Chapter 7 : McGraw Hill Reading Questions - Bus 431

Which statements about diversification of two-asset portfolios are true?

- The benefit of diversification is that the standard deviation of a portfolio is lower than the weighted average standard deviation. - Portfolios of less than perfectly correlated assets always offer some degree of diversification benefit.

Which statements are true about portfolios, capital allocation lines (CALs), and Sharpe ratios?

- The higher the Sharpe ratio, the steeper the capital allocation line. - Steeper CALs provide higher excess returns for any level of risk.

The risk that ______ extensive diversification is called ______ risk.

- can be eliminated by ;unique - remains even after; market

Viewing the investment decision as a top-down process, order the steps of portfolio formation.

1. Capital Allocation 2. Asset Allocation 3. Security Selection

Drag and drop the risk terms against their corresponding synonyms. 1. Systematic Risk 2. Diversifiable Risk

1. Market Risk 2. Unique Risk

Drag and drop the appropriate portfolio form against the corresponding portfolio issues. 1. All investors with identical input lists will hold an identical one 2. Solution is a portfolio with the highest possible Sharpe ratio 3. Solution includes the risk-free asset

1. risky portfolio 2. both risky and complete portfolios 3. complete portfolio

Match the terms to the best fitting statement. 1. Portfolio opportunity set 2. For ρ = −1 3. For ρ = 1

1. shows all combinations of portfolio expected return and standard deviation that can be constructed from the two available assets 2. the portfolio opportunity set reveals the maximum advantage from diversification 3. the correlation between the two funds is perfectly positive.

Order the steps for finding the optimal complete portfolio.

1.) Specify the return characteristics of all securities 2.) Calculate the optimal risky portfolio P 3.) Determine the properties of portfolio P 4.) Calculate the fraction of the complete portfolio allocated to portfolio P and to the risk-free asset 5.) Calculate the share of the complete portfolio invested in each asset

Which part of the investment decision depends on an investor's attitudes toward risk?

Capital Allocation

True or false: The input list is comprised of a set of expected rates of return and a standard deviation matrix.

False

Which statements about the expected return of a two-asset portfolio are correct? Define the expected return of asset D as E(rD), the weight on asset D as wD, the expected return of asset E as E(rE), and the weight on asset E as wE.

It is given by the formula wD E(rD) + wE E(rE). It is the weighted average of the component security expected returns with the investment proportions as weights.

Which statements are true of the efficient frontier as depicted in the figure? (Click to enlarge.)

It is the part of the minimum-variance frontier that lies above the global minimum-variance portfolio. The optimal risky portfolio is the one on it with the highest Sharpe ratio.

Which statements about the variance of a two-asset portfolio are correct? Define the variance of asset D as σD2, the weight on asset D as wD, the variance of asset E as σE2, the weight on asset E as wE., and the covariance of the asset returns as Cov(rD,rE). [Recall that a variance is the covariance of an asset with itself.]

It is the weighted sum of covariances, where each weight is the product of the portfolio proportions of the pair of assets in the covariance term. It is given by the formula w2DD2 σ2DD2 + w2EE2 σ2EE2 + 2 wD wE Cov(rD,rE).

Which statements are true of the optimal risky two-asset portfolio? Define the variables as in the text. Recall that E(RD) is the expected excess return of D and E(rD) is its expected return.

It solves the Sharpe ratio maximization problem. It is given by the formula wD = E(RD)σ2E−E(RE)Cov(RD,RE)E(RD)σ2E+E(RE)σ2D−[E(RD)+E(RE)]Cov(RD,RE)𝐸(𝑅𝐷)σE2-𝐸(𝑅𝐸)Cov(𝑅𝐷,𝑅𝐸)𝐸(𝑅𝐷)σE2+𝐸(𝑅𝐸)σD2-[𝐸(𝑅𝐷)+𝐸(𝑅𝐸)]Cov(𝑅𝐷,𝑅𝐸).

Which of the following is an example of risk sharing?

Selling portions of a risky portfolio to outside investors

The idea that portfolio choice can be separated into two independent tasks—first, determination of the optimal risky portfolio and second the choice of the optimal complete portfolio—is referred to as the ___________ property.

Separation

The portfolio's risk premium in excess of the risk-free rate, divided by the standard deviation, is referred to as its ________ ratio.

Sharpe

Which of the following is NOT involved with establishing the risky portfolio (asset allocation)?

Specify the return characteristics of all securities (expected returns, variances, covariances)

Spreading a portfolio over many investments to avoid excessive exposure to any one source of risk is the definition of

diversification

The graph representing a set of portfolios that maximize expected return at each level of portfolio risk is called the ________ - ________- of risky assets.

efficient frontier

True or false: The minimum-variance portfolio has a standard deviation larger than that of either of the individual component assets.

false

The insurance principle relies on the idea that firm-specific risk among different shares of stock is:

independent

The set of parameters such as expected returns, variances, and covariances necessary to determine the optimal risky portfolio is referred to as the ______ list

input

The standard deviation of a two-asset portfolio is less than the weighted average of the individual security standard deviations if the correlation of the two assets is:

less than zero. equal to zero. equal to negative one. less than one.

The portfolio of risky assets with lowest risk is referred to as the _______-_______ portfolio.

minimum variance

The expected return-standard deviation pairs of all portfolios that can be constructed from a given set of assets is referred to as the portfolio _________ set.

opportunity

The combination of risky assets that maximizes the Sharpe ratio is the _________ risky portfolio.

optimal

The insurance principle states that:

overall risk can be reduced if it is derived from many different sources.

Risk sharing is a complement to risk

pooling

Spreading your exposures across multiple uncorrelated risky ventures or by investing in many risk assets is referred to as risk

pooling

Constraints that restrict investment strategies or vehicles______ t he Sharpe ratio of that portfolio.

reduce

When many investors each take a portion of portfolio of a given size it is referred to as risk

sharing

Examples of a type of constraint aimed at ruling out investments in industries or constraints considered ethically or politically undesirable are:

social governance-focused environmental

Extensive diversification can be expected to ______ firm-specific risk.

substantially reduce

In the case of perfect correlation, all risk is

systematic

As portfolios become more diversified, the impact of a new security on portfolio risk is primarily driven by:

the covariance of the security with the portfolio components.