FIN 320 chap 12

16) 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.

...Answer: A Explanation: A) Without trading, the *portfolio weights will increase* for the stocks in the portfolio whose *returns are above the overall portfolio return*.

17) Which of the following equations is *INCORRECT*? A) xi = total value of portfolio / value of investment B) Rp = Σi xiRi C) Rp = x1R1 + x2R2 + ... + xnRn D) E[Rp} = E[Σi xiRi]

...Answer: A Explanation: A) xi = *value of investment / total value of porfolio*

12.2 The Volatility of a Portfolio 1) When we *combine stocks in a portfolio*, the *amount of risk that is eliminated* depends on the degree to which the *stocks face common risks and move together*.

...Answer: TRUE

12) *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 unpredictable D) stocks are always effected by the market Answer:

A) *stocks do not move identically*

21) You observe the following scatterplot of Ford's weekly returns against the S&P 500. Which of the following statements is true about Ford's beta against the S&P 500? A) Ford's beta appears to be positive. B) Ford's beta appears to be negative. C) Ford's beta appears to be zero- there is no apparent relation between its return and the S&P return. D) Beta has nothing to do with the relationship seen in this scatterplot. Answer:

A) Ford's beta appears to be *positive*.

22) Which of the following statements is *FALSE*? A) The risk premium of a security is equal to the market risk premium (the amount by which the market's expected return exceeds the risk-free rate) divided by the amount of market risk present in the security's returns measured by its beta with the market. B) We refer to the beta of a security with the market portfolio simply as the securities beta. 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. Answer:

A) The risk premium of a security is equal to the market risk premium (the amount by which the market's expected return exceeds the risk-free rate) divided by the amount of market risk present in the security's returns measured by its beta with the market.

20) 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. Answer:

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*.

17) Which of the following statements is *FALSE*? A) While the sign of the 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. Answer:

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

9) 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 Answer:

A) XOM, GM

14) For each *1% change in the market portfolio's excess return*, the investment's excess return is expected to change by ________ percent due to risks that it has in common with the market. A) beta B) alpha C) zero D) cannot say for sure Answer:

A) beta

17) The systematic risk (beta) of a portfolio is ________ by holding more stocks, even if they each had the same systematic risk. A) unchanged B) increased C) decreased D) cannot say for sure Answer:

A) unchanged

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

A) value weighted

18) 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 variable the portfolio will be.

Answer: CC) Almost all of the *correlations between stocks are negative*, illustrating the general tendency of stocks to move together.

21) Which of the following equations is *INCORRECT*? A) Cov(Ri,Rj) = Σ(Ri - Ri)(Rj - Rj) B) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) C) Corr(Ri,Rj) = Cov(Ri, Rj)/ Var (Ri) Var(Rj) D) Cov(Ri,Rj) = E[(Ri - E[Ri])(Rj - E[Rj])]

Answer: CC) Corr(Ri,Rj) = Cov(Ri, Rj)/ Var (Ri) Var(Rj) Explanation: C) Corr(Ri,Rj) = Cov(Ri, Rj)/ SD (Ri) SD(Rj)

19) 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.

Answer: DD) The *variance of a portfolio* depends *only on the variance* of the individual stocks. Explanation: D) The variance of a portfolio depends on the variance and correlations of the individual stocks.

12.1 The Expected Return of a Portfolio 1) Stocks have both diversifiable risk and undiversifiable risk, but *only diversifiable risk is rewarded* with higher expected returns.

Answer: FALSE

12.3 Measuring Systematic Risk 1) If you build a *large enough portfolio*, you can *diversify away all the risks* of a portfolio.

Answer: FALSE

2) If two stocks are *perfectly negatively correlated*, a portfolio with equal weighting in each stock will always have a volatility (standard deviation) of *0*.

Answer: FALSE

4) When we form an equally weighted portfolio of stocks and keep increasing the number of stocks in the portfolio, the volatility of the portfolio also increases.

Answer: FALSE

12.4 Putting It All Together: The Capital Asset Pricing Model 1) The market or equity risk premium can be estimated by computing the historical average excess return of the market portfolio.

Answer: TRUE

2) For large portfolios, investors should expect a *higher return for higher volatility*, but this does not hold true for individual stocks.

Answer: TRUE

2) The security market line is a graph of the expected return of a stock as a function of systematic risk (beta).

Answer: TRUE

3) *Correlation* is the degree to which the returns of two stocks share common risks.

Answer: TRUE

3) A portfolio comprises two stocks, *A and B*, with *equal amounts of money invested* in each. If stock *A's stock price increases* and that of stock *B decreases*, the weight of stock A in the portfolio will increase.

Answer: TRUE

3) The *Capital Asset Pricing Model (CAPM)* says that the excess return on a stock is equal to its beta times the market risk premium.

Answer: TRUE

23) 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. Answer:

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

16) 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 prices of the stocks 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. Answer: B

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

17) 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. Answer:

B) beta.

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

B) common economic events.

16) The Capital Asset Pricing Model asserts that the ________ return is equal to the risk-free rate plus a risk premium for systematic risk. A) realized return B) expected return C) holding period return D) ex-post return Answer:

B) expected return

14) 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 Answer:

B) higher than

9) 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 and the *stocks returns have zero correlation*, the overall volatility of returns of the portfolio is A) unchanged at 30%. B) less than 30%. C) more than 30%. D) cannot say for sure Answer:

B) less than 30%.

16) 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) cannot say for sure Answer:

B) low

11) 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) diversifiable, diversifiable Answer:

B) unsystematic, systematic

21) 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) When the Capital Asset Pricing Model (CAPM) assumptions hold, choosing an optimal portfolio is relatively straightforward: it is the combination of the risk-free investment and the market portfolio. 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. Answer:

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

29) Which of the following combinations of two stocks would give you the *biggest reduction in risk*? A) Duke Energy and Wal-Mart B) Wal-Mart and Microsoft C) Microsoft and Duke Energy D) No combination will reduce risk. Answer:

C) Microsoft and Duke Energy

8) 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 Answer:

C) XOM, XOM

12) 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 Answer:

C) in proportion to their value.

14) We can *reduce volatility* by investing in less than perfectly 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. Answer:

C) is less than the weighted average volatility

10) 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 and the stocks returns have a *correlation of 1*, the overall volatility of returns of the portfolio is A) more than 30%. B) less than 30%. C) unchanged at 30%. D) cannot say for sure Answer: C

C) unchanged at 30%.

11) 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) cannot say for sure Answer:

C) zero.

15) The *beta of the market portfolio* is: A) 0 B) -1 C) 2 D) 1 Answer:

D) 1

22) 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. Answer:

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

7) 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 Answer:

D) GM, GM Answer: D beta -> systematic volatility -> total risk

20) Which of the following statements is *FALSE*? A) If two stocks move in opposite directions, one will tend to be above average when to other is below average, and 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. Answer:

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

15) 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 1000 stocks. D) at the outset. Answer:

D) at the outset.

10) 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. Answer:

D) depends on the *portfolio that you add it to*.

8) 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*, the overall volatility of the portfolio is A) 30%. B) 26%. C) 28%. D) more information needed Answer:

D) more information needed Answer: D