Conceptual questions from Chapter 11

Which of the following statements is FALSE? A) The risk premium of a security is equal to the market risk premium divided by the amount of market risk present in the security's returns measured by its beta with the market. B) The beta of a portfolio is the weighted average beta of the securities in the portfolio. C) There is a linear relationship between a stock's beta and its expected return. D) A security with a negative beta has a negative correlation with the market, which means that this security tends to perform well when the rest of the market is doing poorly

A) The risk premium of a security is equal to the market risk premium divided by the amount of market risk present in the security's returns measured by its beta with the market.

Which of the following statements is FALSE? A) We say a portfolio is an efficient portfolio whenever it is possible to find another portfolio that is better in terms of both expected return and volatility. B) We can rule out inefficient portfolios because they represent inferior investment choices. C) The volatility of the portfolio will differ, depending on the correlation between the securities in the portfolio. D) Correlation has no effect on the expected return on a portfolio.

A) We say a portfolio is an efficient portfolio whenever it is possible to find another portfolio that is better in terms of both expected return and volatility.

Which of the following statements is FALSE? A) While the sign of a correlation is easy to interpret, its magnitude is not. B) Independent risks are uncorrelated. C) When the covariance equals 0, the returns are uncorrelated. D) To find the risk of a portfolio, we need to know more than the risk and return of the component stocks; we need to know the degree to which the stocks' returns move together.

A) While the sign of a correlation is easy to interpret, its magnitude is not.

Which of the following statements is FALSE? A) Without trading, the portfolio weights will decrease for the stocks in the portfolio whose returns are above the overall portfolio return. B) The expected return of a portfolio is simply the weighted average of the expected returns of the investments within the portfolio. C) Portfolio weights add up to 1 so that they represent the way we have divided our money between the different individual investments in the portfolio. D) A portfolio weight is the fraction of the total investment in the portfolio held in an individual investment in the portfolio.

A) Without trading, the portfolio weights will decrease for the stocks in the portfolio whose returns are above the overall portfolio return.

You expect General Motors (GM) to have a beta of 1.5 over the next year and the beta of Exxon Mobil (XOM) to be 1.9 over the next year. Also, you expect the volatility of General Motors to be 50% and that of Exxon Mobil to be 35% over the next year. Which stock has more systematic risk? Which stock has more total risk? A) XOM, GM B) GM, XOM C) GM, GM D) XOM, XOM

A) XOM, GM

For each 1% change in the market portfolio's excess return, the investment's excess return is expected to change by ________ due to risks that it has in common with the market. A) beta B) alpha C) 0% D) 1%

A) beta

The systematic risk (beta) of a portfolio will ________ by holding more stocks, even if they each had the same systematic risk. A) change B) stay the same C) turn negative D) turn to 0

A) change

Diversification reduces the risk of a portfolio because ________, and some of the risks are averaged out of the portfolio. A) stocks do not move identically B) stocks have common risks C) stocks are fully predictable D) stocks are not affected by the market

A) stocks do not move identically

The S&P 500 index traditionally is a(n) ________ portfolio of the 500 largest U.S. stocks. A) value weighted B) equally weighted C) chain weighted D) price weighted

A) value weighted

Which of the following statements is FALSE? A) The covariance and correlation allow us to measure the co-movement of returns. B) Correlation is the expected product of the deviations of two returns. C) Because the stocks' prices do not move identically, some of the risk is averaged out in a portfolio. D) The amount of risk that is eliminated in a portfolio depends on the degree to which the stocks face common risks and their prices move together.

B) Correlation is the expected product of the deviations of two returns.

Which of the following statements is FALSE? A) The expected return of a portfolio should correspond to the portfolio's beta. B) Graphically, the line through the risk-free investment and the market portfolio is called the capital market line (CML). C) The beta of a portfolio is the weighted average beta of the securities in the portfolio. D) By holding a negative-beta security, an investor can reduce the overall market risk of her portfolio.

B) Graphically, the line through the risk-free investment and the market portfolio is called the capital market line (CML).

A linear regression was done to estimate the relation between Sprint's stock returns and the market's return. The intercept of the line was found to be 0.23 and the slope was 1.47. Which of the following statements is true regarding Sprint's stock? A) Sprint's beta is 0.23. B) Sprint's beta is 1.47. C) The risk-free rate is 1.47%. D) The standard deviation of Sprint's excess returns is 23%.

B) Sprint's beta is 1.47.

A linear regression to estimate the relation between General Motors' stock returns and the market's return gives the best-fitting line that represents the relation between the stock and the market. The slope of this line is our estimate of ________. A) alpha B) beta C) risk-free rate D) volatility

B) beta

Stocks tend to move together if they are affected by ________. A) company specific events B) common economic events C) events unrelated to the economy D) idiosyncratic shocks

B) common economic events

The expected return is usually ________ the baseline risk-free rate of return that we demand to compensate for inflation and the time value of money. A) lower than B) higher than C) similar to D) none of the above

B) higher than

The Capital Asset Pricing Model asserts that the expected return ________. A) is equal to the risk-free rate plus a risk premium for unsystematic risk B) is equal to the risk-free rate plus a risk premium for systematic risk C) is equal to the risk premium plus a risk-free rate for systematic risk D) is equal to the risk premium plus a risk-free rate for unsystematic risk

B) is equal to the risk-free rate plus a risk premium for systematic risk

The volatility of Home Depot Share prices is 50% and that of General Motors shares is 50%. When I hold both stocks in my portfolio and the stocks returns have zero correlation, the overall volatility of returns of the portfolio is ________. A) more than 25% B) less than 50% C) more than 50% D) less than 25%

B) less than 50%

Companies that sell household products and food have very little relation to the state of the economy because such basic needs do not go away. These stocks tend to have ________ betas. A) high B) low C) negative D) infinite

B) low

If you build a large enough portfolio, you can diversify away all ________ risk, but you will be left with ________ risk. A) diversifiable, unsystematic B) unsystematic, systematic C) systematic, undiversifiable D) undiversifiable, diversifiable

B) unsystematic, systematic

Which of the following statements is FALSE? A) Stock returns will tend to move together if they are affected similarly by economic events. B) Stocks in the same industry tend to have more highly correlated returns than stocks in different industries. C) Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together. D) With a positive amount invested in each stock, the more the stocks move together and the higher their covariance or correlation, the more volatile the portfolio will be.

C) Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together.

Which of the following statements is FALSE? A) Because all investors should hold risky securities in the same proportions as the efficient portfolio, their combined portfolio will also reflect the same proportions as the efficient portfolio. B) The Capital Asset Pricing Model (CAPM) assumptions hold that the return on any portfolio is the combination of the risk-free rate of return plus a risk premium proportional to the amount of systematic risk in the investment. C) Graphically, when the tangent line goes through the market portfolio, it is called the security market line (SML). D) A portfolio's risk premium and volatility are determined by the fraction that is invested in the market.

C) Graphically, when the tangent line goes through the market portfolio, it is called the security market line (SML).

You expect General Motors (GM) to have a beta of 1 over the next year and the beta of Exxon Mobil (XOM) to be 1.2 over the next year. Also, you expect the volatility of General Motors to be 30% and that of Exxon Mobil to be 40% over the next year. Which stock has more systematic risk? Which stock has more total risk? A) GM, GM B) GM, XOM C) XOM, XOM D) XOM, GM

C) XOM, XOM

Historically, the average excess return of the S&P 500 over the return of U.S. Treasury bonds has been ________ and is proxy for the market risk premium. A) between 10% and 12% B) between 14% and 16% C) between 5% and 7% D) between 11% and 13%

C) between 5% and 7%

The market portfolio is the portfolio of all risky investments held ________. A) in descending weights B) in ascending weights C) in proportion to their value D) based on previous year performance

C) in proportion to their value

We can reduce volatility by investing in less than perfectly positively correlated assets through diversification because the expected return of a portfolio is the weighted average of the expected returns of its stocks, but the volatility of a portfolio ________. A) is higher than the weighted average volatility B) is independent of weights in the stocks C) is less than the weighted average volatility D) depends on the expected return

C) is less than the weighted average volatility

The volatility of Home Depot share prices is 30% and that of General Motors shares is 15%. When I hold both stocks in my portfolio and the stocks returns have a correlation of 1, the overall volatility of returns of the portfolio is ________. A) more than 15% B) less than 30% C) unchanged at 30% D) equal to 15%

C) unchanged at 30%

The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I hold both stocks in my portfolio with an equal amount in each, and the stocks returns have a correlation of minus 1, the overall volatility of returns of the portfolio is ________. A) more than 30% B) unchanged at 30% C) zero D) equal to 60%

C) zero

The beta of the market portfolio is ________. A) 0 B) -1 C) 2 D) 1

D) 1

Which of the following statements is FALSE? A) When stocks are perfectly positively correlated, the set of portfolios is identified graphically by a straight line between them. B) An investor seeking high returns and low volatility should only invest in an efficient portfolio. C) When the correlation between securities is less than 1, the volatility of the portfolio is reduced due to diversification. D) Efficient portfolios can be easily ranked, because investors will choose from among them those with the highest expected returns.

D) Efficient portfolios can be easily ranked, because investors will choose from among them those with the highest expected returns.

You expect General Motors (GM) to have a beta of 1.3 over the next year and the beta of Exxon Mobil (XOM) to be 0.9 over the next year. Also, you expect the volatility of General Motors to be 40% and that of Exxon Mobil to be 30% over the next year. Which stock has more systematic risk? Which stock has more total risk? A) XOM, GM B) XOM, XOM C) GM, XOM D) GM, GM

D) GM, GM

Which of the following statements is FALSE? A) If two stocks move in opposite directions, the covariance will be negative. B) The correlation between two stocks has the same sign as their covariance, so it has a similar interpretation. C) The covariance of a stock with itself is simply its variance. D) The covariance allows us to gauge the strength of the relationship between stocks.

D) The covariance allows us to gauge the strength of the relationship between stocks

Which of the following statements is FALSE? A) A stock's return is perfectly positively correlated with itself. B) When the covariance equals 0, the stocks have no tendency to move either together or in opposition of one another. C) The closer the correlation is to -1, the more the returns tend to move in opposite directions. D) The variance of a portfolio depends only on the variance of the individual stocks.

D) The variance of a portfolio depends only on the variance of the individual stocks.

As we add more uncorrelated stocks to a portfolio where the stocks are held in equal weights, the benefit of diversification is most dramatic ________. A) after 20 stocks have been added B) when there are more than 500 stocks C) when there are more than 1,000 stocks D) at the outset

D) at the outset

The amount of a stock's risk that is diversified away ________. A) is independent of the portfolio that you add it to B) depends on market risk premium C) depends on risk-free rate of interest D) depends on the portfolio that you add it to

D) depends on the portfolio that you add it to

The volatility of Home Depot share prices is 20% and that of General Motors shares is 20%. When I hold both stocks in my portfolio, the overall volatility of the portfolio is ________. A) 20% B) 16% C) 18% D) not possible to calculate as information is inadequate

D) not possible to calculate as information is inadequate