Portfolio Management Quiz

While assessing an investor's risk tolerance, a financial adviser is least likely to ask which of the following questions?

"What rate of investment return do you expect?" While the degree of risk tolerance will have an affect on expected returns, assessing the risk tolerance comes first, and the resulting set of feasible returns follows. The other questions address risk tolerance.

Which of the following institutional investors is most likely to have low liquidity needs?

A defined benefit pension plan has less need for liquidity than a bank or a property and casualty insurance company. Banks have high liquidity needs because assets may have to be sold quickly if depositors withdraw their funds. Property and casualty insurance companies need to keep liquid assets to meet claims as they arise.

An equally weighted portfolio of a risky asset and a risk-free asset will exhibit:

A risk free asset has a standard deviation of returns equal to zero and a correlation of returns with any risky asset also equal to zero. As a result, the standard deviation of returns of a portfolio of a risky asset and a risk-free asset is equal to the weight of the risky asset multiplied by its standard deviation of returns. For an equally weighted portfolio, the weight of the risky asset is 0.5 and the portfolio standard deviation is 0.5 × the standard deviation of returns of the risky asset.

Which is NOT an assumption of capital market theory?

Capital market theory assumes that all investments are infinitely divisible. The other statements are basic assumptions of capital market theory.

Which of the following statements about portfolio management is most accurate?

Combining the CML (risk-free rate and efficient frontier) with an investor's indifference curve map separates out the decision to invest from what to invest in and is called the separation theorem. The investment selection process is thus simplified from stock picking to efficient portfolio construction through diversification. The other statements are false. As an investor diversifies away the unsystematic portion of risk, the correlation between his portfolio return and that of the market approaches positive one. (Remember that the market portfolio has no unsystematic risk). The SML measures systematic risk, or beta risk.

Which of the following statements about the importance of risk and return in the investment objective is least accurate?

Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible.

An asset manager's portfolio had the following annual rates of return: Year Return 20X7 +6% 20X8 -37% 20X9 +27% The manager states that the return for the period is −5.34%. The manager has reported the:

Geometric Mean Return = - 1 = −5.34% Holding period return = (1 + 0.06)(1 − 0.37)(1 + 0.27) − 1 = −15.2% Arithmetic mean return = (6% − 37% + 27%) / 3 = −1.33%.

In Fama and French's multifactor model, the expected return on a stock is explained by:

In the Fama and French model, the three factors that explain individual stock returns are firm size, the firm's book value-to-market value ratio, and the excess return on the market portfolio. The Carhart model added price momentum as a fourth factor.

Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has instructed him to put only securities that are undervalued on the buy list. Today, Snow is to make a recommendation on the following two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return. Here, the holding period (or expected) return is calculated as: (ending price - beginning price + any cash flow or dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate - risk free rate). For Bahre: ER = 10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced - do not put on buy list. For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly priced - do not put on buy list (per Snow's manager).

Investors who are less risk averse will have what type of indifference curves for risk and expected return?

Investors who are less risk averse will have flatter indifference curves, meaning they are willing to take on more risk for a slightly higher return. Investors who are more risk averse require a much higher return to accept more risk, producing steeper indifference curves.

A bond analyst is looking at historical returns for two bonds, Bond 1 and Bond 2. Bond 2's returns are much more volatile than Bond 1. The variance of returns for Bond 1 is 0.012 and the variance of returns of Bond 2 is 0.308. The correlation between the returns of the two bonds is 0.79, and the covariance is 0.048. If the variance of Bond 1 increases to 0.026 while the variance of Bond B decreases to 0.188 and the covariance remains the same, the correlation between the two bonds will:

P1,2 = 0.048/[(0.026) 0.5 × (0.188)0.5]= 0.69 which is lower than the original 0.79.

Which one of the following portfolios cannot lie on the efficient frontier? Portfolio Expected Return Standard Deviation A 20% 35% B 11% 13% C 8% 10% D 8% 9%

Portfolio C cannot lie on the frontier because it has the same return as Portfolio D, but has more risk.

Three portfolios have the following expected returns and risk: Portfolio Expected return Standard deviation Jones 4% 2% Kelly 6% 5% Lewis 7% 8% A risk-averse investor choosing from these portfolios could rationally select:

Risk aversion means that to accept greater risk, an investor must be compensated with a higher expected return. For the three portfolios given, higher risk is associated with higher expected return. Therefore a risk-averse investor may select any of these portfolios. A risk-averse investor will not select a portfolio if another portfolio offers a higher expected return with the same risk, or lower risk with the same expected return.

Stock A has a standard deviation of 0.5 and Stock B has a standard deviation of 0.3. Stock A and Stock B are perfectly positively correlated. According to Markowitz portfolio theory how much should be invested in each stock to minimize the portfolio's standard deviation?

Since the stocks are perfectly correlated, there is no benefit from diversification. So, invest in the stock with the lowest risk.

Which of the following statements best describes an investment that is not on the efficient frontier?

The efficient frontier outlines the set of portfolios that gives investors the highest return for a given level of risk or the lowest risk for a given level of return. Therefore, if a portfolio is not on the efficient frontier, there must be a portfolio that has lower risk for the same return. Equivalently, there must be a portfolio that produces a higher return for the same risk.

An analyst gathered the following data for Stock A and Stock B: Time Period Stock A Returns Stock B Returns 1 10% 15% 2 6% 9% 3 8% 12% What is the covariance for this portfolio?

The formula for the covariance for historical data is: cov1,2 = {Σ[(Rstock A − Mean RA)(Rstock B − Mean RB)]} / (n − 1) Mean RA = (10 + 6 + 8) / 3 = 8, Mean RB = (15 + 9 + 12) / 3 = 12 Here, cov1,2 = [(10 − 8)(15 − 12) + (6 − 8)(9 − 12) + (8 − 8)(12 − 12)] / 2 = 6

A line that represents the possible portfolios that combine a risky asset and a risk free asset is most accurately described as a:

The line that represents possible combinations of a risky asset and the risk-free asset is referred to as a capital allocation line (CAL). The capital market line (CML) represents possible combinations of the market portfolio with the risk-free asset. A characteristic line is the best fitting linear relationship between excess returns on an asset and excess returns on the market and is used to estimate an asset's beta.

The market portfolio in the Capital Market Theory contains which types of investments?

The market portfolio contains all risky assets in existence. It does not contain any risk-free assets.

In the context of the CML, the market portfolio includes:

The market portfolio has to contain all the stocks, bonds, and risky assets in existence. Because this portfolio has all risky assets in it, it represents the ultimate or completely diversified portfolio.

According to Markowitz, an investor's optimal portfolio is determined where the:

The optimal portfolio for an investor is determined as the point where the investor's highest utility curve is tangent to the efficient frontier.

In the context of the capital market line (CML), which of the following statements is CORRECT?

The other statements are false. Market risk cannot be reduced through diversification; market risk = systematic risk. The two classes of risk are unsystematic risk and systematic risk.

Assets A (with a variance of 0.25) and B (with a variance of 0.40) are perfectly positively correlated. If an investor creates a portfolio using only these two assets with 40% invested in A, the portfolio standard deviation is closest to:

The portfolio standard deviation = [(0.4)2(0.25) + (0.6)2(0.4) + 2(0.4)(0.6)1(0.25)0.5(0.4)0.5]0.5 = 0.5795

The correlation of returns on the risk-free asset with returns on a portfolio of risky assets is:

The risk-free asset has zero correlation of returns with any portfolio of risky assets.

Which of the following actions is best described as taking place in the execution step of the portfolio management process?

The three major steps in the portfolio management process are (1) planning, (2) execution, and (3) feedback. The planning step includes evaluating the investor's needs and preparing an investment policy statement. The execution step includes choosing a target asset allocation, evaluating potential investments based on top-down or bottom-up analysis, and constructing the portfolio. The feedback step includes measuring and reporting performance and monitoring and rebalancing the portfolio.

Given the following information, what is the required rate of return on Bin Co?

Use the capital asset pricing model (CAPM) to find the required rate of return. The approximate risk-free rate of interest is 5% (2% real risk-free rate + 3% inflation premium). k = 5% + 1.3(4%) = 10.2%.

When the market is in equilibrium:

When the market is in equilibrium, expected returns equal required returns. Since this means that all assets are correctly priced, all assets plot on the SML. By definition, all stocks and portfolios other than the market portfolio fall below the CML. (Only the market portfolio is efficient.

Which of the following statements about portfolio theory is least accurate?

When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will decrease the overall portfolio standard deviation. Any time the correlation coefficient is less than one, there are benefits from diversification. The other choices are true.