Xiao Exam 2
Firm-specific risk is also referred to as A. systematic risk, diversifiable risk. B. systematic risk, market risk. C. diversifiable risk, market risk. D. diversifiable risk, unique risk. E. nondiversifiable, market risk.
D. diversifiable risk, unique risk.
Non-systematic risk is also referred to as A. market risk, diversifiable risk. B. firm-specific risk, market risk. C. diversifiable risk, market risk. D. diversifiable risk, unique risk. E. nondiversifiable risk, unique risk.
D. diversifiable risk, unique risk.
The risk that cannot be diversified away is A. firm-specific risk. B. unique. C. non-systematic risk. D. market risk. E. unique risk and non-systematic risk.
D. market risk.
You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05. The slope of the capital allocation line formed with the risky asset and the risk-free asset is equal to a. 0.4667 b.0.8000 c. 2.14 d. 0.41667 e. Cannot be determined.
(0.12 − 0.05)/0.15 = 0.4667.
Assume that the risk-free rate of interest is 4% and the expected rate of return on the market is 13%. A share of stock sells for $60 today. It will pay a dividend of $6 per share at the end of the year. Its beta is 1.4. What do investors expect the stock to sell for at the end of the year? What is the expected stock price?
0.04 + [1.4 × (0.13 − 0.04)] = 16.6% E(r) - (D1 + P1 - P0)/P0 = 0.166 = (P1 - $60 + $6)/$60 = $63.96
You manage a risky portfolio with an expected rate of return of 22% and a standard deviation of 34%. The T-bill rate is 6%. Your client's degree of risk aversion is A = 1.7, assuming a utility function U = E(r) − ½Aσ². a. What proportion, y, of the total investment should be invested in your fund? b. What are the expected value and standard deviation of the rate of return on your client's optimized portfolio?
1. =(risky portfolio return-risk free rate)/(A*standard deviation of risky portfolio^2) =(.22-.06)/(1.7*.34*.34) =81.42% Expected return= w1*r1+w2*r2=.8142*.22+(1-.8142)*.06 = 19.03 Standard deviation=.8142*.34=.2768
key assumptions of CAPM
1. all investors are mean variance optimizers 2. investors have a common planning horizon of a single period 3. homogeneous expectations- everyone has the same information and input lists 4. all investors can borrow or lend at the same risk free rate and can take short positions on traded securities 5. no transaction costs 6. no taxes
Which of the following statement(s) is (are) false regarding the selection of a portfolio from those that lie on the Capital Allocation Line? A. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors. B. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors. C. Investors choose the portfolio that maximizes their expected utility. D. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors and more risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors. E. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors and investors choose the portfolio that maximizes their expected utility.
A. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors.
The individual investor's optimal portfolio is designated by: A. The point of tangency with the indifference curve and the capital allocation line. B. The point of highest reward to variability ratio in the opportunity set. C. The point of tangency with the opportunity set and the capital allocation line. D. The point of the highest reward to variability ratio in the indifference curve. E. None of these is correct.
A. The point of tangency with the indifference curve and the capital allocation line. The indifference curve represents what is acceptable to the investor; the capital allocation line represents what is available in the market. The point of tangency represents where the investor can obtain the greatest utility from what is available.
The first major step in asset allocation is: A. assessing risk tolerance. B. analyzing financial statements. C. estimating security betas. D. identifying market anomalies. E. determining how much money a client needs to make.
A. assessing risk tolerance Assessing risk tolerance should be the first consideration in asset allocation. Where to allocate the risky assets should be the second step. ex. Stocks, Corporate Bonds, etc.
The global minimum variance portfolio formed from two risky securities will be riskless when the correlation coefficient between the two securities is A. 0.0 B. 1.0 C. 0.5 D. -1.0 E. negative
D. -1.0
For a two-stock portfolio, what would be the preferred correlation coefficient between the two stocks? A. +1.00. B. +0.50. C. 0.00. D. -1.00. E. -0.65.
D. -1.00.
Other things equal, diversification is most effective when A. securities' returns are uncorrelated. B. securities' returns are positively correlated. C. securities' returns are high. D. securities' returns are negatively correlated. E. both securities' returns are positively correlated and securities' returns are high.
D. securities' returns are negatively correlated. Negative correlation among securities results in the greatest reduction of portfolio risk, which is the goal of diversification.
The central implication of the CAPM is that risk premia will be ______ exposure to systematic risk and ______ firm-specific risk.
Directly proportional to; independent of
What must be the beta of a portfolio with E(rP) = 13.5%, if rf = 3% and E(rM) = 9%? what is the beta of the portfolio?
E(rP) = rf + βP × [E(rM) − rf]0.135 = 0.03 + βP × [0.09 − 0.03] → βP = 0.105/0.06 = 1.75
In a return-standard deviation space, which of the following statements is(are) true for risk-averse investors? (The vertical and horizontal lines are referred to as the expected return-axis and the standard deviation-axis, respectively.) I) An investor's own indifference curves might intersect. II) Indifference curves have negative slopes. III) In a set of indifference curves, the highest offers the greatest utility. IV) Indifference curves of two investors might intersect. I and II only II and III only I and IV only III and IV only None of the options are correct.
III and IV only
Consider a portfolio that offers an expected rate of return of 12% and a standard deviation of 25%. T-bills offer a risk-free 7% rate of return. What is the maximum level of risk aversion for which the risky portfolio is still preferred to T-bills? Q: What is the maximum level of risk aversion for which the risky portfolio is stilll preferred to T-bills?
Utility function = Expected rate - 0.5*Aversion*Standard deviation^2 7% = 12% - 0.5*Aversion*25%^2 Aversion = (12% - 7%) / (0.5*0.0625) = 5% / 0.0313 = 1.60
According to the mean-variance criterion, which one of the following investments dominates all others? a. E(r) = 0.15; Variance = 0.20 b. E(r) = 0.10; Variance = 0.20 c. E(r) = 0.10; Variance = 0.25 d. E(r) = 0.15; Variance = 0.25 e. None of these options dominates the other alternatives.
a. E(r) = 0.15; Variance = 0.2
According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false? a. The expected rate of return on a security increases in direct proportion to a decrease in the risk-free rate. b. The expected rate of return on a security increases as its beta increases. c. A fairly priced security has an alpha of zero. d. In equilibrium, all securities lie on the security market line.
a. The expected rate of return on a security increases in direct proportion to a decrease in the risk-free rate.
You manage a risky portfolio with an expected rate of return of 19% and a standard deviation of 31%. The T-bill rate is 5%. Suppose that your client prefers to invest in your fund a proportion y that maximizes the expected return on the complete portfolio subject to the constraint that the complete portfolio's standard deviation will not exceed 19%. a. What is the investment proportion, y? b. What is the expected rate of return on the complete portfolio?
a. σC = y × 31%If your client prefers a standard deviation of at most 19%, then: y = 19/31 = 0.6129 = 61.29% invested in the risky portfolio. b. E(rc) = (1 − y) × T-bill rate + (y) × Risky rate 13.58% = (1 − 0.6129) × 0.05 + 0.6129 × 0.19
Standard deviation and beta both measure risk, but they are different in that beta measures a. both systematic and unsystematic risk. b. only systematic risk, while standard deviation is a measure of total risk. c. only unsystematic risk, while standard deviation is a measure of total risk. d. both systematic and unsystematic risk, while standard deviation measures only systematic risk. e. total risk, while standard deviation measures only nonsystematic risk.
b. only systematic risk, while standard deviation is a measure of total risk. Standard deviation and beta both measure risk, but they are different in that beta measures only systematic risk while standard deviation is a measure of total risk.
According to the Capital Asset Pricing Model (CAPM), fairly-priced securities have a. positive betas. b. zero alphas. c. negative betas. d. positive alphas.
b. zero alphas. A zero alpha results when the security is in equilibrium (fairly priced for the level of risk).
You manage a risky portfolio with an expected rate of return of 17% and a standard deviation of 38%. The T-bill rate is 6%. Your client chooses to invest 85% of a portfolio in your fund and 15% in an essentially risk-free money market fund. What are the expected return and standard deviation of the rate of return on his portfolio?
expected return = 0.85*17% + 0.15*6% = 15.3% standard deviation = 0.85*38% = 32.3%
The CAPM is based on two sets of assumptions: first, that _____ are mean-variance optimizers with a common time horizon and information and second, that _____ are well-functioning with few impediments to trading.
investors markets
mutual fund theory
investors will choose to invest their entire risky portfolio in a market index mutual fund
The optimal risky portfolio in the CAPM is the _____ portfolio
market
Because the CAPM holds that in equilibrium the market portfolio is the unique mean-variance efficient tangency portfolio, a(n) _____ strategy is efficient.
passive
The utility score an investor assigns to a particular portfolio, other things equal, a. will decrease as the rate of return increases. b. will decrease as the standard deviation decreases. c. will decrease as the variance decreases. d. will increase as the variance increases. e. will increase as the rate of return increases.
will increase as the rate of return increases.
You manage a risky portfolio with an expected rate of return of 17% and a standard deviation of 38%. The T-bill rate is 6%.Suppose that your client prefers to invest in your fund a proportion y that maximizes the expected return on the complete portfolio subject to the constraint that the complete portfolio's standard deviation will not exceed 17%. Q: What is the investment proportion of, y? Q: What is the expected rate of return on the complete portfolio?
y x 38 = 17 y = 0.45 or 45% This implies that 1- y is invested in the T bills so 1-y = 55% Portfolio return = y x return of risky asset + (1-y) x return on Tbill Portfolio return = 0.45 x 17+ (1-0.45) x 6 Portfolio return = y x return of risky asset + (1-y) x return on Tbill Portfolio return = 0.45 x 17+ (1-0.45) x 6 Portfolio return = 10.95%
A statistic(s) that measures how the returns of two risky assets move together is: A. variance. B. standard deviation. C. covariance. D. correlation. E. both covariance and correlation.
E. both covariance and correlation.
The risk that can be diversified away is A. firm-specific risk. B. beta. C. systematic risk. D. market risk. E. non-systematic risk.
A. firm-specific risk.
The expected return of a portfolio of risky securities A. is a weighted average of the securities' returns. B. is the sum of the securities' returns. C. is the weighted sum of the securities' variances and covariances. D. is both a weighted average of the securities' returns and a weighted sum of the securities' variances and covariances. E. is the weighted sum of the securities' covariances.
A. is a weighted average of the securities' returns.
Systematic risk is also referred to as A. market risk, nondiversifiable risk. B. market risk, diversifiable risk. C. unique risk, nondiversifiable risk. D. unique risk, diversifiable risk. E. firm-specific risk.
A. market risk, nondiversifiable risk.
A reward-to-volatility ratio is useful in: A. measuring the standard deviation of returns. B. understanding how returns increase relative to risk increases. C. analyzing returns on variable rate bonds. D. assessing the effects of inflation. E. None of these is correct.
B. understanding how returns increase relative to risk increases.
The Capital Allocation Line provided by a risk-free security and N risky securities is A. the line that connects the risk-free rate and the global minimum-variance portfolio of the risky securities. B. the line that connects the risk-free rate and the portfolio of the risky securities that has the highest expected return on the efficient frontier. C. the line tangent to the efficient frontier of risky securities drawn from the risk-free rate. D. the horizontal line drawn from the risk-free rate. E. the line that connects the risk-free rate and the global maximum-variance portfolio of the risky securities.
C. the line tangent to the efficient frontier of risky securities drawn from the risk-free rate.
The standard deviation of a portfolio of risky securities is A. the square root of the weighted sum of the securities' variances. B. the square root of the sum of the securities' variances. C. the square root of the weighted sum of the securities' variances and covariances. D. the square root of the sum of the securities' covariances. E. is the weighted sum of the securities' covariances.
C. the square root of the weighted sum of the securities' variances and covariances.
Diversifiable risk is also referred to as A. systematic risk, unique risk. B. systematic risk, market risk. C. unique risk, market risk. D. unique risk, firm-specific risk. E. systematic risk, firm-specific risk.
D. unique risk, firm-specific risk.
Consider the following information about a risky portfolio that you manage and a risk-free asset: E(rP) = 13%, σP = 17%, rf = 5%. a. Your client wants to invest a proportion of her total investment budget in your risky fund to provide an expected rate of return on her overall or complete portfolio equal to 7%. What proportion should she invest in the risky portfolio, P, and what proportion in the risk-free asset? b. What will be the standard deviation of the rate of return on her portfolio? c. Another client wants the highest return possible subject to the constraint that you limit his standard deviation to be no more than 12%. Which client is more risk averse? First client Second client
a. E(rC) = 7% = 5% + y × (13% - 5%) ⇒ a. y= (0.07-0.05)/(0.13-0.05) - 25% a. Risk-free asset ⇒ 1 - 0.2500 = 0.7500 or 75.00% b. σC = y × σP = 0.2500 × 17% = 4.25% c. The first client is more risk averse, preferring investments that have less risk as evidenced by the lower standard deviation.
The risk-free rate is 7%. The expected market rate of return is 15%. If you expect a stock with a beta of 1.3 to offer a rate of return of 12%, you should a. buy the stock because it is overpriced. b. sell short the stock because it is overpriced. c. sell the stock short because it is underpriced. d. buy the stock because it is underpriced. e. None of the options, as the stock is fairly priced.
b. 12% < 7% + 1.3(15% − 7%) = 17.40%; therefore, stock is overpriced and should be shorted.
You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05. A portfolio that has an expected outcome of $115 is formed by a. investing $100 in the risky asset. b. investing $80 in the risky asset and $20 in the risk-free asset. c. borrowing $43 at the risk-free rate and investing the total amount ($143) in the risky asset. d. investing $43 in the risky asset and $57 in the riskless asset. e. Such a portfolio cannot be formed.
c. borrowing $43 at the risk-free rate and investing the total amount ($143) in the risky asset. For $100: (115 − 100)/100 = 15%; 0.15 = w1(0.12) + (1 - w1)(0.05); 0.15 = 0.12w1 + 0.05 − 0.05w1; 0.10 = 0.07w1; w1 = 1.43($100) = $143; (1 − w1)$100 = −$43.
According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio increases a. directly with alpha. b. inversely with alpha. c. directly with beta. d. inversely with beta. e. in proportion to its standard deviation.
c. directly with beta. The market rewards systematic risk, which is measured by beta, and thus, the risk premium on a stock or portfolio varies directly with beta.
The CAPM applies to a. portfolios of securities only. b. individual securities only. c. efficient portfolios of securities only. d. efficient portfolios and efficient individual securities only. e. all portfolios and individual securities.
e. all portfolios and individual securities. The CAPM is an equilibrium model for all assets. Each asset's risk premium is a function of its beta coefficient and the risk premium on the market portfolio.
Which of the following is not a source of systematic risk? A. The business cycle. B. Interest rates. C. Personnel changes. D. The inflation rate. E. Exchange rates.
C. Personnel changes.
The variance of a portfolio of risky securities A. is a weighted sum of the securities' variances. B. is the sum of the securities' variances. C. is the weighted sum of the securities' variances and covariances. D. is the sum of the securities' covariances. E. is the weighted sum of the securities' covariances.
C. is the weighted sum of the securities' variances and covariances.
In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is A) unique risk. B) beta. C) standard deviation of returns. D) variance of returns. E) none of the above.
B) beta.
Steve is more risk-averse than Edie. On a graph that shows Steve and Edie's indifference curves, which of the following is true? Assume that the graph shows expected return on the vertical axis and standard deviation on the horizontal axis. I) Steve and Edie's indifference curves might intersect. II) Steve's indifference curves will have flatter slopes than Edie's. III) Steve's indifference curves will have steeper slopes than Edie's. IV) Steve and Edie's indifference curves will not intersect. V) Steve's indifference curves will be downward sloping and Edie's will be upward sloping. A. I and V B. I and III C. III and IV D. I and II E. II and IV
B. I and III
According to the mean-variance criterion, which of the statements below is correct? Investment E(r) St. Dev A 10% 5% B 21% 11% C 18% 23% D 24% 16% A. Investment B dominates Investment A. B. Investment B dominates Investment C. C. Investment D dominates all of the other investments. D. Investment D dominates only Investment B. E. Investment C dominates investment A.
B. Investment B dominates Investment C. Investment B dominates investment C because investment B has a higher return and a lower standard deviation (risk) than investment C.
Consider the following table, which gives a security analyst's expected return on two stocks in two particular scenarios for the rate of return on the market: (see picture) a. What are the betas of the two stocks? The beta of Aggressive Stock: The beta of Defensive Stock: b. What is the expected rate of return on each stock if the two scenarios for the market return are equally likely to be 5% or 24%? The ERR for Aggressive Stock The ERR for Defensive Stock c. What hurdle rate should be used by the management of the aggressive firm for a project with the risk characteristics of the defensive firm's stock if the two scenarios for the market return are equally likely? Also, assume a T-Bill rate of 4%. Hurdle Rate _____?
Beta of Aggressive Stock: βA = (-0.03 - 0.36)/(0.05-0.24) = 2.05 Beta of Defense Stock: βD= (0.04-0.09)/(0.05-0.24) = 0.26 ------------------------------------------- The ERR for Aggressive Stock: E(rA) = 0.5 × (−0.03 + 0.36) = 0.165 = 16.5% The ERR for Defensive Stock: E(rD) = 0.5 × (0.04 + 0.09) = 0.065 = 6.5% --------------------------------------------- The required return for the defensive stock is: E(rD) = 0.04 + 0.26 × (0.145 − 0.04) = 6.73%
Which of the following statements is (are) true? I) Risk-averse investors reject investments that are fair games. II) Risk-neutral investors judge risky investments only by the expected returns. III) Risk-averse investors judge investments only by their riskiness. IV) Risk-loving investors will not engage in fair games. A. I only B. II only C. I and II only D. II and III only E. II, III, and IV only
C. I and II only
In the mean-standard deviation graph, which one of the following statements is true regarding the indifference curve of a risk-averse investor? A. It is the locus of portfolios that have the same expected rates of return and different standard deviations. B. It is the locus of portfolios that have the same standard deviations and different rates of return. C. It is the locus of portfolios that offer the same utility according to returns and standard deviations. D. It connects portfolios that offer increasing utilities according to returns and standard deviations. E. It is irrelevant to making a decision of what portfolio would best suit the investor.
C. It is the locus of portfolios that offer the same utility according to returns and standard deviations.
Which of the following statements regarding risk-averse investors is true? a. They only care about the rate of return. b. They accept investments that are fair games. c. They only accept risky investments that offer risk premiums over the risk-free rate. d. They are willing to accept lower returns and high risk. e. They only care about the rate of return, and they accept investments that are fair games.
c. They only accept risky investments that offer risk premiums over the risk-free rate. Risk-averse investors only accept risky investments that offer risk premiums over the risk-free rate.
Two investment advisers are comparing performance. One averaged a 20% rate of return and the other a 19% rate of return. However, the beta of the first investor was 1.1, whereas that of the second investor was 1. a. Can you tell which investor was a better selector of individual stocks (aside from the issue of general movements in the market)? Second Investor First Investor Cannot Determine b. If the T-bill rate was 5% and the market return during the period was 10%, which investor would be considered the superior stock selector? Second investor First investor Cannot determine c. What if the T-bill rate was 2% and the market return was 18%? Second investor First investor Cannot determine
r1 = 20%; r2 = 19%; β1 = 1.1; β2 = 1 a. Cannot Determine To determine which investor was a better selector of individual stocks we look at abnormal return, which is the ex-post alpha; that is, the abnormal return is the difference between the actual return and that predicted by the SML. Without information about the parameters of this equation (risk-free rate and market rate of return) we cannot determine which investor was more accurate. b. First Investor If rf = 5% and rM = 10%, then (using the notation alpha for the abnormal return): α1 = 0.20 − [0.05 + 1.1 × (0.10 − 0.05)] = 0.20 − 0.105 = 10% α2 = 0.19 − [0.05 + 1 × (0.10 − 0.05)] = 0.19 − 0.10 = 9% Here, the first investor has the larger abnormal return and thus appears to be the superior stock selector. By making better predictions, the first investor appears to have tilted his portfolio toward underpriced stocks. c. Second Investor If rf = 2% and rM = 18%, then: α1 = 0.20 − [0.02 + 1.1 × (0.18 − 0.02)] = 0.20 − 0.196 = 0.4% α2 = 0.19 − [0.02 + 1 × (0.18 − 0.02)] = 0.19 − 0.18 = 1% Here, not only does the second investor appear to be the superior stock selector, but the first investor's predictions appear valueless (or worse).
You manage a risky portfolio with an expected rate of return of 20% and a standard deviation of 36%. The T-bill rate is 5%. Your client's degree of risk aversion is A = 1.6, assuming a utility function U = E(r) − ½Aσ². a. What proportion, y, of the total investment should be invested in your fund? b. What are the expected value and standard deviation of the rate of return on your client's optimized portfolio?
y*= (0.20 - 0.5)/(1.6 * 0.36^2) = 0.15/0.2074 = 72.34% E(rC)=0.05 + 0.15 × y* = 0.05 + (0.7234 × 0.15) = 0.1585 = 15.85% σC=0.7234 × 36% = 26.04%
According to the Capital Asset Pricing Model (CAPM), a security with a a. positive alpha is considered overpriced. b. zero alpha is considered to be a good buy. c. negative alpha is considered to be a good buy. d. positive alpha is considered to be underpriced.
d. A security with a positive alpha is one that is expected to yield an abnormal positive rate of return, based on the perceived risk of the security, and thus is underpriced.
A security has an expected rate of return of 0.12 and a beta of 1.1. The market expected rate of return is 0.09, and the risk-free rate is 0.04. The alpha of the stock is a. 9.7% b. 7.7% c. 5.3% d. 2.5%
d. 2.5% 12% − [4% +1.1(9% − 4%)] = 2.50%.
Given the capital allocation line, an investor's optimal portfolio is the portfolio that a. maximizes her expected profit. b. maximizes her risk. c. minimizes both her risk and return. d. maximizes her expected utility. e. None of the options are correct.
d. maximizes her expected utility. By maximizing expected utility, the investor is obtaining the best risk-return relationships possible and acceptable for her.
The efficient frontier of risky assets is A. the portion of the investment opportunity set that lies above the global minimum variance portfolio. B. the portion of the investment opportunity set that represents the highest standard deviations. C. the portion of the investment opportunity set which includes the portfolios with the lowest standard deviation. D. the set of portfolios that have zero standard deviation. E. both the portion of the investment opportunity set that lies above the global minimum variance portfolio and the portion of the investment opportunity set that represents the highest standard deviations.
A. the portion of the investment opportunity set that lies above the global minimum variance portfolio.
The certainty equivalent rate of a portfolio is A. the rate that a risk-free investment would need to offer with certainty to be considered equally attractive as the risky portfolio. B. the rate that the investor must earn for certain to give up the use of his money. C. the minimum rate guaranteed by institutions such as banks. D. the rate that equates "A" in the utility function with the average risk aversion coefficient for all risk-averse investors. E. represented by the scaling factor "-.005" in the utility function.
A. the rate that a risk-free investment would need to offer with certainty to be considered equally attractive as the risky portfolio.
An investor who wishes to form a portfolio that lies to the right of the optimal risky portfolio on the Capital Allocation Line must: A. lend some of her money at the risk-free rate and invest the remainder in the optimal risky portfolio. B. borrow some money at the risk-free rate and invest in the optimal risky portfolio. C. invest only in risky securities. D. such a portfolio cannot be formed. E. both borrow some money at the risk-free rate and invest in the optimal risky portfolio and invest only in risky securities
B. borrow some money at the risk-free rate and invest in the optimal risky portfolio. This is the kink
The change from a straight to a kinked capital allocation line is a result of: A. reward-to-volatility ratio increasing. B. borrowing rate exceeding lending rate. C. an investor's risk tolerance decreasing. D. increase in the portfolio proportion of the risk-free asset. E. a flawed theory.
B. borrowing rate exceeding lending rate. The CAL is the straight line and the kink after that is when they borrow. Try to remember the graph he showed from class lol.
Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum variance portfolio has a standard deviation that is always A. greater than zero. B. equal to zero. C. equal to the sum of the securities' standard deviations. D. equal to -1. E. between zero and -1.
B. equal to zero.
Efficient portfolios of N risky securities are portfolios that A. are formed with the securities that have the highest rates of return regardless of their standard deviations. B. have the highest rates of return for a given level of risk. C. are selected from those securities with the lowest standard deviations regardless of their returns. D. have the highest risk and rates of return and the highest standard deviations. E. have the lowest standard deviations and the lowest rates of return.
B. have the highest rates of return for a given level of risk. Portfolios that are efficient are those that provide the highest expected return for a given level of risk.
The variable (A) in the utility function represents the: A. investor's return requirement. B. investor's aversion to risk. C. certainty-equivalent rate of the portfolio. D. minimum required utility of the portfolio. E. the security's variance.
B. investor's aversion to risk. A is an arbitrary scale factor used to measure investor risk tolerance. The higher the value of A, the more risk averse the investor.
The presence of risk means that A. investors will lose money. B. more than one outcome is possible. C. the standard deviation of the payoff is larger than its expected value. D. final wealth will be greater than initial wealth. E. terminal wealth will be less than initial wealth.
B. more than one outcome is possible. Either a loss or a gain.
The unsystematic risk of a specific security A. is likely to be higher in an increasing market. B. results from factors unique to the firm. C. depends on market volatility. D. cannot be diversified away. E. is likely to be lower in a decreasing market.
B. results from factors unique to the firm. Unsystematic (or diversifiable or firm-specific) risk refers to factors unique to the firm. Such risk may be diversified away; however, market risk will remain.
The measure of risk in a Markowitz efficient frontier is: A. specific risk. B. standard deviation of returns. C. reinvestment risk. D. beta. E. unique risk.
B. standard deviation of returns.
Nondiversifiable risk is also referred to as A. systematic risk, unique risk. B. systematic risk, market risk. C. unique risk, market risk. D. unique risk, firm-specific risk. E. systematic risk, firm-specific risk.
B. systematic risk, market risk.
Market risk is also referred to as A. systematic risk, diversifiable risk. B. systematic risk, nondiversifiable risk. C. unique risk, nondiversifiable risk. D. unique risk, diversifiable risk. E. firm-specific risk.
B. systematic risk, nondiversifiable risk. Market, systematic, and nondiversifiable risk are synonyms referring to the risk that cannot be eliminated from the portfolio. Diversifiable, unique, nonsystematic, and firm-specific risks are synonyms referring to the risk that can be eliminated from the portfolio by diversification.
In the mean-standard deviation graph, the line that connects the risk-free rate and the optimal risky portfolio, P, is called ______________. A. the Security Market Line B. the Capital Allocation Line C. the Indifference Curve D. the investor's utility line E. skewness
B. the Capital Allocation Line This is the straight line. The Capital Allocation Line (CAL) illustrates the possible combinations of a risk-free asset and a risky asset available to the investor.
Portfolio theory as described by Markowitz is most concerned with: A. the elimination of systematic risk. B. the effect of diversification on portfolio risk. C. the identification of unsystematic risk. D. active portfolio management to enhance returns. E. the elimination of unsystematic risk.
B. the effect of diversification on portfolio risk.
When two risky securities that are positively correlated but not perfectly correlated are held in a portfolio, A. the portfolio standard deviation will be greater than the weighted average of the individual security standard deviations. B. the portfolio standard deviation will be less than the weighted average of the individual security standard deviations. C. the portfolio standard deviation will be equal to the weighted average of the individual security standard deviations. D. the portfolio standard deviation will always be equal to the securities' covariance. E. both the portfolio standard deviation will be greater than the weighted average of the individual security standard deviations and it will always be equal to the securities' covariance
B. the portfolio standard deviation will be less than the weighted average of the individual security standard deviations. Whenever two securities are less than perfectly positively correlated, the standard deviation of the portfolio of the two assets will be less than the weighted average of the two securities' standard deviations. There is some benefit to diversification in this case.
In a two-security minimum variance portfolio where the correlation between securities is greater than -1.0 A. the security with the higher standard deviation will be weighted more heavily. B. the security with the higher standard deviation will be weighted less heavily. C. the two securities will be equally weighted. D. the risk will be zero. E. the return will be zero.
B. the security with the higher standard deviation will be weighted less heavily.
Which of the following statements is (are) true regarding the variance of a portfolio of two risky securities? A. The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance. B. There is a linear relationship between the securities' coefficient of correlation and the portfolio variance. C. The degree to which the portfolio variance is reduced depends on the degree of correlation between securities. D. The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance and there is a linear relationship between the securities' coefficient of correlation and the portfolio variance. E. The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance and the degree to which the portfolio variance is reduced depends on the degree of correlation between securities.
C. The degree to which the portfolio variance is reduced depends on the degree of correlation between securities. The lower the correlation between the returns of the securities, the more portfolio risk is reduced.
Which of the following statements regarding risk-averse investors is true? A. They only care about the rate of return. B. They accept investments that are fair games. C. They only accept risky investments that offer risk premiums over the risk-free rate. D. They are willing to accept lower returns and high risk. E. They only care about the rate of return and accept investments that are fair games.
C. They only accept risky investments that offer risk premiums over the risk-free rate.
In the mean-standard deviation graph an indifference curve has a ________ slope. A. negative B. zero C. positive D. northeast E. cannot be determined
C. positive Indifference Curve has positive slope in mean-standard deviation graph.
In a return-standard deviation space, which of the following statements is (are) true for risk-averse investors? (The vertical and horizontal lines are referred to as the expected return-axis and the standard deviation-axis, respectively.) I) An investor's own indifference curves might intersect. II) Indifference curves have negative slopes. III) In a set of indifference curves, the highest offers the greatest utility. IV) Indifference curves of two investors might intersect. A. I and II only B. II and III only C. I and IV only D. III and IV only E. II and IV only
D. III and IV only Indifference Curve has positive slope for mean-standard deviation graph. An investor's own indifference curve can never intersect but can intersect between another investor's indifference curve.
Which of the following statements regarding the Capital Allocation Line (CAL) is false? A. The CAL shows risk-return combinations. B. The slope of the CAL equals the increase in the expected return of the complete portfolio per unit of additional standard deviation. C. The slope of the CAL is also called the reward-to-volatility ratio. D. The CAL is also called the efficient frontier of risky assets in the absence of a risk-free asset. E. The CAL shows risk-return combinations and is also called the efficient frontier of risky assets in the absence of a risk-free asset.
D. The CAL is also called the efficient frontier of risky assets in the absence of a risk-free asset.
Which of the following statements is (are) false regarding the variance of a portfolio of two risky securities? A. The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance. B. There is a linear relationship between the securities' coefficient of correlation and the portfolio variance. C. The degree to which the portfolio variance is reduced depends on the degree of correlation between securities. D. The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance and there is a linear relationship between the securities' coefficient of correlation and the portfolio variance. E. The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance and the degree to which the portfolio variance is reduced depends on the degree of correlation between securities.
D. The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance and there is a linear relationship between the securities' coefficient of correlation and the portfolio variance.
When an investment advisor attempts to determine an investor's risk tolerance, which factor would they be least likely to assess? A. The investor's prior investing experience B. The investor's degree of financial security C. The investor's tendency to make risky or conservative choices D. The level of return the investor prefers E. The investor's feelings about loss
D. The level of return the investor prefers
Which statement about portfolio diversification is correct? A. Proper diversification can eliminate systematic risk. B. The risk-reducing benefits of diversification do not occur meaningfully until at least 50-60 individual securities have been purchased. C. Because diversification reduces a portfolio's total risk, it necessarily reduces the portfolio's expected return. D. Typically, as more securities are added to a portfolio, total risk would be expected to decrease at a decreasing rate. E. Proper diversification can eliminate systematic risk and increases return.
D. Typically, as more securities are added to a portfolio, total risk would be expected to decrease at a decreasing rate.
Treasury bills are commonly viewed as risk-free assets because A. their short-term nature makes their values insensitive to interest rate fluctuations. B. the inflation uncertainty over their time to maturity is negligible. C. their term to maturity is identical to most investors' desired holding periods. D. both their short-term nature makes their values insensitive to interest rate fluctuations and the inflation uncertainty over their time to maturity is negligible. E. both the inflation uncertainty over their time to maturity is negligible and their term to maturity is identical to most investors' desired holding periods.
D. both their short-term nature makes their values insensitive to interest rate fluctuations and the inflation uncertainty over their time to maturity is negligible.
The exact indifference curves of different investors A. cannot be known with perfect certainty. B. can be calculated precisely with the use of advanced calculus. C. allow the advisor to create more suitable portfolios for the client. D. cannot be known with perfect certainty but they do allow the advisor to create more suitable portfolios for the client. E. None of these is correct.
D. cannot be known with perfect certainty but they do allow the advisor to create more suitable portfolios for the client.
To build an indifference curve we can first find the utility of a portfolio with 100% in the risk-free asset, then A. find the utility of a portfolio with 0% in the risk-free asset. B. change the expected return of the portfolio and equate the utility to the standard deviation. C. find another utility level with 0% risk. D. change the standard deviation of the portfolio and find the expected return the investor would require to maintain the same utility level. E. change the risk-free rate and find the utility level that results in the same standard deviation.
D. change the standard deviation of the portfolio and find the expected return the investor would require to maintain the same utility level.
Unique risk is also referred to as A. systematic risk, diversifiable risk. B. systematic risk, market risk. C. diversifiable risk, market risk. D. diversifiable risk, firm-specific risk. E. market risk.
D. diversifiable risk, firm-specific risk.
Elias is a risk-averse investor. David is a less risk-averse investor than Elias. Therefore, A. for the same risk, David requires a higher rate of return than Elias. B. for the same return, Elias tolerates higher risk than David. C. for the same risk, Elias requires a lower rate of return than David. D. for the same return, David tolerates higher risk than Elias. E. cannot be determined.
D. for the same return, David tolerates higher risk than Elias. The more risk averse the investor, the less risk that is tolerated for a given rate of return.
Based on their relative degrees of risk tolerance A. investors will hold varying amounts of the risky asset in their portfolios. B. all investors will have the same portfolio asset allocations. C. investors will hold varying amounts of the risk-free asset in their portfolios. D. investors will hold varying amounts of the risky asset and the risk-free asset in their portfolios. E. investors would perform vastly different levels of security analysis.
D. investors will hold varying amounts of the risky asset and the risk-free asset in their portfolios. By determining levels of risk tolerance, investors can select the optimum portfolio for their own needs; these asset allocations will vary between amounts of risk-free and risky assets based on risk tolerance.
Asset allocation A. may involve the decision as to the allocation between a risk-free asset and a risky asset only. B. may involve the decision as to the allocation among different risky assets only. C. may involve considerable security analysis. D. may involve the decision as to the allocation between a risk-free asset and a risky asset and may involve the decision as to the allocation among different risky assets. E. may involve the decision as to the allocation between a risk-free asset and a risky asset and may involve considerable security analysis.
D. may involve the decision as to the allocation between a risk-free asset and a risky asset and may involve the decision as to the allocation among different risky assets.
The riskiness of individual assets A. should be considered for the asset in isolation. B. should be considered in the context of the effect on overall portfolio volatility. C. should be combined with the riskiness of other individual assets in the proportions these assets constitute the entire portfolio. D. should be considered in the context of the effect on overall portfolio volatility and should be combined with the riskiness of other individual assets in the proportions these assets constitute the entire portfolio. E. is irrelevant to the portfolio decision.
D. should be considered in the context of the effect on overall portfolio volatility and should be combined with the riskiness of other individual assets in the proportions these assets constitute the entire portfolio. The relevant risk is portfolio risk; thus, the riskiness of an individual security should be considered in the context of the portfolio as a whole.
A fair game A. will not be undertaken by a risk-averse investor. B. is a risky investment with a zero risk premium. C. is a riskless investment. D. will not be undertaken by a risk-averse investor and is a risky investment with a zero risk premium. E. will not be undertaken by a risk-averse investor and is a riskless investment.
D. will not be undertaken by a risk-averse investor and is a risky investment with a zero risk premium. A fair game is a risky investment with a payoff exactly equal to its expected value. Since it offers no risk premium, it will not be acceptable to a risk-averse investor.
The Capital Market Line I) is a special case of the Capital Allocation Line. II) represents the opportunity set of a passive investment strategy. III) has the one-month T-Bill rate as its intercept. IV) uses a broad index of common stocks as its risky portfolio. A. I, III, and IV B. II, III, and IV C. III and IV D. I, II, and III E. I, II, III, and IV
E. I, II, III, and IV
Which of the following statements is (are) false? I) Risk-averse investors reject investments that are fair games. II) Risk-neutral investors judge risky investments only by the expected returns. III) Risk-averse investors judge investments only by their riskiness. IV) Risk-loving investors will not engage in fair games. A. I only B. II only C. I and II only D. II and III only E. III, and IV only
E. III, and IV only
Which of the following statement(s) is (are) true regarding the selection of a portfolio from those that lie on the Capital Allocation Line? A. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors. B. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors. C. Investors choose the portfolio that maximizes their expected utility. D. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors and investors will choose the portfolio that maximizes their expected utility. E. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors and investors will choose the portfolio that maximizes their expected utility.
E. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors and investors will choose the portfolio that maximizes their expected utility.
The utility score an investor assigns to a particular portfolio, other things equal, A. will decrease as the rate of return increases. B. will decrease as the standard deviation decreases. C. will decrease as the variance decreases. D. will increase as the variance increases. E. will increase as the rate of return increases.
E. will increase as the rate of return increases. Utility is enhanced by higher expected returns and diminished by higher risk.
Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 14%. According to the capital asset pricing model: a. What is the expected rate of return on the market portfolio? b. What would be the expected rate of return on a stock with β = 0? c. Suppose you consider buying a share of stock at $52. The stock is expected to pay $3.5 dividends next year and you expect it to sell then for $55. The stock risk has been evaluated at β = −.5. Is the stock overpriced or underpriced?
a. Since the market portfolio, by definition, has a beta of 1, its expected rate of return is 14.00%. ------------------------------------------ b. β = 0 means no systematic risk. Hence, the stock's expected rate of return in market equilibrium is the risk-free rate, 5.00% ------------------------------------------- c. Using the SML, the fair expected rate of return for a stock with β = −0.5 is: E(r) = 0.05 + [(−0.5) × (0.14 − 0.05)] = 0.5% The actually expected rate of return, using the expected price and dividend for next year is: E(r) = (($55 + 3.5)/$52 -1 = 12.5% Asset underpriced
Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $65,000 or $315,000 with equal probabilities of 0.5. The alternative risk-free investment in T-bills pays 5% per year. a. If you require a risk premium of 6%, how much will you be willing to pay for the portfolio? Price: b. Suppose that the portfolio can be purchased for the amount you found in (a). What will be the expected rate of return on the portfolio? Rate of Return: c. Now suppose that you require a risk premium of 12%. What price are you willing to pay? Price:
a. The expected cash flow is: (0.5 × $65,000) + (0.5 × 315,000) = $190,000.With a risk premium of 6% over the risk-free rate of 5%, the required rate of return is 11%. Therefore, the present value of the portfolio is:$190,000/1.11 = $171,171 b. If the portfolio is purchased for $171,171 and provides an expected cash inflow of $190,000, then the expected rate of return [E(r)] is as follows:$171,171 × [1 + E(r)] = $190,000Therefore, E(r) = 11%. The portfolio price is set to equate the expected rate of return with the required rate of return. c. If the risk premium over T-bills is now 12%, then the required return is:5% + 12% = 17%The present value of the portfolio is now:$190,000/1.17 = $162,393
In equilibrium, the marginal price of risk for a risky security must be a. equal to the marginal price of risk for the market portfolio. b. greater than the marginal price of risk for the market portfolio. c. less than the marginal price of risk for the market portfolio. d. adjusted by its degree of nonsystematic risk. e. None of the options are true.
a. equal to the marginal price of risk for the market portfolio. In equilibrium, the marginal price of risk for a risky security must be equal to the marginal price of risk for the market. If not, investors will buy or sell the security until they are equal.
The capital allocation line can be described as the a. investment opportunity set formed with a risky asset and a risk-free asset. b. investment opportunity set formed with two risky assets. c. line on which lie all portfolios that offer the same utility to a particular investor. d. line on which lie all portfolios with the same expected rate of return and different standard deviations.
a. investment opportunity set formed with a risky asset and a risk-free asset. The CAL has an intercept equal to the risk-free rate. It is a straight line through the point representing the risk-free asset and the risky portfolio, in expected-return/standard deviation space.
onsider a portfolio that offers an expected rate of return of 11% and a standard deviation of 21%. T-bills offer a risk-free 6% rate of return. What is the maximum level of risk aversion for which the risky portfolio is still preferred to T-bills?
a. less than 2.27 When we specify utility by U = E(r) − 0.5Aσ2, the utility level for T-bills is: 0.06 The utility level for the risky portfolio is: U = 0.11 − 0.5 × A × (0.21)2 = 0.11 − 0.0221 × A In order for the risky portfolio to be preferred to bills, the following must hold :0.11 − 0.0221A > 0.06 ⇒⇒ A < 0.05/0.0221 = 2.27 A must be less than 2.27 for the risky portfolio to be preferred to bills.
The change from a straight to a kinked capital allocation line is a result of a. reward-to-volatility ratio increasing. b. borrowing rate exceeding lending rate. c. an investor's risk tolerance decreasing. d. increase in the portfolio proportion of the risk-free asset
b. borrowing rate exceeding lending rate.