Investment Management Midterm 1

The covariance of the market's returns with the stock's returns is 0.008. The standard deviation of the market's returns is 0.08, and the standard deviation of the stock's returns is 0.11. What is the correlation coefficient of the returns of the stock and the returns of the market? a. 0.91 b. 1.00 c. 1.25

A

The variance of returns is 0.09 for Stock A and 0.04 for Stock B. The covariance between the returns of A and B is 0.006. The correlation of returns between A and B is: a. 0.10 b. 0.20 c. 0.30

A

A portfolio was created by investing 25% of the funds in Asset A (standard deviation = 15%) and the balance of the funds in Asset B (standard deviation = 10%) If the correlation coefficient is 0.75, what is the portfolio's standard deviation? a. 10.6% b. 12.4% c. 15.0%

A

A stock with a beta of 0.7 currently priced at $50 is expected to increase in price to $55 by year-end and pay a $1 dividend. The expected market return is 15%, and the risk-free rate is 8%. The stock is: a. overpriced, so do not buy it b. underpriced, so buy it c. properly priced, so buy it

A

According to the CAPM, what is the required rate of return for a stock with a beta of 0.7, when the risk-free rate is 7% and the expected market rate of return is 14%? a. 11.9% b. 14.0% c. 16.8%

A

The 1-year return on a price-weighted index of these three stocks is closest to: a. 12.5% b. 13.5% c. 18.0%

A

A long time horizon and low liquidity requirements best describe the investment of a(n): a. endowment b. insurance company c. bank

A- an endowment has long time horizon and low liquidity needs, as an endowment generally intends to fund its causes perpetually. Both insurance companies and banks require high liquidity

A stock is selling at $50. An investor's valuation model estimates its intrinsic value to be $40. Based on her estimate, she would most likely place a: a. short-sale order b. stop order to buy c. market order to buy

A- if the investor believes the stock is overvalued in the market, the investor should place a short-sale order, which would be profitable if the stock moves toward her value estimate

In a defined contribution pension plan: a. the employee accepts the investment risk b. the plan sponsor promises a predetermined retirement income to participants c. the plan manager attempts to match the fund's assets to its liabilities

A- in a defined contribution pension plan, the employee accepts the investment risk. The plan sponsor and manager neither promise a specific level of retirement income to participants nor make investment decisions. These are features of a defined benefit plan.

Compared to exchange-traded funds (ETFs), open-end mutual funds are typically associated with lower: a. brokerage costs b. minimum investment amounts c. management fees

A- open-end mutual funds do not have brokerage costs, as the shares are purchased from and redeemed with the fund company. Minimum investment amounts and management fees are typically higher for mutual funds.

Portfolio diversification is least likely to protect against losses: a. during severe market turmoil b. when markets are operating normally c. when the portfolio securities have low return correlation

A- portfolio diversification has been shown to be relatively ineffective during severe market turmoil. Portfolio diversification is most effective when the securities have low correlation and the markets are operating normally

Which of the following asset classes has historically had the highest returns and standard deviation? a. small-cap stocks b. large-cap stocks c. long-term corporate bonds

A- small-cap stocks have had the highest annual return and standard deviation of return over time. Large-cap stocks and bonds have historically had lower risk and return than small-cap stocks

New issues of securities are transactions in the: a. primary market b. secondary market c. seasoned market

A- the primary market refers to the market for newly issued securities

As the number of stocks in a portfolio increase, the portfolio's systematic risk: a. can increase or decrease b. decreases at a decreasing rate c. decreases at an increasing rate

A- when you increase the number of stocks in a portfolio, unsystematic risk will decrease at a decreasing rate. However, the portfolio's systematic risk can be increased by adding higher-beta stocks or decreased by adding lower-beta stocks

In a 5-year period, the annual returns on an investment are 5%, -3%, -4%, 2%, and 6%. The standard deviation of annual returns on this investment is closest to: a. 4.0% b. 4.5% c. 20.7%

B

The risk-free rate is 6%, and the expected market return is 15%. A stock with a beat of 1.2 is selling for $25 and will pay a $1 divined at the end of the year. If the stock is priced at $30 at year-end, it is: a. overpriced, so short it b. underpriced, so buy it c. underpriced, so short it

B

Which of the following limit buy orders would be the most likely to go unexecuted? a. a marketable order b. an order behind the market c. an order making a new market

B- a behind-the-market limit order would be least likely executed. In the case of a buy, the limit buy order price is below the best bid. It will likely not execute until security prices decline. A marketable buy order is the most likely to trade because it is close to the best ask price. In an order that is making a new market or inside the market, the limit buy order price is between the best bid and ask.

A portfolio to the right of the market portfolio on the CML is: a. a lending portfolio b. a borrowing portfolio c. an inefficient portfolio

B- a portfolio to the right of a portfolio on the CML has more risk than the market portfolio. Investors seeking to take on more risk will borrow at the risk-free rate to purchase more of the market portfolio

Which of the following would most likely represent an inappropriate use of an index? a. as a reflection of market sentiment b. comparing a small-cap manager against a broad market c. using the CAPM to determine the expected return and beta

B- comparing a small-cap manager against a broad market would be an inappropriate use of an index. A benchmark should be consistent with the manager's investment approach and style. A manager's performance will depend to a large degree on its chosen style

Compared to investing in a single security, diversification provides investors a way to: a. increase the expected rate of return b. decrease the volatility of returns c. increase the probability of high returns

B- diversification provides an investor reduced risk. However, the expected return is generally similar or less than that expected from investing in a single risky security. very high or very low returns become less likely.

A portfolio was created by investing 25% of the funds in Asset A (standard deviation = 15%) and the balance of the funds in Asset B (standard deviation = 10%) Which of the following available portfolios most likely falls below the efficient frontier? a. Portfolio A, Expected Return 7%, Expected Standard Deviation 14% b. Portfolio B, Expected Return 9%, Expected Standard Deviation 26% c. Portfolio C, Expected Return 12%, Expected Standard Deviation 22%

B- portfolio B must be the portfolio that fall between the Markowitz efficient frontier because there is a portfolio (Portfolio C) that offers a higher return and lower risk

Which of the following statements about risk-adverse investors is most accurate? A risk-averse investor is: a. seeks out the investment with minimum risk, while return is not a major consideration b. will take additional investment risk if sufficiently compensated for this risk c. avoids participating in global equity markets

B- risk-averse investors are generally willing to invest in risky investments, if the returns of the investment is sufficient to reward the investor for taking on this risk. Participants in securities markets are generally assumed to be risk-averse investors

A measure of how the returns of two risky assets move in relation to each other its the: a. range b. covariance c. standard deviation

B- the covariance is defined as the co-movement of the returns of two assets or how well the returns of two risky assets move together. Range and standard deviation are mesa rues of dispersion and measure risk, not how assets move together

A financial intermediary buys a stock and then resells it a few days later at a higher price. Which intermediary would this most likely describe? a. broker b. dealer c. arbitrageur

B- this situation best describers a dealer. A dealer buys an asset for its inventory in the hopes of reselling it later at a higher price. Brokers stand between buyers and sellers of the same security at the same location and time. Arbitrageurs trade in the same security simultaneously in different markets

Which of the following statements about correlation is least accurate? a. diversification reduces risk when correlation is less than 1 b. if the correlation coefficient is 0, zero variance portfolio can be constructed c. the lower the correlation coefficient, the greater the potential benefits from diversification

B- zero-variance portfolio can only be constructed if the correlation coefficient between assets is -1. Diversification benefits can be had when correlation is less than +1, and the lower the correlation, the greater the potential benefit

A portfolio was created by investing 25% of the funds in Asset A (standard deviation = 15%) and the balance of the funds in Asset B (standard deviation = 10%) If the correlation coefficient is -0.75, what is the portfolio's standard deviation? a. 2.8% b. 4.2% c. 5.3%

C

According to the CAPM, what is the expected rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the market rate of return is 12%? a. 7.2% b. 12.0% c. 13.2%

C

The 1-year return on a market capitalization-weighted index of these stocks is closest to: a. 12.5% b. 13.5% c. 18.0%

C

The 1-year return on an equal-weighted index of these three stocks is closest to: a. 12.0% b. 12.5% c. 13.5%

C

The covariance of the market's returns with a stock's returns in 0.005 and the standard deviation of the market's return is 0.05. What is the stock's beta? a. 1.0 b. 1.5 c. 2.0

C

Daniel Ferramosco is concerned that a long-term bond he holds might default. He therefore buys a contract that will compensate him in the case of default. What type of contract does he hold? a. physical derivative contract b. primary derivative contract c. financial derivative contract

C- Daniel holds a derivate contract that has a value determined by another financial contract; in this case, the long-term bond

Market float of a stock is best described as its: a. total outstanding shares b. shares that are available to domestic investors c. outstanding shares excluding those held by controlling shareholders

C- Market float represents shares available to the investing public and excludes shares held by controlling shareholders. Free float is a narrower measure that also excludes shares that are not available to foreign investors

A top-down security analysis begins by: a. analyzing a firm's business prospects and quality of management b. identifying the most attractive companies within each industry c. examining economic conditions

C- a top-down analysis begins with an analysis of broad economic trends. After an industry that is expected to perform well is chosen, the most attractive companies within that industry are identified. A bottom-up analysis begins with criteria such as firms' business prospects and quality of management.

Which of the following is least likely to be considered an appropriate schedule for reviewing and updating an investment policy statement? a. at regular intervals (e.g. every year) b. when there is a major change in the client's constraints c. frequently, based on the recent performance of the portfolio

C- an IPS should be updated at regular intervals and whenever there is a major change in the client's objectives or constraints. Updating an IPS based on portfolio performance is not recommended

Which of the following is least accurate regarding fixed income indexes? a. replicating the return on a fixed income security index is difficult for investors b. there is a great deal of heterogeneity in the composition of fixed income security indexes c. due to the large universe of fixed income security issues, data for fixed income securities are relatively easy to obtain

C- fixed income securities are largely traded by dealers and trade infrequently. Data are therefore difficult to obtain

Hedge funds most likely: a. have stricter reported requirements than a typical investment firm because of their use of leverage and derivatives b. hold equal values of long and short securities c. are not offered for sale to the general public

C- hedge funds may not be offered for sale to the general public; they can be sold only to qualified investors who meet certain criteria. Hedge funds that hold equal value of long and short securities today make up only a small percentage of funds; many other kinds of hedge funds exist that make no attempt to be market neutral. Hedge funds have reporting requirements that are less strict than those of a typical investment firm

In a defined benefit pension plan: a. the employee assumes the investment risk b. the employer contributes to the employee's retirement account each period c. the plan sponsor promises a predetermined retirement income to participants

C- in a defined benefit plan, the employer promises a specific level of benefits to employees when they retire. Thus, the employer bears the investment risk

Low risk tolerance and high liquidity requirements best describe the typical investment needs of a(n): a. defined-benefit pension plan b. foundation c. insurance company

C- insurance companies need to be able to pay claims as they arise, which leads to insurance firms having low risk tolerance and high liquidity needs. Defined benefit pension plans and foundations both typically have high risk tolerance and low liquidity needs

Most of the widely used global security indexes are: a. price-weighted b. equal-weighted c. market capitalization-weighted

C- most global security indexes are market capitalization-weighted with a float adjustment to reflect the amount of shares available to investors

Which of the following statements about the SML and CML is least accurate? a. securities that plot above the SML are undervalued b. investors expect to be compensated for systematic risk c. securities that plot on the SML have no value to investors

C- securities that plot on the SML are expected to earn their equilibrium rate of return and, therefore, do have value to an investor and may have diversification benefits as well. The other statements are true.

What is the risk measure associated with the capital market line (CML)? a. beta risk b. unsystematic risk c. total risk

C- the capital market line (CML) plots return against total risk which is measured by standard deviation of returns

Total risk equals: a. unique plus diversifiable risk b. market plus nondiversifible risk c. systematic plus unsystematic

C- total risk equals systemic plus unsystematic risk. Unique risk is diversifiable and is unsystematic. Market (systematic) risk is nondiversifiable risk.