Investments Chapter 5

One of three stocks will be added to a portfolio. To maximize the risk reduction benefit, the portfolio manager should buy the stock that has a correlation with the existing portfolio that is:

-0.3

A two-asset portfolio's standard deviation is minimized when the correlation between the two assets equals:

-1

How many statements are false? Statement 1: The utility function is the investor's degree of risk aversion in terms of risk and return. Statement 2: Indifference curve is a combination of risk and return among which the investor is indifferent.

0

BM, an individual investor, decided to invest in LL Company and MM Company. Here are the pieces of information about the two investments: CompanyNumber of Shares in PortfolioStandard DeviationExpected ReturnLL15%10%MM92%11% Given that both investments have a correlation of 1, what is the standard deviation of BM's portfolio?

0.023

Setia, an individual investor, decided to invest in HH Company and II Company. Here are the pieces of information about the two investments: CompanyNumber of Shares in PortfolioStandard DeviationExpected ReturnHH86%4%II25%10% Given that both investments have a covariance of .8, what is the variance of Setia's portfolio?

0.2584

Bert Smith, CFA, recommends three equity funds for his new client Walter Clay. Smith uses mean-variance analysis and optimization to derive allocation decisions. Clay admittedly knows little about investing beyond some knowledge of the benefits of diversification. Smith gathers data on the following three funds, along with his recommended allocation: FundExpected ReturnStandard DeviationAllocationBlue Sky8%18%60%Green Earth12%25%30%Red Space14%31%10% The correlation matrix: FundBlue SkyGreen EarthRed SpaceBlue Sky1.00Green Earth0.631.00Red Space0.390.411.00 Clay asks for a detailed explanation from Smith on efficiency and correlation as well as the possibility of adding a risk-free security to the suggested portfolio. Smith responds with two observations: Observation 1: We could add a risk-free government bond fund and this would provide more efficient allocation choices. Observation 2: Adding a risk-free government bond fund will have significant diversification benefits because the correlation between the government bond fund and the suggested portfolio is likely to be negative. Finally, Smith informs Clay that another fund, Core Fund, might be a good addition to his portfolio because it has an expected return of 15% and a standard deviation of 28%. With respect to observations 1 and 2, Smith is most likely correct in stating:

1

How many statements are correct? Statement 1: More risk-averse investors have flatter indifference curves. Statement 2: The optimal risky portfolio is found at the intersection of the capital allocation line and the efficient frontier.

1

Use the following data to answer the next three questions. Ivan purchased a single share of stock for $125 ex-dividend on January 1, 2018. Ivan purchased a second share of stock in the same company for $86 ex-dividend on January 1, 2019. This company annually declares a $12 per share dividend on December 31 of each year, which Ivan leaves in his account but does not reinvest in partial shares. Ivan sold both shares on December 31, 2019 after dividends were declared. i. What is the money-weighted return for this portfolio if Ivan sells each share at $105.00?

10.4

Alicia invested 30% of her funds in Asset A (standard deviation = 12%). She then invested the rest of her funds in Asset B, whose variance was estimated to be 0.02. Compute her portfolio's standard deviation, if the covariance between the two assets equals 0.014.

13.03

Alfred Morgan purchases 100 shares for $120 each in Period 1 and receives a dividend of $6 per share at the end of this period. In Period 2, he purchases an additional 100 shares for $135 each and receives a dividend of $6.75 per share at the end of this period. He sells all the shares for $150 each at the end of Period 2. What is the money-weighted rate of return on Alfred's investment?

16.59

How many statements are true? Statement 1: A risk-seeking investor has a less steep indifference curve as compared to a risk-averse investor. Statement 2: The theoretical result that all investors will hold a combination of the risk-free asset and the market portfolio is called the two-fund separation theorem.

2

How many statements are true? Statement 1: In a situation where a risk-averse investor is given a list of investments with the same expected return, the investor will choose the investment with the least risk, in which risk is measured by the standard deviation. Statement 2: Contrary to a risk-averse investor, a risk-seeking investor will always pick the investment with more risk.

2

How many statements are true? Statement 1: The minimum variance frontier is composed of all possible minimum-variance portfolios. Statement 2: The Global minimum-variance portfolio is found on the farthest left of the minimum variance frontier, as it is the least risky. Statement 3: A minimum variance portfolio consists of portfolios with the highest standard deviations for a given level of expected return.

2

Consider the following statements about portfolio return measurement: I: The time-weighted rate of return is significantly influenced by cash withdrawals or additions to the portfolio. II: The money-weighted rate of return is simply the internal rate of return of an investment that accounts for the timing and amount of all dollar flows into and out of the portfolio. III: If the investment is for more than one year, the time-weighted rate of return is obtained by calculating the geometric mean of the annual returns. Which of the following is true?

2 and 3

How many of the portfolios listed below could not lie on the efficient frontier? PortfolioReturnRiskX8%4%Y8%8%Z7%4%A11%8%B8%7%

3

A portfolio is invested equally between two assets. The assets have standard deviations of 4% and 8%, and the correlation between the two assets is 0.3. The standard deviation of the combined portfolio is closest to:

4.98%

Two assets have zero correlation. If a portfolio is invested with 30% in the first asset that has a variance of 12, and 70% in the second asset that has a variance of 8, the variance of the combined portfolio is closest to:

5.0

Which of the following statements is true

An investment that is not on the efficient frontier may create a portfolio that has higher risk for the same return.

The following statements were made by a portfolio manager: When the correlation between the securities is +1, an increase in the returns of the portfolio can happen only with an increase in the risk of the portfolio. When the correlation between the securities is 0 or −1, an increase in the returns of the portfolio can happen despite a decrease in the risk of the portfolio. Which of the following is true?

Both are correct

Compared to a risk-averse investor, the utility curve of a risk-seeking investor would be:

Flatter compared to the utility curve of a risk-averse investor

Which of the following statements about the efficient frontier is least likely true?

For a risk-neutral investor, the indifference curve and capital allocation line always tangent the efficient frontier at the same point.

If an investor had been consistently pulling assets from a mutual fund as it fell in value, how will their money-weighted rate of return differ from the mutual fund's return?

Higher

Bert Smith, CFA, recommends three equity funds for his new client Walter Clay. Smith uses mean-variance analysis and optimization to derive allocation decisions. Clay admittedly knows little about investing beyond some knowledge of the benefits of diversification. Smith gathers data on the following three funds, along with his recommended allocation: FundExpected ReturnStandard DeviationAllocationBlue Sky8%18%60%Green Earth12%25%30%Red Space14%31%10% The correlation matrix: FundBlue SkyGreen EarthRed SpaceBlue Sky1.00Green Earth0.631.00Red Space0.390.411.00 Clay asks for a detailed explanation from Smith on efficiency and correlation as well as the possibility of adding a risk-free security to the suggested portfolio. Smith responds with two observations: Observation 1: We could add a risk-free government bond fund and this would provide more efficient allocation choices. Observation 2: Adding a risk-free government bond fund will have significant diversification benefits because the correlation between the government bond fund and the suggested portfolio is likely to be negative. Finally, Smith informs Clay that another fund, Core Fund, might be a good addition to his portfolio because it has an expected return of 15% and a standard deviation of 28%. Given the Core Fund data, Smith can most likely conclude that the Red Space Fund is:

Inefficient

Which of the following statements regarding assumptions of Markowitz's Portfolio Theory is most accurate?

Investment decisions are based only on expected return and expected risk.

A risk averse investor:

Is ready to take high risk only if it is compensated by a proportionately high return.

Which of the following statements is most accurate regarding Markowitz's efficient frontier? It contains the portfolios that have the:

Maximum rate of return for any given level of standard deviation of returns.

Do increases in correlation coefficients between different asset class pairs during a financial crisis provide diversification benefits to investors?

No. As correlation coefficients increase during a crisis, the diversification benefit is reduced because all assets tend to move together during crisis.

The point at which the capital allocation line tangents the efficient frontier is the:

Optimal risky portfolio for all investors irrespective of their risk preferences.

Rachel Dent, an investor, purchased shares of Log-on Net Inc. in the following manner: Period 1: Purchased 100 shares for $125 each at the beginning of the period and received a dividend of $6.25 per share at the end of the period. Period 2: Purchased an additional 200 shares for $130 each at the beginning of the period and received a dividend of $8.45 per share at the end of the period. Period 3: Purchased another 200 shares for $135 each and the dividend for the period was $8.75 per share. She sold all the shares for $140 each at the end of the period. Based solely on the information given, in which time period did Rachel's investment perform the best?

Period 2

Which of the following statements about the effect of correlation of constituent securities on the overall risk of a portfolio is most likely true?

Portfolio standard deviation is equal to the weighted average of the standard deviation of the constituent securities when they are perfectly positively correlated.

Which one of the following three statements concerning the Markowitz efficient frontier is false?

Portfolios on the Markowitz efficient frontier carry the highest return and lowest risk.

According to Markowitz Portfolio Theory:

Risk is measured by the volatility of expected returns

An investor's portfolio is currently composed of a single asset, Asset K. The best way to lower portfolio risk is through the addition of which asset?

Row A

Bert Smith, CFA, recommends three equity funds for his new client Walter Clay. Smith uses mean-variance analysis and optimization to derive allocation decisions. Clay admittedly knows little about investing beyond some knowledge of the benefits of diversification. Smith gathers data on the following three funds, along with his recommended allocation:

Row B

Investment managers are often evaluated based on the returns produced by a portfolio. Consider the following cases and ascertain which method is the most appropriate measure of portfolio return in each case: Case A: Rachel John, an investor, determines the timing and amount of the investments. The portfolio manager simply executes her orders. Case B: Arjun Singh, an investor, gives free rein to his investment manager to handle his portfolio. The manager solely decides when additions or withdrawals are to be made and by what amount. Case ACase BA.Money-weighted rate of returnTime-weighted rate of returnB.Time-weighted rate of returnMoney-weighted rate of returnC.Time-weighted rate of returnTime-weighted rate of return

Row B

An analyst gathered the following information regarding three portfolios. Which portfolio is most likely to plot below the Markowitz efficient frontier? Portfolio Expected ReturnStandard DeviationA8%13%B15%16%C11%20%

Row C

An investor purchases a share for $11 at the beginning of the year. At the end of Year 1, the stock pays a dividend of $0.75. At the beginning of the second year, the investor purchases another share of the same company for $10. At the end of the second year, the investor sells both shares for $12 each after receiving a $1 per share dividend. The money-weighted rate of return and the time-weighted rate of return are closest to: Money-Weighted Rate of ReturnTime-Weighted Rate of ReturnA.101.43%12.7%B.27.4%13.3%C.17.3%12.7%

Row C

Which of the following is most accurate when measuring the performance of investment managers? Deposition of FundsEffectA.Prior to a period of superior performanceMoney-weighted return ﹤ Time-weighted returnB.After a period of superior performanceTime-weighted return ﹤ Money-weighted returnC.Prior to a period of poor performanceMoney-weighted return ﹤ Time-weighted return

Row C

Nesrin built a portfolio out of an investments universe of 10 stocks. She is considering adding another stock. What can she do to improve the efficiency of her portfolio?

Select a stock with a low correlation to your portfolio

As the number of stocks in a portfolio increases, which of the following three measures decreases?

Standard deviation of the returns of portfolio

An analyst is currently building a portfolio for two of its clients, Alistair and Stuart. Both the investors have different risk preferences. Alistair's indifference curve lies below Stuart's indifference curve. Which of the following statements about the clients' risk tolerance and portfolio preferences is most likely true?

Stuart's optimal portfolio would be acceptable to Alistair.

As the number of stocks in an equally weighted portfolio increases, which of the following three measures contributes most to the portfolio return variance?

The average covariance across all stock return pairs.

When adding an asset to a multiasset portfolio, in order to estimate the standard deviation of the combined portfolio, it is most important to consider:

The covariance between the assets' returns and the returns of the other assets in the portfolio.

Which of the following statements about indifference curves is least likely true?

The slope of an indifference curve indicates that the additional return required for every unit of additional risk increases at a constant rate.

A set of new securities is added to an already existing portfolio. The new securities are less than perfectly correlated. Which of the following situations is most likely to occur as a result of the action?

The total portfolio risk decreases, but the systematic risk remains the same.

The optimal portfolio for an investor is best described as the point:

Where his/her highest utility curve is tangential to the efficient frontier.

It is least accurate to say that combining two assets in a portfolio will:

always reduce the risk on the portfolio to less than the risk of either asset

According to capital market portfolio, the optimal risky portfolio is most likely comprised of all:

assets and weighted based on market value weights.

Which of the following portfolios has total risk exactly equal to the weighted average of the standard deviations of the constituent securities? Portfolio A: There is no correlation between the securities. Portfolio B: The prices of constituent securities move in opposite directions. Portfolio C: It gives absolutely no diversification benefits to the investor.

c

XM, an individual investor, decided to look at the history of her bond investments. Here are the pieces of information gathered: BondVariance of ReturnX0.034Y0.054 Even with a covariance of 0.004, XM expects that the variance of Bond X will increase by 0.02 and the variance of Bond Y will decrease by 0.03. If these expectations do materialize, what will be the effect to the correlation between the two bonds?

increase

If an investor has flat indifference curves, it is likely to indicate that the investor: Is aggressive. Is conservative. Has a long time horizon.

is aggressive

The minimum-variance frontier represents portfolios with the lowest:

level of risk for each level of expected return.

Through diversification in a stock portfolio, an investor can avoid:

nonsystematic risk

The global minimum variance portfolio is:

on the Markowitz efficient frontier.

Which of the following three asset return measures is least likely to affect the standard deviation of an investor's portfolio returns?

return on the asset

The demand for increasing yields on bonds as credit risk increases is evidence of an investor's:

risk averse behavior

For a portfolio comprising many assets, the most important factor to consider when adding an asset to the portfolio from the standpoint of diversification is:

that security's average covariance with the other assets.

Jiang Bo Chang purchased 100 shares for ¥125 each in 2009 and received a dividend of ¥6.25 per share at the end of the year. He purchased an additional 200 shares for ¥130 each and received a dividend of ¥8.45 per share in 2010. He again purchased 200 shares for ¥135 each in 2011 and the dividend for the year was ¥8.75 per share. He sold all the shares for ¥138 each at the end of 2011. If the money-weighted return method was used instead of the time-weighted return to evaluate the performance of the investment, the investment would appear to have performed:

worse because the performance was relatively weak during the period of highest investment.