Investments Exam 2

Which tools can help to determine an optimal investment portfolio? 1. Mean-variance optimization model 2. Risk tolerance questionnaire 3. Tactical asset allocation

1 and 2 The mean-variance optimization model and the risk tolerance questionnaire can be used to help determine an optimal investment portfolio. The mean-variance optimization model is designed to determine the optimal portfolio, given a client's risk tolerance level; therefore, the risk tolerance questionnaire will be utilized to assess the appropriate level of risk to be used within the model

The highest annual range of returns for the S&P 500 has occurred for which of the following?

1-year rolling returns As the holding period increases for the S&P 500, the average range in returns has decreased significantly

Jocko was just told that the expected return for Echo stock was 20%, based on the CAPM. Assuming that the market return and the risk-free rate are 12% and 4%, respectively, what is the beta for Echo?

2.0 20% = 4% + beta(12%-4%) solving for beta =2.0

Eugene Fama is known for each of the following except: A) Research on fixed-income attribution analysis B) Decomposition of portfolio manager's performance C) Development of the efficient markets hypothesis D) Winner of the Nobel Prize in economic sciences

A) Research on fixed-income attribution analysis Fama is one of the fathers of modern portfolio theory but is not known for work done in fixed income attribution analysis

The Nacho Equity Fund has a beta of 1.44 and a standard deviation of 20.8%. It has returned 12.9% during the past year when the return on one-year Treasury bills has been 3.2%. The Sharpe Ratio of the Nacho Equity Fund is closest to: A)0.466. B)0.620. C)6.736. D)8.958.

A)0.466. Sharpe = (Portfolio Return-Risk Free Rate)/(Standard Deviation)Sharpe = (12.9-3.2)/20.8=0.466

Which of the following about the CML are true? 1. The capital market line is tangent to the efficient frontier. 2. As an investor moves away from the point of tangency toward the risk-free rate, the percentage of Treasury bills in the portfolio will increase. 3. As an investor moves away from the point of tangency toward the risk-free rate, the percentage of long-term bonds in the portfolio will increase. 4. The portfolio at the point of tangency includes an equal proportion of stocks and bonds. A)1 and 2. B)1 and 4. C)2 and 3. D)3 and 4.

A)1 and 2. All points on the CML are the new efficient frontier. At tangency, all risky assets are included. The CML is the line that connects the risk-free rate with the market portfolio.

The highest annual range of returns for the S&P 500 has occurred for which of the following? A)1-year rolling returns. B)5-year rolling returns. C)10-year rolling returns. D)20-year rolling returns.

A)1-year rolling returns. As the holding period increases for the S&P 500, the average range in returns has decreased significantly.

Overconfidence is most likely to be displayed by: A)A financial advisor with a three-year record of outperformance. B)An individual investor with 100% allocation to a broad equity index. C)The board of trustees of a college endowment fund comprised of liberal arts professors. D)A foundation with 100% allocation to risk-free government bonds because of low risk tolerance.

A)A financial advisor with a three-year record of outperformance. Financial advisors who have outperformed the market for a long time period are very likely to be overconfident in their ability to pick winners. The problem is that historical success is not very often repeated over similar time periods. Passive investors are typically not overconfident. Liberal arts professors serving on a college endowment board are not likely to be overconfident. Government bond investors are probably the least likely to be overconfident.

Prospect theory most likely suggests investors: A)Avoid regret when making important financial decisions. B)Are not restricted to bounded rationality. C)Avoid making decisions heuristically. D)Are free of emotional biases.

A)Avoid regret when making important financial decisions. Prospect theory suggests that behavioral investors will make decisions to avoid the feelings of regret, such as signaling to the rest of the capital markets that they have selected a losing stock. Behavioral investors are rationally bounded, take short cuts (heuristics) and have many emotional biases.

A financial analyst computes present value of a firm's operating cash flows to calculate an intrinsic value of the shares. The analyst is most likely using: A)Discounted cash flow technique. B)Relative valuation methodology. C)Indexing. D)Technical analysis.

A)Discounted cash flow technique. Discounted cash flow analysis includes estimating future cash flows and then discounting them at an appropriate interest rate. The present value is often times referred to as the intrinsic value of the company.

Modern portfolio theory was originally advanced by: A)Harry Markowitz and the identification of standard deviation as a measure of risk. B)William Sharpe and the capital asset pricing model. C)Eugene Fama and the efficient markets hypothesis. D)Stephen Ross and the arbitrage pricing theory.

A)Harry Markowitz and the identification of standard deviation as a measure of risk. Harry Markowitz wrote his seminal paper on the efficient frontier in 1952. This research is considered to be the origination of modern portfolio theory, which formed the basis of the CAPM, the EMH, and APT that followed by Sharpe, Fama, and Ross. Markowitz was the first to understand the importance of standard deviation in risk management. All of these researchers are considered to be the fathers of modern finance.

A market in which an investor forms a well-diversified portfolio by using only the CEO's degree and university attended to consistently outperform the relevant benchmark is most likely: A)Inefficient. B)Weak form efficient. C)Semi-strong form efficient. D)Strong form efficient.

A)Inefficient. Markets are efficient when they reflect at least a minimum of relevant information. Although the CEO's education history is likely to be an important part of the hiring process, those credentials are not likely to be inputs for an outperforming portfolio.

Which of the following is the most accurate description of the difference between what behavioral and rational investors value? a-gains and losses-final wealth b-gains-losses c-losses-final wealth d-final wealth-final wealth A)Option a. B)Option b. C)Option c. D)Option d.

A)Option a. One of the significant differences between investors that are rational and those who exhibit behavioral tendencies is their goals. Rational investors value end of period wealth while those influenced by emotions and heuristics value both short and long-term gains and losses. This difference can lead to completely different portfolio construction.

Portfolio X and Portfolio Z have identical levels of total risk and similar weighting schemes. The correlations among the securities in X are much lower than those in Z. Which statement is most accurate? A)Portfolio X has a lower standard deviation. B)Portfolio X has a higher variance. C)Portfolio Z has greater diversification. D)Portfolio Z has much lower expected return.

A)Portfolio X has a lower standard deviation. Correlation coefficients are much lower for X, which means it will have a lower standard deviation.

Information reflected in security prices in a semi-strong form market most likely includes all of the following except: A)Private information regarding the merger of industry leaders. B)Dividend information contained in the board of director announcement. C)Stock prices during the previous week. D)Board of director election results one week after the election.

A)Private information regarding the merger of industry leaders. The semi-strong form level of efficiency does not include privately held or insider information. Prices in a semi-strong form market would reflect information about dividends, historical stock prices, and election results after they bare announced, but would not reflect private information on mergers.

Eugene Fama is known for each of the following except: A)Research on fixed-income attribution analysis. B)Decomposition of portfolio manager's performance. C)Development of the efficient markets hypothesis. D)Winner of the Nobel Prize in economic sciences.

A)Research on fixed-income attribution analysis. Fama is one of the fathers of modern portfolio theory but is not known for work done in fixed-income attribution analysis.

Charlie has been trading in stocks on a very short term basis for several months. Although he had good results at first, the volume of his activity created significant trading costs and he has recently been incurring losses regularly. He continues to trade frequently regardless of the outcome because of the adrenaline rush associated with day trading. Which emotional bias is he committing? A)Self-control bias. B)Clustering illusion. C)Irrational escalation. D)Optimism bias.

A)Self-control bias. The clustering illusion results from over focus on short term trends, believing they will continue. An example of irrational escalation would be buying more of a winning stock despite evidence that the company may be having problems. Optimism bias occurs when an investor fails to consider downside risk but focuses on the upside.

Which of the following would be included in the market portfolio? 1. Stocks & bonds. 2. Hedge funds. 3. Risk-free asset. A)1 only. B)1 and 2. C)1, 2 and 3. D)2 and 3.

B)1 and 2. The market portfolio consists of all risky assets. Therefore, it would not include the risk-free asset.

While standard deviation and beta are both measures of risk, there are differences between the two. Which of the following is correct? A)Beta measures all risk. B)Beta measures only systematic risk C)Beta measures only unsystematic risk. D)Standard deviation and beta are different, but both measure total risk.

B)Beta measures only systematic risk Beta measures systematic risk, while standard deviation measures total risk (systematic and unsystematic risk).

The _____ is a graphical representation of expected return and risk, as measured by standard deviation. A)APT. B)CML. C)SML. D)Efficient frontier.

B)CML. The CML represents the expected return relative to risk as measured by standard deviation.

Examples of emotional biases most likely include: A)Anchoring. B)Clustering illusion. C)Mental accounting. D)Gambler's fallacy.

B)Clustering illusion. The tendency to believe that short term price patterns are repeatable over subsequent short-term periods is the clustering illusion and it is an emotional bias. The other choices are cognitive errors.

An investor who purchases a variety of mutual funds that mimic the performance of the S&P 500 Index, the Russell 2000, and the NASDAQ Composite is most likely pursuing a strategy of: A)Discounting cash flows. B)Indexing. C)Technical analysis. D)Relative valuation.

B)Indexing. Indexing is a form of passive investing in which the investor simply purchases an index of returns using mutual funds or exchange-traded funds.

A financial analyst computes the price to sales ratio as a comparison to determine which company is most expensive. The analyst is most likely using: A)Discounted cash flow technique. B)Relative valuation methodology. C)Indexing. D)Technical analysis.

B)Relative valuation methodology. Relative valuation method uses price multiples to determine the relative value of each individual stock. The price-to-sales ratio is commonly used for firms that do not have a long history of positive earnings.

A large firm announces it has hired a design company to change its corporate logo. The new logo will be shown publicly for the first time the following day. Shareholders react by bidding up the shares by 10% over the relevant benchmark. No other information about this firm is released. The shareholder reaction can best be described as: A)Anchoring. B)Representativeness. C)Cognitive dissonance. D)Mental accounting.

B)Representativeness. Representativeness is a simple heuristic decision making tool in which investors make quick decisions without regards to probability distributions or searching for the true factors that should influence the decision. When investors bid up the price of a company's shares just because it changes its logo, the shareholders are hoping the new logo increases the firm's profitability. Since no other information is released around this time, the price reaction is likely attributed to representativeness.

Which tools can help to determine an optimal investment portfolio? 1. Mean-variance optimization model. 2. Risk tolerance questionnaire. 3. Tactical asset allocation. A)1 only. B)2 only. C)1 and 2. D)All of the above.

C)1 and 2. The mean-variance optimization model and the risk tolerance questionnaire can be used to help determine an optimal investment portfolio. The mean-variance optimization model is designed to determine the optimal portfolio, given a client's risk tolerance level; therefore, the risk tolerance questionnaire will be utilized to assess the appropriate level of risk to be used within the model.

John Diggle's portfolio generates a return of 14% when the risk-free rate of interest is 3% and the return due to the risk of the portfolio is 10%. The Fama decomposition would assign a selectivity value that is closest to: A)-1%. B)0%. C)1%. D)7%.

C)1%. Total portfolio return 14%Less return due to portfolio risk 10%Less risk-free rate 3%Equals selectivity 1%

Jocko was just told that the expected return for Echo stock was 20%, based on the CAPM. Assuming that the market return and the risk-free rate are 12% and 4%, respectively, what is the beta for Echo? A)1.0. B)1.5. C)2.0. D)2.5.

C)2.0. 20% = 4% + β(12% - 4%)Solving for β = 2.0

XYZ common stock has a beta of 0.50, while ABC common stock has a beta of 2.0. The expected return on the market is 12% and the risk-free rate is 4%. Based on the CAPM, and making use of the information, the required return on XYZ common stock should be ____, and the required return on ABC common stock should be____. A)4%; 16%. B)6%; 24%. C)8%; 20%. D)10%; 28%.

C)8%; 20%. XYZ: 0.04 + 0.5(0.12 - 0.04) = 8%ABC: 0.04 + 2.0(0.12 - 0.04) = 20%

Which of the following statements regarding time diversification and forecasting is NOT correct? A)The variability of an investment tends to decrease as the holding period increases. B)The further one attempts to forecast into the future, the more likely that the forecast will be wrong. C)An incorrect forecast spread across may periods will be discounted and will not significantly distort results. D)Sensitivity analysis may be used in conjunction with forecasting to identify best-case and worst-case scenarios.

C)An incorrect forecast spread across may periods will be discounted and will not significantly distort results. If the forecast is wrong and was spread across many periods, the error is compounded and can significantly distort the results. Furthermore, as the length of the projection period increases, the uncertainty about the accuracy of the forecast grows.

Most variation in portfolio returns over an extended period of time is attributable to ______. A)Security selection. B)Market timing. C)Asset allocation. D)Market cycles.

C)Asset allocation. Over time, asset allocation represents the largest impact on performance for investors.

A rational investor would most likely: A)Use emotional cues to rebalance portfolios. B)Take shortcuts when making asset allocation decisions. C)Completely and accurately process covariance data. D)Be influenced by the frame of an investment decision.

C)Completely and accurately process covariance data. Behavioral investors are subject to emotional issues, susceptible to the temptation of taking short cuts, and allow framing to influence their decisions. Rational investors, on the other hand, completely process and accurately process relevant information, including information about covariances among stocks.

An investor adds a second corporate bond to her portfolio after the first bond substantially outperformed during the previous year. The first bond has been upgraded after its recent performance from CC to CCC. The second bond is currently rated CC and the investors seeks a repeat performance based on no additional information. The investor is most likely suffering from: A)Representativeness. B)Anchoring. C)Gambler's fallacy. D)Hindsight bias.

C)Gambler's fallacy. The gambler's fallacy is the thought that an investor has influence over an outcome because of a previous experience with a similar event. In this case, the investor is hoping to repeat the outperformance just because one speculative grade bond performed well.

Money managers who tend to pursue strategies that their colleagues have recently been successful with most likely show signs of: A)Illusion of control. B)Clustering illusion. C)Herd mentality. D)Anchoring.

C)Herd mentality. Money managers are often guilty of following the crowd, especially after hot stocks or hot IPOs. This is known as the herd mentality.

The most likely violation of the modern portfolio theory assumptions is: A)Investors making rational decisions. B)Institutional investors having no impact on prices even when making large trades. C)Individual investors facing bid and ask prices when they trade. D)All investors being able to borrow at the risk-free rate of interest.

C)Individual investors facing bid and ask prices when they trade. MPT assumptions include the existence of markets that have no transactions costs. Bid-ask spreads are one form of transactions cost. The remaining choices are critical MPT assumptions.

Sarah recently reviewed her portfolio as part of her year-end performance assessment. She sold several stocks that had positive results for the year but held on to two stocks that were below her purchase price. She did not re-evaluate the potential performance for these stocks. Which form of bias is she exhibiting? A)Hindsight bias. B)Confirmation bias. C)Loss aversion. D)Overconfidence bias.

C)Loss aversion. Hindsight bias occurs when investors recall positive outcomes but fail to remember the negative one. Confirmation bias entails searching for information that supports your existing position. Overconfidence bias occurs when investors overestimate their ability to identify mispriced securities.

The behavioral finance aspect that most likely offers a unique and reasonable explanation for the persistence of the equity premium puzzle is: A)Emotional bias. B)Bounded rationality. C)Myopic loss aversion. D)Heuristic security valuation.

C)Myopic loss aversion. Investors tend to avoid short-term losses at the expense of other portfolio components. The implication is that investors require very high long-term returns to compensate them for the losses occurring in the short term. Therefore, myopic loss aversion offers a reasonable explanation for the difference between equity returns and government bond yields that cannot be explained by differences in risk.

When investors perception of risk decreases, then the SML should: A)Remain parallel to the original SML but shift upwards. B)Remain parallel to the original SML but shift downwards. C)Rotate downward (clockwise). D)Rotate upwards (counterclockwise).

C)Rotate downward (clockwise). If the perception of risk decreases, then the return for the market portfolio should decrease. Since the Rf remains the same, it results in a rotation downward - the slope decreases.

Which of the following is a graphical representation of expected return and beta? A)ALA. B)CML. C)SML. D)Efficient frontier.

C)SML. The SML represents the expected return relative to risk as measured by beta.

Harold Smith sits on four boards of directors of publicly held companies, each operating in a different industry. Smith has an ethical clause in each of his board contracts but ignores them by trading on information he learns during board meetings. Smith generates an average return on these trades that is well above any relevant benchmark. The market under these conditions is most likely: A)Inefficient. B)Weak form efficient. C)Semi-strong form efficient. D)Strong form efficient.

C)Semi-strong form efficient. Only in a strong form market do prices reflect all relevant information including insider information. Since Smith is able to generate superior returns, the market can only be semi-strong form efficient.

Jordan has a fairly diversified portfolio and is considering adding another security to it. Which of the following is correct? A)She should add a security that is fairly highly correlated as her portfolio is already diversified. B)She should add a security that is not correlated as it will provide the most diversification. C)She should add a security that is negatively correlated to achieve the best diversification. D)None of the above are correct.

C)She should add a security that is negatively correlated to achieve the best diversification. The best correlation to add to a portfolio would be negative. Correlation ranges from +1 to -1.

Technical analysis most likely relies on the belief that: A)Markets are efficient. B)Asset prices reflect all relevant and available information. C)Stock price patterns exist and can be predicted. D)Behavioral investors do not affect stock prices.

C)Stock price patterns exist and can be predicted. Technical analysis is almost the opposite of fundamental analysis. Technicians do not believe that capital markets are efficient, that prices are reflective of relevant information, and that behavioral investors can be ignored. Rather, they believe that historical price and volume data can be used to predict future stock price through the analysis of patterns.

Colin, who is 25 years old, invested $60,000 in an S&P 500 index fund, $30,000 in a fixed income fund, and $10,000 in a money market fund. At the end of the year, his portfolio investments had the following values: index fund: $80,000, fixed income fund $35,000, money market fund $10,000. He decides to rebalance his portfolio to match the initial allocation. What type of asset allocation is Colin engaging in? A)Mean-Variance. B)Tactical. C)Strategic. D)Core-Satellite.

C)Strategic. Tactical asset allocation seeks to outperform the market over short period of time by placing investment dollars in asset classes the investor believes will outperform the market. Strategic asset allocation is concerned with allocating investor wealth across a broad selection of asset classes to generate returns and reduce the likelihood of incurring significant losses. Strategic asset allocation requires rebalancing periodically.

Brisco believes that the market premium will go up over the next two months due to expectations about the market portfolio. What should happen to the SML? A)The slope of the SML should remain the same but the SML will shift upwards. B)The slope of the SML should remain the same but the SML will shift downwards. C)The slope of the SML should increase. D)The slope of the SML should decrease.

C)The slope of the SML should increase. If the expected return on the market increases, then the slope of the SML should increase as the Rf remains the same.

Assets that lie above the SML are considered to be _______. A)Overvalued based on its beta. B)Overvalued based on its standard deviation. C)Undervalued based on its beta. D)Undervalued based on its standard deviation.

C)Undervalued based on its beta. An asset above the SML would have a higher expected return and therefore be considered undervalued.

What type of risk does a portfolio have with a beta of 1.5?

Cannot determine from the question Recall that beta is a measure of the risk of a portfolio relative to the market. It is derived through regression analysis, and its significance and reliability are measured by R-squared. A portfolio with a beta of 1.5 will certainly have systematic risk but may also have unsystematic risk

Rebalancing a portfolio is performed in response to changes in the economic environment, in the life cycle of the client, or to re-establish the initial asset mix. Which of the following would trigger a rebalancing situation? 1. Changes in liquidity needs. 2. Changes in tax circumstances. 3. Changes in time horizon for goals. A)1 and 2. B)1 and 3. C)2 and 3. D)1, 2 and 3.

D)1, 2 and 3. All would trigger rebalancing.

Mary invests $9,600 of her $12,000 available assets into the Metro Doughnut Company with the remainder in the Safe Bond Fund. The Metro Doughnut Company and the Safe Bond Fund are positively correlated. Changes in the Safe Bond Fund explain 4% of the returns for the Metro Doughnut Company. If the Metro Doughnut Company has a standard deviation of 20% and the Safe Bond Fund has a standard deviation of 5%, what is the standard deviation of the combined portfolio? A)17.29%. B)17.00%. C)16.87%. D)16.23%.

D)16.23%. Both funds in each portfolio have the same risk and similar weightings. The question does not provide the correlation between the two investments. Rather, it provides the r-squared value of 4%, which means that the correlation must be 20%. r2 = correlation coefficient2; therefore, correlation coefficient = the square root of r2. Since the COV is not provided, we must substitute: correlation coefficient x standard deviation of A x standard deviation of B.

Which of the following is not one of the assumptions of the CAPM? A)All investors are rational and have the same expectations about the relationship between risk and return for investment alternatives. B)Investors can borrow and lend at the risk-free rate of return. C)CAPM assumes no taxes or transaction costs. D)All of the above are assumptions of the CAPM.

D)All of the above are assumptions of the CAPM. All of the choices are assumptions of the CAPM.

Adrian Chase, a portfolio manager, generates a return of 14% when the benchmark returns 11.5%. The manager's security selection decisions outperform by 150 basis points. Which is least accurate? A)Asset allocation decisions helped the manager outperform the benchmark. B)The manager outperforms the benchmark by 250 basis points. C)The manager excelled in both asset allocation and security selection decisions. D)Asset allocation decisions outperform by 250 basis points.

D)Asset allocation decisions outperform by 250 basis points. Total outperformance can be divided into asset allocation and security selection decisions. The total outperformance in this case is 250 basis pints. If the manager outperformed in security selection by 150 basis points, the difference had to be made up in the asset allocation decision. Asset allocation had to be 100 basis points.

Ollie wants to increase the expected return on his portfolio above that of the market portfolio. According to the CML, what should he do? A)Invest in riskier assets. B)Add stocks with higher betas. C)Add stocks with higher standard deviations. D)Borrow money at the risk-free rate of return and invest in the market portfolio.

D)Borrow money at the risk-free rate of return and invest in the market portfolio. The CML consists of portfolios that are a combination of the risk-free return and the market portfolio. Lending portfolios have less than 100% invested in the market portfolio. Borrowing portfolios have more than 100% invested in the market portfolio.

Which of the following statements is true about equity returns, as represented by the S&P 500 from 1928 - 2016? A)The historical average returns for the 1-year rolling return and the 20-year rolling return are significantly different (more than a 2% difference). B)While the variation in the range of returns is different, the difference is not significant between the 1-year rolling return and the 20-year rolling return. C)Both a and b are true. D)Both a and b are false.

D)Both a and b are false. Choice a is false as the average returns are similar, 11.42% vs 11.03%. Choice b is false as the range in return is enormous for the 1-year period and much narrower for the 20-year return.

Which of the following statements about the CAPM and APT are correct? A)Both models are multifactor models. B)Both models use beta as the risk measure. C)Both models make use of the "market portfolio." D)Both models are used as asset pricing models.

D)Both models are used as asset pricing models. CAPM is a single factor model while APT is a multi-factor model. APT does not use beta nor the market portfolio. Both models are asset pricing models.

What type of risk does a portfolio have with a beta of 1.5? A)Systematic risk only. B)Unsystematic risk only. C)Systematic and unsystematic risk. D)Cannot determine from the question.

D)Cannot determine from the question. Recall that beta is a measure of the risk of a portfolio relative to the market. It is derived through regression analysis, and its significance and reliability are measured by R-squared. A portfolio with a beta of 1.5 will certainly have systematic risk but may also have unsystematic risk.

Perhaps the biggest behavior mistake made by both individual investors and money managers during the dot combubble was: A)Loss aversion. B)Mental accounting. C)Assuming market efficiency. D)Herd mentality.

D)Herd mentality. Buying high risk investments is the opposite of loss aversion. Although one could argue for some minor mental accounting issues if the investments were part of the high risk portion of a portfolio, most were simply following the crowd. Answer c is not a behavioral finance mistake.

The indifference curve for an investor who is indifferent to risk would be ______. A)Upward sloping. B)Downward sloping. C)Vertical. D)Horizontal.

D)Horizontal. An investor that is indifferent to risk does not demand higher returns for increases in risk. Therefore, the investor's indifference curve will be flat or horizontal.

A characteristic of behavioral finance least likely includes an investor that: A)Takes shortcuts when making allocation decisions. B)Fails to completely process new information. C)Has emotional biases. D)Is risk averse.

D)Is risk averse. Behavioral investors are loss averse, not risk averse. They also take shortcuts, only process information, partially, and have emotional biases and make cognitive errors.

Ollie is considering two portfolios: 1) Portfolio A with a return of 12% and a standard deviation of 20% and 2) Portfolio B with a return of 6% and a standard deviation of 10%. Which of the following statements are correct about portfolio return and risk? A)If the correlation between A and B is 1.0, then the standard deviation of a 50/50 portfolio will be the same as an 80/20 portfolio. B)At a correlation of -1, 100% of the portfolio invested in B will generate the lowest portfolio standard deviation. C)Both a and b are correct. D)Neither a or b is correct.

D)Neither a or b is correct. Choice a is incorrect as the standard deviation will change based on the change in the portfolio weightings. Choice b is incorrect as the lowest standard deviation will occur around a 30A/70B portfolio. With 100%, the standard deviation equals 10%. There are many combinations of A and B that produce lower measures of standard deviation.

Considering the CML, which of the following is correct? A)The point at which the CML is tangent to the efficient frontier consists of a portfolio of 50% risky assets and 50% risk-free asset. B)As a portfolio moves from the point of tangency to the risk-free rate, the percentage of bonds will increase. C)As a portfolio moves beyond the point of tangency (to the right), the allocation to equities increases. D)None of the above is correct.

D)None of the above is correct. Choice a is incorrect as the point of tangency represents the market portfolio, which consists of all risky assets. Choice b is incorrect because the percent of the risk-free asset increases, not bonds. Choice c is incorrect as the percent of stocks does not increase, the portfolio is simply leveraged.

Examples of cognitive errors least likely include all of the following except: A)Anchoring. B)Cognitive dissonance. C)Mental accounting. D)Overconfidence.

D)Overconfidence. Overconfidence is an example of an emotional bias, not a cognitive error.

Examples of cognitive errors would least likely include: A)Reacting slowly to new information regarding an investment. B)Making inaccurate estimates of future profitability. C)Assigning too little weight to new information. D)Performing research on an IPO before committing to it.

D)Performing research on an IPO before committing to it. Traditional investors perform due diligence before making an investment, including an initial public offering. Cognitive errors made by investors include reacting slowly to new information and also include over and under-reacting to new information. Investors who assign too little or too much weight to new information tend to make inaccurate estimates. Investors who take shortcuts also make significant mistakes. Cognitive errors can lead to estimates that have a large degree of error.

A fixed income manager identifies the ten bonds in the portfolio with the longest duration. The manager increased allocation to those bonds because of expectations that yields will fall over the next three months. The results of this decision will most likely be revealed in the: A)Policy effect. B)Trading effect. C)Analysis effect. D)Rate anticipation effect.

D)Rate anticipation effect. The rate anticipation effect will show any tactical decisions made by the portfolio manager by altering duration over the short term. When rates fall, the price of those longer duration bonds will rise dramatically and improve total bond return.

When investors perception of risk increases, then the SML should: A)Remain parallel to the original SML but shift upwards. B)Remain parallel to the original SML but shift downwards. C)Rotate downward (clockwise). D)Rotate upwards (counterclockwise).

D)Rotate upwards (counterclockwise). If the perception of risk increases, then the return for the market portfolio should increase. Since the Rf remains the same, it results in a rotation upward - the slope increases.

An investor owns a well-diversified portfolio that contains the equity securities of large U.S. corporations. The beta of the portfolio is 1.0. The most appropriate benchmark for this portfolio is: A)S&P Small Cap 600. B)Wilshire 5000. C)Dow Jones Industrial Average. D)S&P 500 Index.

D)S&P 500 Index. The S&P 500 Index is comprised of the largest 500 U.S. stocks, so it makes perfect sense to use this index as the benchmark, especially since the beta of the portfolio matches the beta of the index.

Keri has a fairly diversified portfolio and is considering adding another security to it. She would like the additional security to enhance the diversification of the portfolio. Which one should she add? A)Security A has a correlation of 0.95 with her portfolio. B)Security B has a correlation of 0.55 with her portfolio. C)Security C has a correlation of 0.05 with her portfolio. D)Security D has a correlation of -0.25 with her portfolio.

D)Security D has a correlation of -0.25 with her portfolio. Security D has the lowest correlation relative to Keri's portfolio. Based on her objectives that is the best security to add as it will provide further diversification to the portfolio.

Inputs to the Fama Decomposition model least likely include: A)Risk-free rate of interest. B)The client's preferred beta. C)The money manager's market timing skills. D)The annualized rate of inflation.

D)The annualized rate of inflation. Fama does not require the use of the inflation rate. Fama does begin, as do many other models, with the risk-free rate and then adds systematic risk, market timing and security selection skills of the money manager.

The return from the CAPM is which of the following? A)The risk-free return. B)The actual return. C)The risk-premium. D)The expected return.

D)The expected return. CAPM = Rf + B(Rm - Rf) = the expected return based on beta, the market premium and the risk-free rate of return.

Which is least accurate regarding stock market anomalies? A)Low price to book value firms tend to outperform firms with high price to book values. B)Anomalies tend to refute the efficient markets hypothesis. C)Firms that have a relatively low number of analysts following them tend to outperform. D)The lowest dividend yielding Dow firms outperform the Dow Index.

D)The lowest dividend yielding Dow firms outperform the Dow Index. The Dogs of the Dow are those firms that pay the highest dividends among the firms in the index. They tend to have the lowest prices and they outperform the entire index.

A financial analyst computes present value of a firm's operating cash flows to calculate an intrinsic value of the shares. The analyst is most likely using:

Discounted cash flow technique Discounted cash flow analysis includes estimating future cash flows and then discounting them at an appropriate interest rate. The present value is often times referred to as the intrinsic value of the company

Modern portfolio theory was originally advanced by:

Harry Markowitz and the identification of standard deviation as a measure of risk Harry Markowitz wrote his seminal paper on the efficient frontier in 1952. This research is considered to be the origination of modern portfolio theory, which formed the basis of the CAPM, the EMH, and APT that followed by Sharpe, Fama, and Ross. Markowitz was the first to understand the importance of standard deviation in risk management. All of these researchers are considered to be the fathers of modern finance

Perhaps the biggest behavior mistake made by both individual investors and money managers during the dot com bubble was:

Herd mentality Buying high risk investments is the opposite of loss aversion. Although one could argue for some minor mental accounting issues if the investments were part of the high risk portion of a portfolio, most were simply following the crowd.

An investor who purchases a variety of mutual funds that mimic the performance of the S&P 500 Index, the Russell 2000, and the NASDAQ Composite is most likely pursuing a strategy of:

Indexing Indexing is a form of passive investing in which the investor simply purchases an index of returns using mutual funds or exchange traded funds

The behavioral finance aspect that most likely offers a unique and reasonable explanation for the persistence of the equity premium puzzle is:

Myopic loss aversion Investors tend to avoid short-term losses at the expense of other portfolio components. The implication is that investors require very high long-term returns to compensate them for the losses occurring in the short term. Therefore, myopic loss aversion offers a reasonable explanation for the difference between equity returns and government bond yields that cannot be explained by differences in risk

A financial analyst computes the price to sales ratio as a comparison to determine which company is most expensive. The analyst is most likely using:

Relative valuation methodology Relative valuation method uses price multiples to determine the relative value of each individual stock. The price-to-sales ratio is commonly used for firms that do not have a long history of positive earnings

A large firm announces it has hired a design company to change its corporate logo. The new logo will be shown publicly for the first time the following day. Shareholders react by bidding up the shares by 10% over the relevant benchmark. No other information about this firm is released. The shareholder reaction can best be described as:

Representativeness Representativeness is a simple heuristic decision making tool in which investors make quick decisions without regards to probability distributions or searching for the true factors that should influence the decision. When investors bid up the price of a company's shares just because it changes its logo, the shareholders are hoping the new logo increases the firm's profitability. Since no other information is released around this time, the price reaction is likely attributed to representativeness

An investor owns a well-diversified portfolio that contains the equity securities of large U.S. corporations. The beta of the portfolio is 1.0. The most appropriate benchmark for this portfolio is:

S&P 500 Index The S&P 500 Index is comprised of the largest 500 US stocks, so it makes perfect sense to use this index as the benchmark, especially since the beta of the portfolio matches the beta of the index

The ___ is a graphical representation of expected return and risk, as measured by beta.

SML The SML represents the expected return relative to risk as measured by beta

Harold Smith sits on four boards of directors of publicly held companies, each operating in a different industry. Smith has an ethical clause in each of his board contracts but ignores them by trading on information he learns during board meetings. Smith generates an average return on these trades that is well above any relevant benchmark. The market under these conditions is most likely:

Semi-strong form efficient Only in a strong form market do prices reflect all relevant information including insider information. Since Smith is able to generate superior returns, the market can only be semi-strong form efficient