Module 2 - Investment Risk, Return, and Performance

During the past year, the portfolio of your largest client had a return of 10% and a beta of 1.1. During the same year, the average T-bill rate was 1.25%. What is the Treynor ratio for the performance of this portfolio? A) .1527 B) .0796 C) 5.50 D) .0993

B) .0796 The Treynor ratio divides the excess return (return − risk-free rate) by the beta—in this case, (.10 − .0125) ÷ 1.1 = .0796.

The risk-free rate is 1.25%, the market rate of return is 8%, the standard deviation of XYZ stock is 20, and the beta of XYZ stock is 1.10. Using the capital asset pricing model in conjunction with this information, what is the expected return of XYZ stock? A) 7.7% B) 8.68% C) 12.2% D) 12.1%

B) 8.68% CAPM is the risk-free rate plus beta times excess return, or Rs = 1.25% + (8% − 1.25%) 1.1 = 8.68%.

Which one of the following is a type of systematic risk? A) Default risk B) Reinvestment risk C) Liquidity risk D) Financial risk

B) Reinvestment risk Reinvestment risk is a type of systematic risk. The others are considered unsystematic risks

Which one of the following has a direct bearing on which investments are appropriate for achieving a goal? A) The investment's beta B) The investor's time horizon C) The investor's net worth D) The investment's alpha

B) The investor's time horizon The time horizon has a direct bearing; net worth does not, and beta and alpha are measures of volatility and performance.

Stock ABC has an average return of 9.0% with a standard deviation of 7.0%. What is the range of expected returns for ABC 68% of the time? A) +2.0% to +23.0% B) −12.0% to +23.0% C) +2.0% to +16.0% D) −5.0% to +16.0%

C) +2.0% to +16.0% 68% of the time the returns will fall within one standard deviation of the average return. One standard deviation below the mean is 9% − 7% = 2% and one standard deviation above the mean is 9% + 7% = 16%.

Gary would like to know the weighted beta coefficient for his portfolio. He owns 100 shares of ACE common stock with a beta of 1.1 and total current market value of $5,000; 400 shares of BDF common stock with a beta of .70 and total current market value of $8,000; and 200 shares of GIK common stock with a beta of 1.5 and total current market value of $10,000. What is the overall weighted beta coefficient for Gary's portfolio? A) 1.10 B) 1.05 C) 1.13 D) 1.01

C) 1.13 1.1INPUT (ENTER)5S+ .7INPUT (ENTER)8S+1.5INPUT (ENTER)10S+SHIFT 6, `xw = 1.13

If an investor were looking to add another investment to her portfolio, which of the following correlation coefficients would provide the greatest risk reduction? A) A small cap fund with a correlation of 0.5 B) A large cap stock fund with a correlation of 1.0 C) A managed futures fund with a correlation of -0.25 D) A natural resource fund with a correlation of 0

C) A managed futures fund with a correlation of -0.25 The scale for correlation coefficients goes from -1.0 (perfectly negatively correlated) to 1.0 (perfectly positively correlated). The further to the left you go on the scale, the lower the correlation and the greater the risk reduction.

Bill is highly confident, strong willed, and difficult to advise. Which one of the following best describes Bill's investor personality? A) Individualist B) Celebrity C) Adventurer D) Guardian

C) Adventurer An adventurer is impetuous, confident, strong willed, and difficult to advise.

The amount of debt used in a company's capital structure is directly related to which of the following risks? A) Event risk B) Business risk C) Financial risk D) Liquidity risk

C) Financial risk Financial risk is the degree to which a company utilizes debt to finance its operations.

Several individual investments each have high standard deviations. Which of the following are true about the standard deviation for a portfolio of these same investments? I. It has to be high because the standard deviations are high. II. It has to be low because the standard deviations are high. III. It can be low if there is a low correlation of returns between the investments. IV. It can be high if there is a high correlation of returns between the investments. A) I and IV B) I and III C) III and IV D) II and III

C) III and IV If the investments have a low correlation coefficient between them, they will reduce investment risk, which can result in a portfolio with a low standard deviation. If the investments have a high correlation of returns between them, then they will not reduce investment risk, and the portfolio will continue to have high systematic risk, hence a high standard deviation for the portfolio.

What is the importance of understanding the correlation of assets in a portfolio? A) It ensures that the portfolio has a positive Sharpe ratio. B) It determines the overall return of the portfolio. C) It measures the degree of how one investment moves in relation to another. D) It allows investors to avoid risk altogether.

C) It measures the degree of how one investment moves in relation to another. The correlation of assets in a portfolio measures the degree of how one investment moves in relation to another.

Ophelia is considering the purchase of the Quest Mutual Fund, which has a beta of 1.2, standard deviation of 15, and a return of 11%. The current risk-free rate is 4%, and the market risk premium is 7%. Should Ophelia purchase the fund? A) No, because of the fund's Sharpe ratio. B) Yes, because the fund has an 11% return. C) No, because the fund has a negative alpha. D) Yes, because of the fund's Treynor ratio.

C) No, because the fund has a negative alpha. This question can be answered with or without a calculation. Sharpe and Treynor cannot be used because we have nothing to compare Quest Mutual Fund to, and both Sharpe and Treynor are comparative measures. The calculation would be as follows: a=¯¯¯rp−[¯¯¯rf+(¯¯¯¯rm−¯¯¯rf)βp] a=11−[4+7(1.2)] a = 11 − [12.40] a = −1.40 The fund has a negative alpha of 1.40, meaning the fund manager has not obtained the return he or she should for the amount of risk taken.

Portfolio X had a Sharpe ratio of 1.10, while Portfolio Y had a Sharpe ratio of .55. Based on this information, which one of the following statements is correct? A) Portfolio X had worse performance than Portfolio Y. B) Portfolio X had twice the performance of Portfolio Y. C) Portfolio X had better performance than Portfolio Y on a risk-adjusted basis. D) Portfolio X had better performance than Portfolio Y.

C) Portfolio X had better performance than Portfolio Y on a risk-adjusted basis. A higher Sharpe ratio does indicate better performance based on the risk taken, as measured by standard deviation.

Allen is willing to invest in securities with above-average risk if he is rewarded for doing so. He has been following the stock of a company that he likes, but is concerned because the stock dropped 8% the last time the S&P 500 dropped 6%. Allen believes that an 11% return for the market next year would be good. The current market risk premium is 7% and the Treasury bill rate is 6.5%. Using the CAPM formula, calculate the required rate of return for the stock and determine if the stock appears to meet Allen's criteria of investing in above-average-risk stocks only if he is rewarded for doing so. A) The required rate of return is 14.9%, and the stock meets Allen's criteria. B) The required rate of return is 12.4%, and the stock does not meet Allen's criteria. C) The required rate of return is 15.6%, and the stock meets Allen's criteria. D) The required rate of return is 17.6%, and the stock meets Allen's criteria.

C) The required rate of return is 15.6%, and the stock meets Allen's criteria. The required rate of return is 6.5% + (7%) 1.3 = 15.6%. The fact that Allen believes 11% would be a good return is not relevant for computation of the required rate of return—only the computed market risk premium is relevant. The market return is computed as 7% + 6.5% = 13.5%. Allen will invest in an above-average risk stock (beta = 1.3) if he can be rewarded for taking the extra risk. He is rewarded because he can expect to earn 2.1% more than the market return by taking the extra risk.

Which one of the following is a better comparative measure of a mutual fund portfolio manager's performance? A) Time-weighted returns because cash flows are taken into consideration B) Dollar-weighted returns because cash flows are taken into consideration C) Time-weighted returns because cash flows are not taken into consideration D) Dollar-weighted returns because cash flows are not taken into consideration

C) Time-weighted returns because cash flows are not taken into consideration Dollar-weighted returns take cash flows into consideration and are a better measure of investor performance. Time-weighted returns, on the other hand, negate the effects of contributions and withdrawals made by investors and are therefore a better measure of a manager's performance.

The higher the standard deviation of an investment in relation to its rate of return, A) the lower the expected rate of return and the lower the level of risk. B) the greater the expected rate of return and the lower the level of risk. C) the greater the level of risk for a given rate of return. D) the lower the level of risk for a given level of return.

C) the greater the level of risk for a given rate of return. The greater the dispersion of returns around an average rate of return, the greater will be the standard deviation and, consequently, the higher the level of risk for a given rate of return.

How does the inverse method of portfolio management reduce portfolio volatility? A) By concentrating on only the highest earning risk factors, reducing exposure to market beta B) By maintaining a fixed portion of the portfolio in the Total U.S. Bond Market C) By increasing market beta exposure D) By decreasing the expected return of the portfolio

A) By concentrating on only the highest earning risk factors, reducing exposure to market beta By concentrating on only the highest earning risk factors, reducing exposure to market beta.

What is the key to building efficient portfolios in traditional-based investing? A) Diversifying across multiple asset classes B) Decreasing market beta exposure C) Decreasing exposure to risk factors D) Maximizing expected returns

A) Diversifying across multiple asset classes Diversifying across multiple asset classes is the key to building efficient portfolios in traditional-based investing.

Which of the following are true regarding Jensen's alpha? I. It compares the risk to an appropriate benchmark. II. It is a stand-alone measure of risk adjusted performance. III. Beta is the relevant risk measurement being used. IV. The greater the positive (negative) alpha, the better (worse) the portfolio manager performed on a risk-adjusted basis. A) II, III, and IV B) II and IV C) I, II, and III D) I and III

A) II, III, and IV Alpha is a stand-alone or absolute measurement, and not a relative measure of risk adjusted return. All other statements are correct.

George's bonds fell in price on news of higher interest rates. To which one of the following risks are George's bonds most likely to be subject? A) Interest rate risk B) Reinvestment risk C) Financial risk D) Default risk

A) Interest rate risk Interest rate risk centers on the inverse relationship of interest rate changes and bond prices, so, in this situation, if interest rates go up, the price of George's bonds go down.

Which one of the following statements is correct? A) Jensen's alpha may be used by itself to judge an investment. B) The Sharpe ratio uses beta as its measure of risk. C) A negative alpha indicates the investment lost money. D) The Treynor ratio uses standard deviation as its measure of risk.

A) Jensen's alpha may be used by itself to judge an investment. Beta is the risk measure for Jensen's alpha, but the Sharpe ratio uses standard deviation as its risk measure. Therefore, the reliability of beta is relevant for Jensen's alpha. Jensen's alpha can be used by itself to judge an investment; the Sharpe ratio must be used in comparison with another Sharpe ratio in judging an investment. A negative alpha indicates the investment did not perform as well as expected given the risk taken. For example, an alpha of -1 means the investment underperformed by 1% compared to what it was expected to return. Accordingly, a negative alpha does not necessarily mean the investment lost money. The Treynor ratio uses beta as its measure of risk.

Which of the following is NOT one of the eight most prominent risk factors discussed in the module? A) Market beta B) Size C) Quality D) Growth

D) Growth The module discusses eight prominent risk factors: market beta, size, value, momentum, profitability, quality, term, and carry. The term "growth" is not mentioned as one of these prominent risk factors.

Which of the following are characteristics of the Sharpe ratio? I. It adjusts the return for variability by using standard deviation as the measure of risk. II. It assumes that the portfolio being evaluated is well diversified. III. Both alpha and beta appear in the ratio formula. IV. It indicates by how much the realized return differs from the return required by the capital asset pricing model. A) III and IV B) I and II C) I, II, and IV D) I only

D) I only Options II, III, and IV are true of Jensen's alpha; option II is true of the Treynor ratio.

Assume each of the asset classes below has the following correlation to long-term government bonds: Treasury bills: .67 Corporate bonds: .81 Large stocks: .37 Small stocks: .12 Which one of the following correctly states the impact of diversification on a portfolio of long-term government bonds? A) There is no diversification effect because all of the correlations are positive. B) Corporate bonds provide more diversification than large stocks. C) Treasury bills provide more diversification than small stocks. D) Small stocks provide more diversification than large stocks.

D) Small stocks provide more diversification than large stocks. Because the correlations of small stocks to long-term government bonds are less than that of large stocks (even though both are positive), small stocks provide more diversification than large stocks.

Which of the following statements accurately describes a limitation of the Capital Asset Pricing Model (CAPM)? A) The CAPM was created by Eugene Fama and Kenneth French in their 1992 paper "The Cross-Section of Expected Stock Returns." B) The CAPM is a flawless model that accurately explains the behavior of financial markets and has not faced any challenges or criticisms. C) The CAPM is the only model that combines market beta, size, and value into a coherent pricing model. D) The CAPM is based on the idea that the risk and return of a portfolio are determined solely by its exposure to market beta, which is a simplified assumption that does not account for other factors that may influence returns.

D) The CAPM is based on the idea that the risk and return of a portfolio are determined solely by its exposure to market beta, which is a simplified assumption that does not account for other factors that may influence returns. The CAPM is based on the idea that the risk and return of a portfolio are determined solely by its exposure to market beta, which is a simplified assumption that does not account for other factors that may influence returns.

What is the main difference between traditional and factor-based investing? A) Traditional investing is a relatively new way of investing, while factor-based investing is the most commonly used by investors. B) Traditional investing relies solely on asset classes for diversification and portfolio returns, while factor-based investing does not. C) Traditional investing involves reducing risk instead of increasing expected returns, while factor-based investing maximizes returns. D) Traditional investing aims to create diversified portfolios by investing in multiple asset classes, while factor-based investing diversifies across various risk factors.

D) Traditional investing aims to create diversified portfolios by investing in multiple asset classes, while factor-based investing diversifies across various risk factors. Traditional investing aims to create diversified portfolios by investing in multiple asset classes, while factor-based investing diversifies across various risk factors.

Which of the following types of risk can be reduced through diversification? A) Interest rate risk B) Endogenous risk C) Systematic risk D) Unsystematic risk

D) Unsystematic risk Unsystematic risk depends on factors unique to a particular asset (i.e., firm-specific risk), so diversification reduces unsystematic risk.

The portfolio performance calculation that investors prefer to see is the A) arithmetic return. B) time-weighted return. C) Jensen's alpha. D) dollar-weighted return.

D) dollar-weighted return. Dollar-weighted returns (also known as internal rate of return) accounts for the client's contributions to and withdrawals from a portfolio and it is the most accurate representation of how the client fared.

Assume a growth stock mutual fund has a beta of 1.3. If the stock market increases by 9%, you would expect this mutual fund to A) decrease by 11.7%. B) decrease by 9%. C) increase by 9%. D) increase by 11.7%.

D) increase by 11.7%. You would expect any fund with a beta of 1.3 to increase by 11.7% (1.3 × 9%).

If a security has an average return of 14.2% and a standard deviation of 8.4, then A) the security's annual volatility can be expected to be within a range approximately 8.4% above and 8.4% below the current fair market value. B) the security's returns can be expected to never be negative. C) the security's returns can be expected to be between 8.4% and 14.2% approximately 95% of the time. D) the security's returns can be expected to be between 5.8% and 22.6% approximately 68% of the time.

D) the security's returns can be expected to be between 5.8% and 22.6% approximately 68% of the time. This security can be expected to have a return that does not range beyond one standard deviation on either side of its average return approximately 68% of the time.