Chapter 7

Potential benefits from diversification arise when correlation is select all that apply >1 -1 <1 1

-1 <1

A correlation of ______________ indicates that one asset's return varies perfectly inversely with the other's; a correlation of ______________ indicates perfect positive correlation; a correlation of _______________ indicated that the returns on the two assets are unrelated.

-1; 1; 0

An investment portfolio has a expected return of 11% and a standard deviation of 13%. If the current 91 day t-bill rate is 4% what is this portfolio's Sharpe Ratio? 0.54 0.15 0.85

0.54 ( S = (0.11-0.04) / 0.13 )

Which of the following adds to portfolio variance and does NOT optimize portfolio diversification? A negative correlation value between portfolio assets A positive correlation value between portfolio assets A zero-correlation value between portfolio assets

A positive correlation value between portfolio assets

Which of the following best describe the Sharpe Ratio? A return on investment that excludes the T-bill return but does not take into account risk A risk adjusted return that accounts for the risk premium earned over the T-bill rate An alternative measure of portfolio variance

A return on investment that excludes the T-bill return but does not take into account risk

Which of the following best describe the Sharpe Ratio? An alternative measure of portfolio variance A risk adjusted return that accounts for the risk premium earned over the t-bill rate A return on investment

A risk adjusted return that accounts for the risk premium earned over the t-bill rate

Asset portfolios that lie ____________ the global minimum variance have a portfolio below the global minimum variance frontier that has the ______________ standard deviation but a ____________ expected return.

Above; same; greater

The ____________ of diversification implies that it is possible to find two assets and choose the investment _____________ that will result in a portfolio with standard deviation ____________ than individual standard deviations of either of the assets.

Benefit; weights; lower

In a well-diversified portfolio, total portfolio risk is primarily driven by the _______________ of the individual securities.

Covariance

Portfolio variance is reduced if the ____________ term is negative. But even if it is positive, the portfolio standard deviation is still less than the weighted average of the individual security standard deviations, unless the two securities have a correlation of ________________.

Covariance; one

___________________reduces firm specific risk which results in total risk being reduced to lower levels.

Diversification

Which of the following is NOT part of the investment decision making process? Diversification allocation Asset allocation Capital allocation Security selection

Diversification allocation

The efficient set of portfolios is also known as the ___________ ___________ of risky assets.

Efficiency frontier

The point of tangency at which the ____________ frontier and the optimal CAL intersect is the __________ portfolio.

Efficiency; optimal

The optimal risky portfolio has a slope that ___________ the slope of all the other feasible portfolios. This slope is the same as the ____________ ratio of the portfolio.

Exceeds; Sharpe

The ________________ _________________ of a portfolio is the weighted average return of its component assets.

Expected return

The _____________ rate of return on a portfolio is the _______________ average of expected returns on the ________________ securities.

Expected; weighted; component

Which of the following is NOT a reason why investment managers require sophisticated models? Greater needs to save by society Growing demand for government pensions Healthy economies of scale Growing array of financial products

Growing demand for government pensions

Which of the following is true regarding portfolio efficiency? Higher correlations between assets reflect lower gains in efficiency Lower correlations between assets reflect lower gains in efficiency Lower correlations result in lower returns to investment

Higher correlations between assets reflect lower gains in efficiency

Which of the following is true of the optimal risky portfolio? select all that apply It has the lowest return for risk trade off. It has the highest Sharpe ratio. It is represented as the CAL with the steepest slope. The only way to diversify it is by adding more corporate bonds.

It has the highest Sharpe ratio. It is represented as the CAL with the steepest slope.

Which of the following best describes the minimum variance portfolio? Its standard deviation is lower than either of its component assets Its returns and standard deviation is larger than its component assets Its standard deviation is larger than its component assets

Its standard deviation is lower than either of its component assets

The minimum variance frontier is a graph of the ________________ (highest/lowest) possible portfolio variance in a portfolio that can be attained by an investor, given its expected return.

Lowest

Which of the following best defines an "efficient" portfolio? Highest variance and highest return Lowest variance and highest expected return Lowest variance and highest past rate of return

Lowest variance and highest expected return

The efficient frontier offers a set of portfolios that _____________ (maximize/minimize) return at every level of ______________.

Maximize; risk

The optimal risky portfolio is the portfolio that _____________ the Sharpe ratio or provides the greatest ___________ at all levels of risk.

Maximizes; return

Which of the following best describes the insurance principle? Optimization of market specific risks across many different sources of market risk Minimization of risk due to risk being spread across several different sources of risk Buying key person insurance on senior management Maximization of firm specific risk

Minimization of risk due to risk being spread across several different sources of risk

An investor in the optimal risky portfolio can target an expected return and ____________ risk, or target an acceptable risk level and _____________ return.

Minimize; maximize

The standard deviation is lower than either of its component assets in the ___________ ___________ portfolio.

Minimum variance

A perfectly hedged two asset portfolio is a portfolio in which both assets are perfectly ___________ correlated resulting in a portfolio standard deviation of ________________.

Negatively; zero

Portfolio optimization techniques that assume a normal distribution of returns and standard deviations as adequate measures of risk may be inadequate to fully measure risk because of the potential ___________ of returns.

Non-normality

In a two asset portfolio, where assets A and B have ____________ ______________ correlation, the portfolio standard deviation is simply the weighted average of the standard deviations of assets A and B.

Perfect positive

Which of the following is required for an investor to create a perfectly hedge position? Perfectly positive correlation between assets Perfectly negative correlation between assets Equal standard deviations in two assets

Perfectly negative correlation between assets

Risk ______________ by itself does not reduce risk, but it improves the risk-return trade-off and is therefore a crucial part of a ____________ strategy.

Pooling; diversification

Even when there is a large ___________________ (positive/negative) correlation of returns, there is still a small positive benefit from diversification.

Positive

Assets that have correlations of less than one optimize diversification and _____________ (increase/reduce) the variance of the weighted average of the portfolio's assets - thus reducing the portfolio's variance.

Reduce

The diversification within a bond portfolio is credited for a good deal of the risk ___________ (increase/reduction) compared to a undiversified bond portfolio.

Reduction

Which of the following statements are correct? Risk sharing by itself does not reduce risk, but it improves the risk-return trade-off by reducing the Sharpe ratio. Risk pooling by itself does not reduce risk, but it improves the risk-return trade-off and is therefore a crucial part of a diversification strategy.

Risk pooling by itself does not reduce risk, but it improves the risk-return trade-off and is therefore a crucial part of a diversification strategy.

Which of the following best describe a short position? Sale of put options on a position Buying of a security using borrowed funds resulting in a negative asset position Sale of security not owned by the investor resulting in negative asset positions

Sale of security not owned by the investor resulting in negative asset positions

According to the Markowitz model, a portfolio manager will offer the _____________ risky portfolio to all investors, regardless of their level of risk aversion.

Same

The _______________ ___________________ separates the portfolio choice problem into two parts. First, the determination of the optimal risky portfolio and second, the capital allocation decision.

Separation property

By excluding short positions from a portfolios there is the potential that which of the following will be included in efficient risky portfolios? Index mutual funds Single assets ETF funds

Single assets

Market, or __________, risk affects all assets in the economy and cannot be diversified away; whereas firm-specific, or ___________, risk can be eliminated by portfolio diversification.

Systematic; unique

Which of the following statements about time diversification are correct? Time diversification may increase risk Time diversification is the same as risk diversification Increasing the term of an investment in a risky investment reduces the Sharpe ratio

Time diversification may increase risk

When comparing investments with different ______________ _____________, the investments must be compared over the same period. The conclusion can be made that while this extension of a risky investment improves the Sharpe ratio, the exposure to longer time horizon also ______________ risk.

Time horizons; increases

Which of the following best describes the investment decision making process? Curvilinear process Top-down process Bottom-up process

Top-down process

Individual assets lie to the right side of the minimum variance frontier which tells us that the risky portfolios comprising only a single asset are inefficient. True or False

True

The greater demand for savings and more sophisticated investment models are two factors that have contributed to the demand for better financial/investment models. True or False

True

The addition of a risky security to an investment portfolio is meant to reduce which type of risk? Unique risk Systematic risk Market risk

Unique risk

Under what circumstances are there no benefits from diversification? When the correlation coefficient between two assets' returns is less than perfectly correlated When the correlation coefficient between two assets' returns is -1 When the correlation coefficient between two assets' returns is zero When the correlation coefficient between two assets' returns is +1

When the correlation coefficient between two assets' returns is +1

It is possible to achieve _______________ risk when investing in ___________________ assets if an investor can find two assets that are perfectly _______________ correlated.

Zero; risky; negatively

The optimal portfolio is found at the tangency point between the CAL and the minimum variance frontier at the tangency point between the SML and the efficient frontier at the tangency point between the CAL and the efficient frontier

at the tangency point between the CAL and the efficient frontier

The objective of determining the mix of debt and equity securities in a portfolio is to maximize the portfolio with the highest slope or ____________. average Sharpe Ratio highest Sharpe Ratio lowest Sharpe Ratio

average Sharpe Ratio

In addition to standard deviation and expected return constraints, portfolio constraints may include the following: select all that apply no negatively correlated assets constraints on short sales minimum level of dividend yield screening investments

constraints on short sales minimum level of dividend yield screening investments

Portfolio optimization and diversification benefits can be obtained by select all the apply diversifying within a risky asset portfolio e.g. a stock portfolio optimizing asset allocation among e.g. stocks and bonds to improve the Sharpe ratio of the complete portfolio finding the complete portfolio with the lowest Sharpe ratio when the standard deviation of the portfolio is less than the standard deviation of the stock portfolio, but the expected return is not reduced

diversifying within a risky asset portfolio e.g. a stock portfolio optimizing asset allocation among e.g. stocks and bonds to improve the Sharpe ratio of the complete portfolio when the standard deviation of the portfolio is less than the standard deviation of the stock portfolio, but the expected return is not reduced

The objective of determining the mix of debt and equity securities in a portfolio is to maximize the portfolio with the highest slope or ____________. lowest Sharpe Ratio highest Sharpe Ratio average Sharpe Ratio

highest Sharpe Ratio

The choice of the optimal portfolio involves the following three steps: select all that apply identify the optimal risky portfolio where the CAL is the steepest diversify the portfolio to minimize systematic risk identify the risk-return combinations of the set of risky assets choose the complete portfolio by mixing the risk-free asset with the optimal risky portfolio identify the optimal risky portfolio where the Sharpe ration is the lowest

identify the optimal risky portfolio where the CAL is the steepest identify the risk-return combinations of the set of risky assets choose the complete portfolio by mixing the risk-free asset with the optimal risky portfolio

The portfolio variance is lower when the correlation coefficient is __________________.

lower

The primary assumption in portfolio optimization is that returns follow _________________. chi square distribution curvilinear model normal distribution

normal distribution

Constraints that restrict investment strategies or vehicles have the effect of _______________ (increasing/reducing) the Sharpe ratio of that portfolio.

reducing

Which of the following best describes the risk behavior of a portfolio with large positive correlation in asset returns? risk decreases as assets returns increase from higher correlation to lowest correlation risk remains flat regardless of the positive correlation risk increases monotonically from the low-risk asset to the high-risk asset

risk increases monotonically from the low-risk asset to the high-risk asset

As portfolios become more diversified, the impact of a new security on portfolio risk is primarily driven by _______. the expected total return of the security the covariance of the security with the portfolio components the overall total variance of the security

the covariance of the security with the portfolio components

Portfolios of less than perfectly correlated assets always offer some degree of diversification benefit so that the covariance is the weighted average of the component variances the portfolio variance is the weighted average of the component variances the lower the correlation, the greater the gain in efficiency the higher the correlation, the greater the gain in efficiency

the lower the correlation, the greater the gain in efficiency

A portfolios expected return is always the ________________ of its asset returns. summation geometric average weighted average

weighted average