IM 2

According to the CAPM, what is the expected rate of return for a stock with a beta of 1.2 when the risk free rate is 6% and the market rate of return is 12%?

13.2

In a 5 year period, the annual returns on an investment are 5%, -3%, -4%, 2%, and 6%. The standard deviation of annual return on this investment is closest to

4.55% Mean annual return = (5% - 3% -4% + 2% +6%) / 5 = 0.012 Squared deviations from mean (expected - actual) 5% - 1.2% = 3.8% 3.8^2 = 14.44 -3% - 1.2% = -4.2% -4.2^2=17.64 -4% - 1.2% = -5.2% -5.2%^2 = 27.04 2% - 1.2% = 0.8% .8% ^2 =0.64 6% - 1.2% = 4.8% 4.8%^2 = 23.04 iv. Sum of squared deviations = 14.44 + 17.64 + 27.04 + 0.64 + 23.04 = 82.8 v. Sample variance 82.8 / (5-1) = 20.7 Sample standard deviation = 20.7^(1/2) = 4.5497

According to the CAPM, what is the required rate o return for a stock with a beta of 0.7 when the risk free rate is 7% and expected market rate of return is 14%?

7 + 0.7(14-7) = 11.9%

A top down security analysis begins by

Examining economic conditions

Compared to ETFs, open end mutual funds are typically associated with lower

1. Brokerage costs 2. Open end mutual funds do not have brokerage costs, as shares are purchased and redeemed with fund company 3. Minimum investment amounts and manned fees are typically higher for mutual funds

Compared to investing in a single security, diversification provides investors a way to

1. Decrease volatility in returns 2. Diversification provides investor reduced risk but expected return is generally similar or less than single risk securities

Mortgages are tied to what government sponsored debt?

10 year T Note

Hedge funds most likely

Are not offered for sale to general public

Which of the following statements about correlation is least accurate? a. Diversification reduces risk when correlation is less than +1 b. If the correlation coefficient is 0, a zero variance portfolio can be constructed c. The lower the correlation coefficient, the great the potential benefits from diversification

B

Which of the following statements about risk-averse investors is most accurate? A risk-averse investor: a. Seeks out investment with minimum risk, while return is not a major consideration b. Will take additional investment risk if sufficiently compensated for this risk c. Avoids participating in global equity markets

B

13. Which of the following statements about the SML and CML is least accurate? a. Securities that plot above SML are undervalued b. Investors expect to be compensated for systematic risk c. Securities that plot on the SML have no value to investors

C

A measure of how the returns of two risk assets move in relation to each other is the

Covariance

Portfolio diversification is least likely to protect against losses

During severe market turmoil

What is an inappropriate schedule for reviewing and updating an investment policy statement

Frequently, based on recent portfolio performance

Low risk tolerance and high liquidity requirements best describe the typical investment needs of a

Insurance company

What affects the long end of the yield curve

Long end determined by market and their required rate of return - fed can only affect long term yield curve through quantitative easing

11. Which of the following available portfolios most likely falls below the efficient frontier E(r) E(Sd) A 7% 14% B 9% 26% C 12% 22%

Portfolio B because there is a portfolio ( C ) that offers higher return and lower risk

Do rising interest rates affect long or short end of yield curve?

Short Rising interest rates affect short end of yield curve (increase 25bp) which affects variable rate loans (but longer end of the yield curve has not changed).

Data needed: A portfolio was created by investing 25% of funds in Asset A ( standard deviation = 15%) and the balance of the funds in Asset B (standard deviation = 10%) If the correlation coefficient is -0.75, what is the portfolios standard deviation?

Sq. root of (0.25^2*0.15^2 + 0.75^2*0.10^2 + 2(.25)(.75)(.15)(.10)(-.75) = Sq root of 0.002812 = 5.3%

Data needed: A portfolio was created by investing 25% of funds in Asset A ( standard deviation = 15%) and the balance of the funds in Asset B (standard deviation = 10%) If the correlation coefficient is 0.75, what is the portfolios standard deviation?

Sq. root of (0.25^2*0.15^2 + 0.75^2*0.10^2 + 2(.25)(.75)(.15)(.10)(.75) = Sq root of 0.01125 = 10.6%

In a defined benefit pension plan

The plan sponsor promises predetermined retirement income to participants

What is the risk measure associated with the capital markets line (CML)?

Total Risk

A portfolio to the right of the market portfolio on the CML is

a borrowing portfolio i. A portfolio to the right of a portfolio on the CML has more risk than the market portfolio. Investors seeking to take on more risk will borrow at risk-free rate to purchase more of the market portfolio

The covariance of the market's returns with a stocks returns is 0.005. and the standard deviation of the markets returns is 0.05. What is the stocks beta?

a. Beta - covariance / market variance i. Market variance = 0.05^2 = 0.0025 0.005 / 0.0025 = 2

12. A stock with a beta of 0.7 currently priced at $50 is expected to increase in price to $55 by year end and pay a $1 dividend. The expected market return is 15%, and the risk free rate is 8%. The stock is

a. Overpriced, so do not buy b. Required rate = 8+ 0.7(15-8) = 12.9% c. Return on stock = (55-50 + 1) / 50 = 0.12 d. Stock falls below SML

The variance of returns is 0.09 for stock a and 0.04 for stock b. the covariance between the returns of A and B is 0.006. The correlation of returns between A and B is

a. Sq root A = sq root of 0.09 = 0.30 b. Sq root B = sq root of 0.04 = 0.20 c. Correlation = 0.006 / [0.3 * 0.2] = 0.10

Total risk equals

a. Systematic risk plus unsystematic risk i. Unique risk is diversifiable and is unsystematic. Market (systematic) risk is no diversifiable

11. The risk free rate is 6% and the expected market return is 15%. A stock with a beta of 1.2 is selling for $25 and will pay $1 dividend at the end of the year. IF the stock is priced at $30 year end, it is

a. Underpriced, so buy it b. Required rate = 6+ 1.2(15-6) = 16.8% c. Return on stock - (30 - 25 + 1) / 25 = 0.24 d. Based on risk , stock plots above SML and is underpriced

As the number of stocks in a portfolio increases, the portfolio's systematic risk

can increase or decrease i. When you increase the number of stocks in a portfolio, the unsystematic risks will decrease at a decreasing rate. However, the portfolios systematic risk can be increased by adding high beta stocks or decreased by adding lower beta stocks

In a defined contribution pension plan

employee accepts investment risk

A longtime horizon and low liquidity requirements best describe the investment needs of an

endowment

What asset classes has historically had the highest returns and standard deviations?

small cap stocks