403 Exam 1

Which of the following is not implied by the capital asset pricing model? -All investors should hold the same portfolio of risky assets. -All investors should hold fully-diversified portfolios. -All investors should hold portfolios with the highest possible Sharpe Ratios. -All investors should have the same portfolio weight on the risk-free asset.

All investors should have the same portfolio weight on the risk-free asset.

Which of the following is correct regarding risk-averse investors investing in risky assets? A. -Investors should hold a small number of carefully selected stocks to maximize their expected return and minimize risk. -Investors should maximize their expected return by bearing as much diversifiable risk as they can tolerate. -They should eliminate all systematic risk by forming well-diversified portfolios. -All investors should hold the same diversified portfolio of risky assets

All investors should hold the same diversified portfolio of risky assets

Which of the following is correct regarding risk-averse investors investing in risky assets? -Investors should hold a small number of carefully selected stocks to maximize their expected return and minimize risk. -Investors should maximize their expected return by bearing as much diversifiable risk as they can tolerate. -They should eliminate all systematic risk by forming well-diversified portfolios. -All investors should hold the same diversified portfolio of risky assets.

All investors should hold the same diversified portfolio of risky assets.

Which of the following statements is correct regarding the tangency portfolio? -It lies at the point where a line connecting the risk-free asset to the efficient frontier is tangent to the efficient frontier. -When combined with the risk-free asset, it produces the highest possible expected return for a given amount of risk. -When combined with the risk-free asset, it produces the lowest possible risk for a given expected return. -It has the highest attainable Sharpe Ratio. -All of the above statements are correct.

All of the above statements are correct.

Given a probability distribution of stock returns, which of the following is equivalent to an increase in risk? -A decrease in the variance of returns. -An increase in mean return. -An increase in the variance of returns. -A decrease in mean return.

An increase in the variance of returns.

Which of the following statements is not correct regarding the security market line (SML)? -Assets that plot below the SML are undervalued; assets that plot above the SML are overvalued. -The slope of the SML equals the expected risk premium on the market portfolio. -The SML graphs assets' expected returns against their betas. -If the CAPM is correct, all assets should plot on the SML

Assets that plot below the SML are undervalued; assets that plot above the SML are overvalued.

The figure above presents the expected returns and standard deviations of five assets in μ-σ space. Which assets are not dominated by any other assets? -B and C -Only C -Only B -C and E

B and C

Which of the following is the name given to the line that connects the risk-free asset and the market portfolio in the expected return-standard deviation (μ-σ) space? -Tangency portfolio -Security market line -Efficient frontier -Capital market line

Capital market line

Which of the following statements is true regarding portfolio diversification? -The goal of diversification is to increase expected returns without increasing portfolio risk. -Diversification refers to the complete elimination of portfolio risk. -It is impossible to reduce portfolio risk without sacrificing expected return. -Diversification cannot reduce systematic risk.

Diversification cannot reduce systematic risk.

Which of the following is not correct regarding beta? -If a stock's returns are uncorrelated with market returns, the beta of the stock must be zero. -The beta of a broad market index equals one. -If a stock has returns that are negatively correlated with market returns, then the stock has a negative beta. -If a stock's returns are perfectly correlated with market returns, the beta of the stock must be one.

If a stock's returns are perfectly correlated with market returns, the beta of the stock must be one.

Under what circumstances should a risk-averse investor add a small amount of a risky asset to an existing portfolio? -If adding the asset increases the Sharpe Ratio of the portfolio. -If it has a greater Sharpe Ratio than the portfolio. -If it has less risk than the portfolio. -If it has a greater expected return than the portfolio

If adding the asset increases the Sharpe Ratio of the portfolio.

If portfolio weight in risk-free asset is less than 0 (Wf < 0)

Investor is borrowing

If portfolio weight in risk-free asset is more than 0 (Wf > 0)

Investor is lending

Beta

Measures the sensitivity of a stock's return to the return on the market

Security Market Line (SML)

Represents expected return-beta relationships of CAPM

Which of the following statements is not correct regarding the efficient frontier? -Risk-averse investors will never add a risky asset to their portfolios that is not on the efficient frontier. -Portfolios on the efficient frontier have the highest expected return for a given amount of risk. -Portfolios on the efficient frontier have the least risk for a given amount of expected return. -Regardless of individual risk tolerance, risk-averse investors will prefer portfolios that are on the efficient frontier to portfolios that are not on the efficient frontier.

Risk-averse investors will never add a risky asset to their portfolios that is not on the efficient frontier.

Which of the following asset classes has had the highest cumulative return since 1926? -Large-cap stocks -Small-cap stocks -Corporate bonds -Treasury bonds

Small-cap stocks

Which of the following asset classes has had the highest historical standard deviation of annual returns since 1926? -Corporate bonds -Treasury bonds -Small-cap stocks -Large-cap stocks

Small-cap stocks

Consider Exhibit 1, which plots portfolio volatility as a function of portfolio size and correlation. Holding portfolio size fixed, the greater the correlation between stocks, the _______ the reduction in standard deviation. In addition, holding correlations fixed and assuming less than perfect correlation, the greater the number of stocks in the portfolio, the ______ the reduction in standard deviation. -Smaller; greater -Smaller; smaller -Greater; smaller -Greater; greater

Smaller; greater

Suppose you want to form an equally-weighted portfolio of two stocks with the lowest possible volatility. You already own stock A, which has a return volatility of 0.5. You are considering four different stocks as the second stock in the portfolio. Stocks B and C have return volatilities of 0.3, and stocks D and E have return volatilities of 0.6. Stock A has a positive correlation of 0.5 with the returns for stocks B and D, and it has a negative correlation of −0.5 with the returns for stocks C and E. In order to minimize portfolio volatility, with which stock should you pair stock A? -Stock E -Stock D -Stock C -Stock B

Stock C

Which of the following is not correct regarding the correlation coefficient? -A correlation coefficient of 0 indicates uncorrelated variables. -A correlation coefficient of −1 indicates perfectly negative correlation. -The correlation coefficient can take any value between negative infinity and positive infinity. -A correlation coefficient of 1 indicates perfectly positive correlation

The correlation coefficient can take any value between negative infinity and positive infinity.

Consider a portfolio that combines a risky asset with the risk-free asset. Assume that the expected return for the risky asset exceeds the risk-free rate. Which of the following statements is not correct? -A positive weight on the risk-free asset indicates that the investor is lending at the risk-free rate. -An investor can boost her expected returns by levering the portfolio. -The investor can achieve an expected return greater than that of the risky asset by lending at the risk-free rate. -A weight greater than one on the risky asset indicates that the investor is borrowing at the risk-free rate.

The investor can achieve an expected return greater than that of the risky asset by lending at the risk-free rate.

Given two stock return distributions such as those displayed in Exhibit 2, which of the two stocks is riskier? -The one with potential outcomes more concentrated around its expected return. -The one with a distribution that is less spread out. -The one with the lower expected return. -The one with a greater variance of returns.

The one with a greater variance of returns.

An analyst believes that at its current price, a certain stock has an expected return of 10% for the coming year. Assume that this stock has a beta of 2.0, the risk-free rate is 2%, and the expected return on the market portfolio is 8%. If the analyst's estimate of the stock's expected return is correct, which of the following statements is true? -The stock appears overpriced. -The stock appears correctly priced. -The stock appears underpriced. -There is insufficient information whether the stock is correctly priced

The stock appears overpriced.

Consider the returns for various asset classes presented in Exhibit 1. Which of the following statements is not correct? -Treasury bonds have earned a higher return than corporate bonds. -Small-cap stocks have earned a higher return than large-cap stocks. -Large-cap stocks have earned a higher return than Treasury bonds. -Treasury bonds have earned a higher return than Treasury bills.

Treasury bonds have earned a higher return than corporate bonds.

Consider two assets having returns R1 and R2, respectively. Assume that a portfolio contains fixed proportions of those two assets, so that the portfolio return equals x1R1 + x2R2 for fixed portfolio weights x1 and x2. Which of the following statements is not correct? -It is possible to create a portfolio with a lower standard deviation than the deviation of return of either individual asset. -In general, the lower the correlation between the returns of the two assets, the lower the risk of a portfolio that consists of fixed proportions of those two assets. -The expected return on the portfolio is a weighted average of the expected returns of the individual component assets. -With two uncorrelated assets, the standard deviation of the portfolio equals x1StDev(R1) + x2StDev(R2).

With two uncorrelated assets, the standard deviation of the portfolio equals x1StDev(R1) + x2StDev(R2).

Minimum-Variance Frontier

a graph of the expected return/variance combinations for all minimum-variance portfolios

Efficient Frontier

a plot of the set of expected returns and standard deviations for all efficient portfolios above the global minimum-variance portfolios. ***Investors should try to hold portfolios on the efficient frontier. These portfolios maximize expected return for a given level of risk

short-term Treasury bills

combinations of risky and risk-free assets

Efficient Portfolios

the highest level of return for a given level of risk as measured by standard deviation

Minimum-Variance Portfolio

the portfolio that has the smallest variance among all portfolios with identical expected return

Global Minimum-Variance Portfolios

the portfolio that provides the lowest standard deviation among all possible portfolios of risky assets