. Diversification can reduce or eliminate __________ risk.

A. all

B. systematic

C. nonsystematic

D. only an insignificant

AACSB: Analytic






57. To construct a riskless portfolio using two risky stocks, one would need to find two stocks with a correlation coefficient of ________.

A. 1B. .

5C. 0D. -

1


Difficulty: 1 EasyLearning Objective: 06-02 Calculate mean; variance; and covariance using either historical data or scenario


58. Some diversification benefits can be achieved by combining securities in a portfolio

as long as the correlation between the securities is _____________.

A. 1B. less than

1C. between 0

and 1D. less than or equal

to 0




59. If an investor does not diversify his portfolio and instead puts all of his money in

one stock, the appropriate measure of security risk for that investor is the ________.

A. stock's standard deviation

B. variance of the market

C. stock's beta

D. covariance with the market index

AACSB: Analytic






60. Which of the following provides the best example of a systematic-risk event?

A. A strike by union workers hurts a firm's quarterly earnings.

B. Mad Cow disease in Montana hurts local ranchers and buyers of beef.

C. The Federal Reserve increases interest rates 50 basis points.

D. A senior executive at a firm embezzles $10 million and escapes to South America.

AACSB: Analytic




61. Which of the following statements is (are) true regarding time diversification?

I. The standard deviation of the average annual rate of return over several years will be smaller than the 1-year standard deviation.II. For a longer time horizon, uncertainty compounds over a greater number of years.III. Time diversification does not reduce risk.

A. I only

B. II only

C. II and III only

D. I, II, and III

AACSB: Analytic



Topic: Risk of Long-Term Investments



62. You find that the annual Sharpe ratio for stock A returns is equal to 1.8. For a 3-year holding period, the Sharpe ratio would equal _______.

A. 1.8

B. 2.48

C. 3.12

D. 5.49

The Sharpe ration grows at a rate of so the 3-year Sharpe ration would be 1.8

× = 3.12.

AACSB: Analytic

Blooms: ApplyDifficulty: 1 Easy



63.

The beta of this stock is ____.

A. .12

B. .35

C. 1.32

D. 4.05

Beta equals slope coefficient = 1.32

AACSB: Analytic

Blooms: Apply



Difficulty: 1 EasyLearning Objective: 06-05 Use index models to analyze the risk and return characteristics of securities and

portfolios.Topic: A Single-Index Stock Market

64.

This stock has greater systematic risk than a stock with a beta of ___.

A. .50

B. 1.5

C. 2D. 3

.50 < 1.32

AACSB: Analytic






65.

The characteristic line for this stock is Rstock = ___ + ___ Rmarket.

A. .35; .12

B. 4.05; 1.32

C. 15.44; .97

D. .26; 1.36

Intercept equals 4.05, and slope equals 1.32.

AACSB: Analytic






66.

_______________ percent of the variance is explained by this regression.

A. 12

B. 35

C. 4.05

D. 80

R2 = 12 means 12% of the variance is explained by the regression.

AACSB: Analytic






67.

The stock is ______ riskier than the typical stock.

A. 32%

B. 15.44%

C. 12%

D. 38%

Beta of 1.32 means that this stock is 32% riskier than the market.

AACSB: Analytic




68. Decreasing the number of stocks in a portfolio from 50 to 10 would likely ________________.

A. increase the systematic risk of the portfolio

B. increase the unsystematic risk of the portfolio

C. increase the return of the portfolio

D. decrease the variation in returns the investor faces in any one year

AACSB: Analytic






69. If you want to know the portfolio standard deviation for a three-stock portfolio, you will have to ______.

A. calculate two covariances and one trivariance

B. calculate only two covariances

C. calculate three covariances

D. average the variances of the individual stocks

AACSB: Analytic




70. Which of the following correlation coefficients will produce the least diversification benefit?

A. -.6

B. -.3

C. 0D. .

8




71. Which of the following correlation coefficients will produce the most diversification

benefits?

A. -.6

B. -.9

C. 0D. .

4






72. What is the most likely correlation coefficient between a stock-index mutual fund and the S&P 500?

A. -1

B. 0C. 1D. .

5




73. Investing in two assets with a correlation coefficient of -.5 will reduce what kind of

risk?

A. Market risk

B. Nondiversifiable risk

C. Systematic risk

D. Unique risk

AACSB: Analytic




74. Investing in two assets with a correlation coefficient of 1 will reduce which kind of risk?

A. Market risk

B. Unique risk

C. Unsystematic risk

D. None of these options (With a correlation of 1, no risk will be reduced.)

AACSB: Analytic






75. A portfolio of stocks fluctuates when the Treasury yields change. Since this risk cannot be eliminated through diversification, it is called __________.


B. systematic risk

C. unique risk

D. none of the options

AACSB: Analytic




76. As you lengthen the time horizon of your investment period and decide to invest for multiple years, you will find that:

I. The average risk per year may be smaller over longer investment horizons.II. The overall risk of your investment will compound over time.III. Your overall risk on the investment will fall.

A. I only

B. I and II only

C. III only

D. I, II, and III

AACSB: Analytic






77. You are considering adding a new security to your portfolio. To decide whether you should add the security, you need to know the security's:

I. Expected returnII. Standard deviationIII. Correlation with your portfolio

A. I only

B. I and II only

C. I and III only

D. I, II, and III

AACSB: Analytic




78. Which of the following is a correct expression concerning the formula for the standard deviation of returns of a two-asset portfolio where the correlation coefficient is positive?

A. σ2rp < (W12σ12 + W22σ22)

B. σ2rp = (W12σ12 + W22σ22)

C. σ2rp = (W12σ12 - W22σ22)

D. σ2rp > (W12σ12 + W22σ22)

AACSB: Analytic






79. What is the standard deviation of a portfolio of two stocks given the following data: Stock A has a standard deviation of 18%. Stock B has a standard deviation of 14%. The portfolio contains 40% of stock A, and the correlation coefficient between the two stocks is -.23.

A. 9.7%

B. 12.2%

C. 14%

D. 15.6%

AACSB: Analytic




80. What is the standard deviation of a portfolio of two stocks given the following data: Stock A has a standard deviation of 30%. Stock B has a standard deviation of 18%. The portfolio contains 60% of stock A, and the correlation coefficient between the two stocks is -1.

A. 0%

B. 10.8%

C. 18%

D. 24%

AACSB: Analytic






81. The expected return of a portfolio is 8.9%, and the risk-free rate is 3.5%. If the portfolio standard deviation is 12%, what is the reward-to-variability ratio of the portfolio?

A. 0B. .4

5C. .7

4D. 1.3

5

Reward-to-variability ratio = (.089 - .035)/.12 = .45

AACSB: Analytic



82. A project has a 60% chance of doubling your investment in 1 year and a 40%

chance of losing half your money. What is the standard deviation of this investment?

A. 25%

B. 50%

C. 62%

D. 73%

E[rp] = (.60)(1) + (.40)(-.5) = .40σ2

rp = (.60)(1 - .40)2 + (.40)(-.5 - .40)2 = .54σrp = .73

AACSB: Analytic






83. A project has a 50% chance of doubling your investment in 1 year and a 50% chance of losing half your money. What is the expected return on this investment project?

A. 0%

B. 25%

C. 50%

D. 75%

E[rp] = (.5)(100) + (.5)(-50) = 25%

AACSB: Analytic




84. The figures below show plots of monthly excess returns for two stocks plotted against excess returns for a market index.

Which stock is likely to further reduce risk for an investor currently holding her portfolio in a well-diversified portfolio of common stock?

A. Stock A

B. Stock B

C. There is no difference between A or B.


AACSB: Analytic






85. The figures below show plots of monthly excess returns for two stocks plotted

against excess returns for a market index.

Which stock is riskier to a nondiversified investor who puts all his money in only one of these stocks?

A. Stock A is riskier.

B. Stock B is riskier.

C. Both stocks are equally risky.


AACSB: Analytic






Date post:	11-Mar-2021
Category:	Documents
Upload:	others
View:	0 times
Download:	0 times

Doç.Dr.Fatma Dilvin TAŞKIN – Yaşar...

Documents