BUS 431
Which of the following statements are true about risk aversion? A risky investment with a risk premium of zero is called a fair game. A risk-averse investor will reject a fair game. Wagering money on an event that has an uncertain outcome in the hope of winning money is called gambling. A risky investment with a risk premium of zero is called speculation.
A risky investment with a risk premium of zero is called a fair game. - ✓ A risk-averse investor will reject a fair game. - ✓ Wagering money on an event that has an uncertain outcome in the hope of winning money is called gambling. - ✓ A risky investment with a risk premium of zero is called speculation. - X
Which of the following represent assumptions of the CAPM? ll investors have homogeneous expectations about expected returns, variances and covariances. Investments are limited to stocks and bonds. All investors have the same holding period. All investors trade without taxes or transaction costs
All investors have homogeneous expectations about expected returns, variances and covariances. - ✓ Investments are limited to stocks and bonds. - ✓ All investors have the same holding period. - X All investors trade without taxes or transaction costs. - ✓
The CAPM predicts that all expected alphas must be ___ in equilibrium.
Any stock with a positive expected alpha is undervalued and will be quickly bought by investors, thus driving up its price to its equilibrium level and reducing its expected alpha to zero Any stock with a negative expected alpha is overvalued and will be quickly sold by investors, thus driving down its price to its equilibrium level and eliminating its negative expected alpha.
Why can diversification not eliminate all risk?
Common factors affect most stocks in a similar fashion. Ex. Business cycle (most companies do well when economy is booming, most lose money in recessionary environments
Risk-averse investors _____. Consider investments that are fair games consider risk-free investments consider speculative prospects with positive risk premiums reject investments that are fair games reject speculative prospects with positive risk premiums
Consider investments that are fair games - X consider risk-free investments - ✓ consider speculative prospects with positive risk premiums - ✓ reject investments that are fair games ✓ reject speculative prospects with positive risk premiums - X
According to the mean-variance criterion, portfolio A is better than portfolio B for a risk-averse investor whenever _____.
E(rA) ≥ E(rB) and σA ≤ σB
If interest is compounded quarterly, the ________ expresses the interest rate as if it were compounded annually.
EAR
In a return-standard deviation space, which of the following statements is(are) true for risk-averse investors?
In a set of indifference curves, the highest offers the greatest utility. Indifference curves of two investors might intersect.
Assumption about investor risk tolerance
Investors are assumed to be risk averse and unwilling to take a risky position without a positive risk premium
Which statement is true regarding the market portfolio?
It includes all publicly traded financial assets It lies on the efficient frontier All securities in the market portfolio are held in proportion to their market values
Which statement is not true regarding the market portfolio?
It is the tangency point between the capital market line and the indifference curve
Which of the following statements is true about a stock's alpha? It represents the difference between a stock's fair expected return and its actual expected return. Fairly priced stocks have positive alphas. Fairly priced stocks have zero alphas. Overpriced stocks have positive alphas. It represents the difference between a stock's fair expected return and the risk premium on the market portfolio.
It represents the difference between a stock's fair expected return and its actual expected return. - ✓ Fairly priced stocks have positive alphas. - X Fairly priced stocks have zero alphas. - ✓ Overpriced stocks have positive alphas. - X It represents the difference between a stock's fair expected return and the risk premium on the market portfolio. - X
An individual security's risk premium is a function of:
Its contribution to the risk of the market portfolio The covariance of returns with the assets that make up the market portfolio
Which term has a different meaning than the others? Nonsystematic risk Market risk Unsystematic risk Diversifiable risk Firm-specific risk
Market Risk
The risk premium is _____. Normally zero for risky assets The reward for bearing risk The difference between the expected rate of return on an asset and the risk-free rate normally positive for risky assets
Normally zero for risky assets - X The reward for bearing risk - ✓ The difference between the expected rate of return on an asset and the risk-free rate - ✓ normally positive for risky assets ✓
Utility Scores of Different Investor Profiles
Risk-Neutral A=0 Risk lover A<0
Which of the following statements are true about the capital allocation line (CAL)? The CAL represents all portfolios with the same expected return but different standard deviations. The CAL represents all portfolios with the same standard deviation but different expected returns. An investor can increase their expected return by borrowing funds and investing more in risky assets (using leverage). An investor can increase their reward-to-volatility ratio by borrowing funds and investing more in risky assets (using leverage). The slope of the capital allocation line is called the Sharpe ratio.
The CAL represents all portfolios with the same expected return but different standard deviations. - X The CAL represents all portfolios with the same standard deviation but different expected returns. - X An investor can increase their expected return by borrowing funds and investing more in risky assets (using leverage). - ✓ An investor can increase their reward-to-volatility ratio by borrowing funds and investing more in risky assets (using leverage). - X The slope of the capital allocation line is called the Sharpe ratio. - ✓
Which statement is not true regarding the Capital Market Line (CML)?
The CML is also called the security market line
Which of the following statements are true about passive vs active investment strategies? The capital market line is the capital allocation line that represents an active investment strategy. A passive strategy is an investment in a stock fund that matches a broad market index and an investment in T-bills. A passive strategy is an investment in a portfolio with a reward-to-volatility ratio of 1. An investment strategy that avoids any security analysis is called a passive strategy. The capital market line represents the investment opportunity set of a passive investment strategy.
The capital market line is the capital allocation line that represents an active investment strategy. - X A passive strategy is an investment in a stock fund that matches a broad market index and an investment in T-bills. - ✓ A passive strategy is an investment in a portfolio with a reward-to-volatility ratio of 1. - X An investment strategy that avoids any security analysis is called a passive strategy. - ✓ The capital market line represents the investment opportunity set of a passive investment strategy. - ✓
Calculate the expected return and standard deviation for all portfolios. Which of the risky portfolios clearly does not belong to the efficient frontier?
The efficient frontier with more than two risky assets is obtained by minimizing the volatility of the risky portfolio for any given value of the portfolio expected return. Both porfolios 2 and 3 yield an expected return of 0.022. However the standard deviation of portfolio 3 is 0.03001, while the standard deviation of porfolio 2 is 0.02467. This implies that, for a given expected return of 0.022, portfolio 3 does not minimize the volatility and thus it does not belong to the efficient frontier.
According to the Capital Asset Pricing Model (CAPM), which of the following statements is false?
The expected rate of return on a security increases in direct proportion to a decrease in the risk-free rate
Which statements are true according to the CAPM? The higher the risk, the higher the expected reward. Total risk matters for the expected reward. Only systematic risk matters for the expected reward. There is reward for bearing risk.
The higher the risk, the higher the expected reward. - ✓ Total risk matters for the expected reward. - X Only systematic risk matters for the expected reward. - ✓ There is reward for bearing risk. - ✓
When an investment advisor attempts to determine an investor's risk tolerance, which factor would they be least likely to assess?
The level of return the investor prefers
The capital allocation line provided by a risk-free security and N risky securities is
The line tangent to the efficient frontier of risky securities drawn from the risk-free rate
Market Portfolio
The market portfolio is the portfolio of all risky assets and is the optimal risky portfolio for all investors according to the CAPM.
The nominal rate of return is _____.
The nominal rate of return is the change in the dollar value of an investment relative to the initial investment, usually expressed in percentage terms, and unadjusted for inflation. The real rate of return is adjusted for inflation
Which statement is true regarding the Capital Market Line (CML)?
The risk measure for the CML is standard deviation. The CML is the line from the risk-free rate through the market portfolio It is the best attainable capital allocation line It always has a positive slope shows the set of portfolios with the highest expected return for any level of risk The capital market line represents the investment opportunity set of a passive investment strategy.
How to determine when an investor is indifferent to risky portfolio and risk-free asset using Utility functions
Use various risk aversion coefficients, find the utility function that has the same rate as the risk free asset
Certainty Equivalent Rate of Return
Utility score of risky portfolios - Meaning that it is the rate that a risk free investment would need to offer to provide the same utility score as the risky portfolio
Which one of the risky portfolios is closest to the optimal risky portfolio?
You do not need to consider the portfolio that does not belong to the efficient frontier. The optimal risky portfolio maximizes the Sharpe ratio.
The first major step in asset allocation is
assessing risk tolerance.
In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is:
beta
Empirical results regarding betas estimated from historical data indicate that:
betas appear to regress toward one over time
An investor who wishes to form a portfolio that lies to the right of the optimal risky portfolio on the capital allocation line must
borrow some money at the risk-free rate, invest in the optimal risky portfolio, and invest only in risky securities
The change from a straight to a kinked capital allocation line is a result of
borrowing rate exceeding lending rate.
The exact indifference curves of different investors
cannot be known with perfect certainty and, although not known with perfect certainty, do allow the advisor to create more suitable portfolios for the client.
The risk premium for common stocks
cannot be zero, for investors would be unwilling to invest in common stocks and must always be positive, in theory.
Indifference Curve
connects all portfolio points with the same utility value
Other things equal, an increase in the government budget deficit
drives the interest rate up.
Systematic risk is also called _____. fundamental risk common risk market risk non-diversifiable risk
fundamental risk - X common risk - ✓ market risk - ✓ non-diversifiable risk - ✓
According to the Capital Asset Pricing Model (CAPM), underpriced securities:
have positive alphas
According to the Capital Asset Pricing Model (CAPM), fairly priced securities:
have zero alphas
The capital market line
is a special case of the capital allocation line. represents the opportunity set of a passive investment strategy. has the one-month T-Bill rate as its intercept. uses a broad index of common stocks as its risky portfolio.
Which statements are correct? The geometric average return _____. is usually less than the arithmetic mean is the simple average of the individual returns is better for forecasting returns over many periods takes into account compounding
is usually less than the arithmetic mean - ✓ is the simple average of the individual returns - X is better for forecasting returns over many periods - ✓ takes into account compounding - ✓
The capital market line is the line through the risk-free asset and the _____.
market portfolio of risky securities (portfolio of all risky assets and optimal risky portfolio for all investors)
According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of:
market risk / beta risk / systematic risk
Given the capital allocation line, an investor's optimal portfolio is the portfolio that
maximizes her expected utility.
The efficient frontier is the subset of feasible portfolios that _____. offers the maximum return for a given standard deviation offers the minimum standard deviation for a given return maximizes the expected return minimizes the standard deviation
offers the maximum return for a given standard deviation - ✓ offers the minimum standard deviation for a given return - ✓ maximizes the expected return - X minimizes the standard deviation - X
According to the CAPM, individual assets plot _____ the SML, and well-diversified portfolios plot _____ the SML.
on; on In the CAPM world, all assets, i.e., individual securities and portfolios, must plot on the SML.
Nonsystematic risk is also called _____. random risk unsystematic risk diversifiable risk firm-specific risk
random risk - X unsystematic risk - ✓ diversifiable risk - ✓ firm-specific risk - ✓
The capital market line _____. shows the set of portfolios with the highest expected return for any level of risk shows the set of portfolios with no risk is tangent to the efficient frontier has a slope of one
shows the set of portfolios with the highest expected return for any level of risk - ✓ shows the set of portfolios with no risk - X is tangent to the efficient frontier - ✓ has a slope of one - X
In the context of the Capital Asset Pricing Model (CAPM) the relevant risk is:
systematic risk / market risk
The market risk, beta, of a security is equal to:
the covariance between the security's return and the market return divided by the variance of the market's returns
The Security Market Line (SML) is:
the line that represents the expected return-beta relationship and can be expressed
When constructing a risky portfolio consisting only of risky assets, an investment manager should offer _____.
the same risky portfolio to all clients Since finding the optimal risky portfolio (ORP) is a purely technical process, it does not involve personal preferences or risk aversion. Risk aversion comes into play when clients allocate capital to the ORP and the risk-free asset to create the complete portfolio. The independence of these two steps is known as the separation property.
The standard deviation of a portfolio of risky securities is
the square root of the weighted sum of the securities' variances and covariances.
In a well diversified portfolio:
unsystematic risk is negligible
CML and SML info
while the measure of risk in the CML is the standard deviation of returns (total risk), the risk measure in the SML is systematic risk, or beta. Securities that are fairly priced will plot on the CML and the SML.