Portfolio Management

The correlation between the risk-free asset and the risky asset equals which of the following: A. 0 B. -1 C. 1

The correlation between the risk-free asset and the risky asset equals which of the following: A. 0 The risk-free investment offers something new to financiers - that is zero-risk and zero correlation with the risky asset. This helps them form their product mix, including both the risk-free rate and the market portfolio.

The market risk premium is equal to the following: A. The expected return of the market minus the risk-free rate B. The expected return of the market plus the risk-free rate C. The risk-free rate minus the expected return of the market

The market risk premium is equal to the following: A. The expected return of the market minus the risk-free rate The market risk premium is the difference between the return on the market rate and the risk-free rate.

What is the risk measure that the capital market line (CML) plots? A. Total risk B. Systematic risk C. Unsystematic risk

What is the risk measure that the capital market line (CML) plots? A. Total risk The capital market line (CML) plots return against total risk, which is measured by the standard deviation of returns.

Which of the following asset classes has historically had the lowest returns and standard deviation? A. Small-capitalization stocks B. Large-capitalization stocks C. Long-term corporate bonds

Which of the following asset classes has historically had the lowest returns and standard deviation? C. Long-term corporate bonds Small-capitalization stocks realized the greatest average return for the highest level of risk followed by large company stocks. Historically, bonds have underperformed stocks.

Which of the following is least likely to be an example of a return generating model? A. Macroeconomic model B. Statistical model C. Regression model

Which of the following is least likely to be an example of a return generating model? C. Regression model The three most commonly used models are: macroeconomic, fundamental, and statistical models. Macroeconomic models use economic factors such as interest rates, employment, and inflation to explain the security's return. Alternatively, fundamental models analyze the relationship between an asset's return and its underlying financials, such as earnings, earnings growth, and market capitalization. And finally, statistical approaches evaluate historical and cross-sectional return data to explain the variance and covariance in returns.

Which of the following statements is least likely true for defined benefit pension plans: A. Defined benefit pension plans offer employees a predetermined benefit on retirement B. Most workers under a defined benefit plan do not have to contribute a portion of their salary C. Defined benefit plans are more portable than defined contribution plans

Which of the following statements is least likely true for defined benefit pension plans: C. Defined benefit plans are more portable than defined contribution plans Both statements A and B are accurate. Statement C is wrong. Defined benefit plans are not as portable as defined contribution plans. As you know, the latter allow employees to roll over the vested portion of their retirement benefits into another plan when they change jobs.

A portfolio to the left of the market portfolio on the CML is: A. A lending portfolio B. A borrowing portfolio C. An inefficient portfolio

A portfolio to the left of the market portfolio on the CML is: A. A lending portfolio Statement A is accurate. Lending portfolio are those that have some stake in the risk-free asset. Put simply, this investment is equivalent to lending to the government at the risk-free rate. Statement B is not accurate. Investors that are interested in high expected returns will be able to borrow money and invest it in the market portfolio, going further along the capital market line. We refer to them as "borrowing" or leverage portfolios. Statement C is wrong. Portfolios that lie on the CML are efficient.

A top-down security analysis is most likely to begin with: A. Identifying attractive investments in particular market sectors B. Analyzing a firm's business prospects and quality of management C. Examining current and projected macroeconomic variables such as GDP growth, inflation, and interest rates.

A top-down security analysis is most likely to begin with: C. Examining current and projected macroeconomic variables such as GDP growth, inflation, and interest rates. Statements A and B are wrong. Company-specific circumstances, such as management quality and business prospects are the focus of a bottom-up analysis. When applying this approach analysts are less concerned with broad economic trends. Instead, they examine details about the particular company. On the other hand, a top-down analysis always starts with the consideration of macroeconomic conditions. Based on the current and forecasted economic environment, analysts evaluate markets and industries with the goal to invest in those that are expected to outperform. Thus, statement C is the right answer

According to the Capital Asset Pricing Model (CAPM), investors should be rewarded for taking on additional: A. Systematic risk B. Unsystematic risk C. Total risk

According to the Capital Asset Pricing Model (CAPM), investors should be rewarded for taking on additional: A. Systematic risk The capital asset pricing model tells us that investors should be rewarded for taking on systematic risk only. If you want to know the systematic risk of your portfolio, you can calculate its beta.

Compared to investing in a single security, the portfolio approach allows investors to: A. Increase the expected rate of return B. Reduce the risk C. Increase the probability of high returns

Compared to investing in a single security, the portfolio approach allows investors to: B. Reduce the risk The portfolio approach to investing can be best summarized by the saying "Don't put all of your eggs in one basket". If we invest our capital in a single security and it fails for some reason, then we will lose all our money. On the contrary, if we spread our funds across multiple asset classes, even if one of them fails, our portfolio will be protected. In other words, the risk of the portfolio will decrease. Thus, B is the right answer. Statement A is incorrect because although the portfolio approach to investing can help you lower the risk, the expected return is generally similar or smaller than the return from investing in a single (risky) security. Statement C is wrong, too. When we combine several securities into a portfolio its return normalizes. In other words, the probability of extreme returns decreases.

Compared to mutual funds, exchange-traded funds (ETFs) have: A. Lower management fees B. Higher minimum investments C. The same amount of brokerage costs

Compared to mutual funds, exchange-traded funds (ETFs) have: A. Lower management fees Statements B and C are not accurate. Mutual funds typically have a higher minimum investment which varies from $250 to $5,000 depending on the type of the fund. ETFs, on the other hand, can be purchased for as little as one share. Open-end mutual funds do not have brokerage costs, because the shares can be purchased from and redeemed with the fund company. A is the right answer. In general, mutual funds are actively managed. As a result, they have higher management fees.

Investors seeking high expected returns will most likely put most of their wealth in: A. The risk-free asset B. The risky portfolio C. The asset offering the lowest standard deviation of returns

Investors seeking high expected returns will most likely put most of their wealth in: B. The risky portfolio Every person should invest in a combination of the risk-free asset and the optimal risky portfolio according to their risk appetite. If they are willing to risk more, they will hold a greater portion of the risky portfolio, and vice versa, if they are reluctant to take chances, they will buy more of the risk-free asset. Investors who are interested in high expected returns will be able to borrow money and invest it in the risky portfolio, going even further along the capital allocation line.

The line that represents a combination of the risk-free asset and a risky portfolio is the: A. Security characteristic line (SCL) B. Capital Allocation Line (CAL) C. Security Market Line (SML)

The line that represents a combination of the risk-free asset and a risky portfolio is the: B. Capital Allocation Line (CAL) The capital Allocation line (CAL) represents a line of all possible combinations of the risk-free and a risky asset (or a portfolio of risky assets). The graph demonstrates the return investors could earn by assuming a given level of risk. Answer C is wrong. The security market line (SML) is a graphical representation of the capital asset pricing model with beta, reflecting systematic risk, on the x-axis, and expected return on the y-axis. Answer C is not correct, either. The SCL is a plot of the excess return of the security on the excess return of the market.

The optimal portfolio is determined by each individual investor's: A. Borrowing rate B. Risk-free rate C. Risk preference

The optimal portfolio is determined by each individual investor's: C. Risk preference The two-fund separation theorem allows us to divide the portfolio decision-making into two distinct steps- investment, and financing. In the first step, we identify the optimal risky portfolio without considering the investor's preferences. The investor's most feasible alternative is determined in the second step. At this stage, we should look at the individual's risk preference, using their indifference curves. The point where these touch the line represents the most favorable choice.

The total risk is equal to which of the following: A. Systematic minus Diversifiable risk B. Unsystematic minus Systematic risk C. Systematic plus Idiosyncratic risk

The total risk is equal to which of the following: C. Systematic plus Idiosyncratic risk The total risk is equal to the systematic + unsystematic, also known as idiosyncratic, or diversifiable risk

Which of the following institutional investors is characterized by high-risk tolerance and high liquidity requirements: A. Insurance companies B. Banks C. Endowments

Which of the following institutional investors is characterized by high-risk tolerance and high liquidity requirements: C. Endowments Statement C is the correct answer. Endowments have a long investment horizon and low liquidity needs. Therefore, these institutions can afford to invest in risky assets. Statement A is wrong. Insurance companies should be able to pay claims as they arise, which leads to low-risk tolerance and high liquidity needs. Statement B is not accurate either. Banks have high liquidity needs and low-risk tolerance because they should be ready to meet investor withdrawals as they occur.

Which of the following institutional investors will most likely have the shortest investment horizon? A. Property and casualty (P&C) insurers B. Life insurance companies C. Endowments

Which of the following institutional investors will most likely have the shortest investment horizon? A. Property and casualty (P&C) insurers Statement A is correct. The liabilities of property and casualty insurers are usually unpredicted and shorter in maturity as compared to the liabilities of life insurance companies. That's why their portfolios are invested in highly liquid and short-term instruments. Endowments have a long investment horizon and low liquidity needs.

Which of the following investment products is least likely to trade at net asset value (NAV)? A. Closed-end mutual funds B. Open-end mutual funds C. Exchange-traded funds (ETFs)

Which of the following investment products is least likely to trade at net asset value (NAV)? A. Closed-end mutual funds Statement A is accurate. With closed-end mutual funds, the number of outstanding shares remains the same. Unlike open-end mutual funds where new shares are created and sold at the current net asset value per share, closed-end funds can sell for a premium or discount to net asset value depending on the demand for the shares. Special redemption provisions for ETFs are designed to keep their market prices very close to their net asset value.

Which of the following is least likely to be an assumption behind the Capital Asset Pricing Model (CAPM)? A. Markets are frictionless B. Investors are risk-averse, utility-maximizing, rational individuals C. Investors have heterogeneous expectations

Which of the following is least likely to be an assumption behind the Capital Asset Pricing Model (CAPM)? C. Investors have heterogeneous expectations Similar to all other approaches, the CAPM ignores various financial markets' complexities by making simplifying assumptions. The main assumptions behind the model are: • Investors are risk-averse, utility-maximizing, rational individuals • Markets are frictionless • Investors have the same one-period time horizon • Investors have homogeneous expectations • All investments are infinitely divisible • Investors are price takers

Which of the following is least likely to be an example of systematic risk? A. An increase in consumer demand B. The replacement of the CEO C. A decrease in interest rates

Which of the following is least likely to be an example of systematic risk? B. The replacement of the CEO Statements A and C are examples of systematic risk. In a broad sense, the systematic risk denotes the uncertainty that is distinctive for the entire market. By contrast, the nonsystematic risk is company-specific.

Which of the following is true? A. Dependent variable is a synonym for explanatory variable B. Explanatory variable is a synonym for independent variable C. Simple regressions sometimes use more than one variable

Which of the following is true? B. Explanatory variable is a synonym for independent variable Statement A is wrong. Depending on the context, an independent variable is sometimes called an "explanatory variable". Statement C is also wrong. If we use only one variable in a regression, it is called a simple regression, while those with more than one variable are called multivariate regressions.

Which of the following statements about correlation is most accurate? A. The lower the correlation, the lower the potential benefits from diversification B. If the correlation coefficient between two assets is 0, they move in complete unison C. When the correlation coefficient is minus 1, we can construct a zero-variance portfolio.

Which of the following statements about correlation is most accurate? C. When the correlation coefficient is minus 1, we can construct a zero-variance portfolio. Answer A is not accurate. The lower the correlation, the higher the potential benefits from diversification. Answer B is also not accurate. A correlation value of 0 indicates that the returns of the two assets are uncorrelated. In other words, knowing the actual value of variable one tells you nothing about the value of variable two. Answer C is correct. A correlation coefficient of minus one means that the returns of the two assets are perfectly negatively correlated, they move in opposite directions 100% of the time. When this is the case, we can construct a zero-variance portfolio.

Which of the following statements about risk-seeking investors is most accurate? A risk-seeking investor: A. Avoids risky investments for a lower, but guaranteed return B. Maximizes both risk and return C. Cares only about return and not risk

Which of the following statements about risk-seeking investors is most accurate? A risk-seeking investor: B. Maximizes both risk and return Statement A is not accurate, it refers to a risk-averse investor. Statement B is correct. A risk-seeking investor would prefer being caught short instead of playing it safe with a confirmed prize. Such individuals are also called risk-seeking because they get extra "utility" from the uncertainty which the exposure provides. A risk-seeking investor would maximize both risks and returns. Statement C is wrong because it applies to a risk-neutral investor.

Which of the following statements is least accurate about the market portfolio? A. The market portfolio consists of all risky assets, or anything that has value B. It is impossible to create a truly diversified market portfolio in practice C. The market portfolio should include only tradable and investable assets

Which of the following statements is least accurate about the market portfolio? C. The market portfolio should include only tradable and investable assets Statement A is accurate. The market portfolio represents a bundle of all possible investments in the world. It includes risky assets such as stocks, bonds, real estate, and even human capital. Anything that has a value. Statement B is also correct. It refers to the Roll's Critique. In 1977 the economist suggests that it is impossible to create a truly diversified market portfolio in practice because this portfolio would need to contain a portion of every asset in the world, including collectibles, commodities, and basically any item that has marketable value. Statement C is wrong. In theory, the market portfolio should include all possible assets-even those that are not tradeable and not investable.

Which of the following statements is least accurate with regards to the capital allocation line? A. Lending portfolios are those that hold some weight in the risk-free asset B. Investors who are interested in high expected returns can borrow money and invest it in the market portfolio. Such portfolios are called borrowing C. The capital allocation line does not allow investors to construct portfolios that lie beyond the market portfolio

Which of the following statements is least accurate with regards to the capital allocation line? C. The capital allocation line does not allow investors to construct portfolios that lie beyond the market portfolio Both statements A and B are accurate. A risk-averse investor may put in a large proportion, even 100 percent, of their securities in a risk-free asset. Such an investment settlement is equivalent to lending to the government. Investors who are interested in high expected returns will be able to borrow money and invest it in the market portfolio, going even further along the capital market line. Statement C is the least accurate.

Which of the following statements is most accurate about a stock that has a beta of 1.5? A. The stock returns are independent of the market returns B. The stock is more volatile than the market C. The stock is as volatile as the market

Which of the following statements is most accurate about a stock that has a beta of 1.5? B. The stock is more volatile than the market A beta of 0 means the stock has no relationship to the market. Stocks with a beta less than one are called defensive because these stocks will lose less if the market performs badly. If, for instance, the market loses 10%, the stock will lose less than that, say 7%. Alternatively, stocks with a beta of 1 will replicate the overall market performance. Should the market gain 1%, we would expect that the stock will also build up with 1%. In the event the market loses 5%, the stock will suffer a 5% loss as well. And, finally, stocks with a beta higher than one will do better than the market when the economy flourishes but will lose even more when that same market goes down. Therefore, if the market grows by 2%, the respective stock will probably earn 2.5 or 3%. Such stocks are also called aggressive.

Which of the following statements is most accurate about money-weighted rate of return? A. Money-weighted rate of return accounts for the timing of cash flows but not for their amount B. Investment managers prefer to use money-weighted rate of return because it allows them to be judged upon their own money-generating skills and not any external factors C. Calculating the money-weighted rate of an investment is equal to finding its Internal rate of return

Which of the following statements is most accurate about money-weighted rate of return? C. Calculating the money-weighted rate of an investment is equal to finding its Internal rate of return The money-weighted rate of return accounts for the amount of cash flows. Hence, its name. But the measure is a poor estimate with regards to cash flow timing. In investment management, clients are those who determine how much money should be given to portfolio managers, not the other way around. The amount of money invested in a portfolio can significantly influence the way IRR is calculated. Therefore, most managers prefer to be judged against other measures such as time-weighted rate of return, unless they have some discretion over the cash flows

Which of the following statements is most accurate about the asset management industry? A. The cost of robo-advisory services is often two times higher than that of traditional investment advice channels B. The majority of assets are managed by active investors, while only a fifth of them is allocated to passive investing C. The asset management industry is entirely driven by "pure-play" independent asset managers

Which of the following statements is most accurate about the asset management industry? B. The majority of assets are managed by active investors, while only a fifth of them is allocated to passive investing Statements A and C are not accurate. The cost of robo-advisory services is often a fraction of traditional investment advice channels. For example, a typical financial advisor charges a 1% annual fee based on a client's assets, while robo-advisor fees typically average 0.20% annually. In addition, the industry is highly competitive. It consists of "pure-play" independent asset managers as well as diversified commercial banks, insurance companies, and brokerages that offer asset management services on top of their core business activities. Thus, statement B is accurate.

Which of the following statements is most accurate about the optimal risky portfolio, according to the capital market theory: A. The optimal risky portfolio has the lowest expected risk B. The optimal risky portfolio offers the highest expected return C. The optimal risky portfolio is the market portfolio

Which of the following statements is most accurate about the optimal risky portfolio, according to the capital market theory: C. The optimal risky portfolio is the market portfolio Statement C is accurate. According to the capital market theory, investors have homogeneous expectations. That is, they all have identical estimates of risk, return, and correlations for all risky assets. Under this assumption, practitioners are believed to face the same efficient frontier of risky portfolios and will all have the very same optimal risky portfolio and capital allocation line. Statements A and B are wrong. The optimal risky portfolio does not offer the highest expected return or the lowest possible risk. It offers the highest return per unit of risk.

Which of the following statements is most accurate with regards to the Markowitz efficient frontier? A. Portfolios that lie on the Markowitz efficient frontier dominate those that lie on the capital allocation line. B. The Markowitz efficient frontier has higher rates of return for a given level of risk. C. Any rational investor will opt for a portfolio that lies below the Markowitz efficient frontier

Which of the following statements is most accurate with regards to the Markowitz efficient frontier? B. The Markowitz efficient frontier has higher rates of return for a given level of risk. Statements A and C are wrong. By combining the risk-free rate with the optimal market portfolio, we create the capital allocation line. All portfolios that line on it dominate those on the Markowitz efficient frontier. Therefore, any rational investor will invest in a proportion of the risk-free rate and the optimal market portfolio. Statement B is correct.

Which of the following statements is most accurate? A. A portfolio has diversification benefits not only when markets operate normally but also in cases of a market turmoil B. The reason that portfolios reduce risk is that prices of the securities included move in the same direction C. Diversification benefits are higher when there is a low correlation between portfolio assets

Which of the following statements is most accurate? C. Diversification benefits are higher when there is a low correlation between portfolio assets Statement C is the right answer. The positive performance of some securities neutralizes the negative performance of others. Therefore, when portfolio securities are not perfectly correlated - that is, when they respond differently to market factors - the portfolio's volatility of returns decreases and the diversification benefits become higher. Statement A is not accurate. Portfolio diversification is not an absolute failsafe for investors. During times of market turmoil, correlations tend to increase, which reduces the benefits of diversification. Statement B is not correct either. When prices of the portfolio securities move in the same direction their correlation is high. As a result, diversification benefits are lower, and the risk reduction is not as high.

Which of the following statements is most accurate? A. The geometric mean return will always be higher than the arithmetic mean return B. The geometric mean return will always be lower than the arithmetic mean return C. The geometric mean return is equal to the arithmetic mean return when the periodic returns are the same

Which of the following statements is most accurate? C. The geometric mean return is equal to the arithmetic mean return when the periodic returns are the same When periodic rates of return vary from period to period, the geometric mean return will always be lower than the arithmetic mean return. The only time that the two measures will be equal is when the holding period returns are the same.

Which of the following statements is most accurate? The capital allocation line is a straight line from the risk-free asset through: A. The Global minimum-variance portfolio B. The Optimal risky portfolio C. Any risky portfolio that lies on the efficient frontier

Which of the following statements is most accurate? The capital allocation line is a straight line from the risk-free asset through: B. The Optimal risky portfolio The investor's optimal portfolio will lie on the capital allocation line, that begins at the risk-free asset and goes through the optimal risky portfolio.

Which of the following statements is most likely true for defined contribution plans: A. The retirement income is predefined B. The employee accepts the investment risk C. The portfolio decisions are left to the employer

Which of the following statements is most likely true for defined contribution plans: B. The employee accepts the investment risk Statement A is wrong. The employer makes no promise regarding the future value of the plan assets and the pension amount. Factors like the amount contributed, investment performance and duration determine the accounts' growth. There is always a risk that employees who are not financially savvy could invest in improper portfolios. Thus, statement C is not accurate either. The defined contribution capital is placed in a mutual fund or other investment vehicle selected by the employee. In other words, investment decisions are left to the worker, who bears all the risk. Statement B is the correct answer.

Which of the following statements regarding hedge funds is most accurate? A. They are more regulated than mutual funds B. Hedge funds are offered to the general public C. The main investment goal of hedge funds is to achieve a positive absolute return

Which of the following statements regarding hedge funds is most accurate? C. The main investment goal of hedge funds is to achieve a positive absolute return Statements A and B are wrong. Hedge funds are less regulated than mutual funds. They are offered only to qualified investors who have a minimum amount of overall portfolio wealth and low liquidity needs. Minimum investments can be quite high, often between $250,000 and $1 million. Thus, statement C is accurate

Which of the following statements regarding the SML and CML are most accurate? A. Two stocks that have the same level of systematic risk will end up in the same place on the Security Market Line B. Both the Security Market Line and the Capital Market Line share the same y-axis which is the systematic risk C. The Capital Market Line applies to undiversified portfolios only

Which of the following statements regarding the SML and CML are most accurate? A. Two stocks that have the same level of systematic risk will end up in the same place on the Security Market Line Statement A is accurate. Stocks that have the same level of systematic risk will end up in the same place on the line, even if that's the place of the market portfolio. Statement B is wrong. The Security Market Line and the Capital Market Line share the same y-axis, which is the expected return. Statement C is not accurate, either. The capital market line helps you price optimal portfolios only. In other words, it is good for determining what an investor would hold, but it is not very useful for describing assets in general. By contrast, we can use the security market line to price any portfolio or asset, both efficient and inefficient.

Which of the following statements related to the security market line (SML) is least accurate? A. The SML is a graphical representation of the capital asset pricing model with beta, reflecting systematic risk, on the x-axis, and expected return on the y-axis B. The SML intersects the y-axis at the risk-free rate of return C. The slope of the Security Market Line represents the expected return on the market

Which of the following statements related to the security market line (SML) is least accurate? C. The slope of the Security Market Line represents the expected return on the market Both Statements A and B are accurate. Statement C is wrong. The slope of the Security Market Line represents the market risk premium. The higher the market risk premium, the steeper the slope, and vice versa

Which of the following types of funds is most likely to hold a few large investments? A. Buyout funds B. Hedge funds C. Venture capital funds

Which of the following types of funds is most likely to hold a few large investments? A. Buyout funds Statement A is accurate. Buyout or private equity funds invest in public companies. They make only a few large investments with the intent of selling the restructured companies in three to five years. Statements B and C are wrong. Hedge funds are similar to mutual funds and invest in a large number of companies. The portfolio returns of venture capital funds resemble a barbell approach to investing. The fund managers make small bets on many young startups, believing that at least one will achieve high growth which will result in a large payout.

Which of the following types of risk can be eliminated by forming a diversified portfolio? A. Systematic risk B. Unsystematic risk C. Total risk

Which of the following types of risk can be eliminated by forming a diversified portfolio? B. Unsystematic risk Unsystematic risk is the risk that is inherent to a specific company or industry. Basically, it is company-specific, even industry-specific risk that can be smoothed out through putting your eggs in various baskets, or, in more technical terms, implementing diversification. On the other hand, the systematic risk will continue to exist, regardless of the number and correlation between securities contained in a portfolio. In a broad sense, this is the uncertainty that is distinctive for the entire market. At the heart of it, systematic risk is based on the day-to-day changes in stock prices and is caused by circumstances that affect all companies.

With respect to the portfolio management process, performance measurement and reporting are most likely to occur in the: A. Planning step B. Feedback step C. Execution step

With respect to the portfolio management process, performance measurement and reporting are most likely to occur in the: B. Feedback step Giving feedback is the final step of the portfolio management process. Once a portfolio is constructed, it has to be monitored and reviewed on a regular basis. When prices of the constituent securities change, their weights change, too. Therefore, the manager needs to rebalance the portfolio periodically in order to match the target asset allocation. The feedback step also includes performance measurement and reporting. Investors should be able to evaluate the portfolio performance relative to a benchmark return

With respect to the portfolio management process, the investment policy statement is prepared in the: A. Planning step B. Feedback step C. Execution step

With respect to the portfolio management process, the investment policy statement is prepared in the: A. Planning step The planning step starts with identifying the investor's needs. The analysis results in an investment policy statement (IPS) which is a written document describing the client's investment objectives and constraints.