Chapter 11

Question 1

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 1

A

Question 2

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 2

B

Question 3

Which of the following statements is false?
A) Dividing the covariance by the volatilities ensures that correlation is always between -1 and +1.
B) Volatility is the square root of variance.
C) The closer the correlation is to 0, the more the returns tend to move together as a result of common risk.
D) If two stocks move together, their returns will tend to be above or below average at the same time, and the covariance will be positive.

Answer 3

C) The closer the correlation is to 1, the more the returns tend to move together as a result of common risk.

Question 4

Which of the following statements is false?
A) Stock returns will tend to move together if they are affect 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 invest in each stock, the more the stocks move together and the higher their covariance or correlation, the more variable the portfolio will be.

Answer 4

C) Almost all of the correlations between stocks are positive, illustrating the general tendency of stocks to move together

Question 5

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 5

D) The variance of a portfolio depends on the variance and correlations of the individual stocks.

Question 6

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 6

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

Question 7

Which of the following statements is false?
A) The variance of a portfolio is equal to the weighted average correlation of each stock within the portfolio.
B) The variance of a portfolio is equal to the sum of the covariances of the returns of all pairs of stocks in the portfolio multiplied by each of their portfolio weights.
C) The variance of a portfolio is equal to the weighted average covariances of each stock within the portfolio.
D) The volatility declines as the number of stocks in a portfolio grows.

Answer 7

A

Question 8

Which of the following statements is false?
A) The volatility declines as the number of stocks in a portfolio grows.
B) An equally weighted portfolio is a portfolio in which the same amount is invested in each stock.
C) As the number of stocks in a portfolio grows large, the variance of the portfolio is determined primarily by the average covariance among the stocks.
D) When combining stocks into a portfolio that puts positive weight on each stock, unless all of the stocks are uncorrelated with the portfolio, the risk of the portfolio will be lower than the weighted average volatility of the individual stocks.

Answer 8

D

Question 9

Which of the following statements is false?
A) The expected return of a portfolio is equal to the weighted average expected return, but the volatility of a portfolio is less than the weighted average volatility.
B) Each security contributes to the volatility of the portfolio according to its volatility, scaled by its covariance with the portfolio, which adjusts for the fraction of the total risk that is common to the portfolio.
C) Nearly half of the volatility of individual stocks can be eliminated in a large portfolio as a result of diversification.
D) The overall variability of the portfolio depends on the total co-movement of the stocks within it.

Answer 9

B

Question 10

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 10

A

Question 11

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 11

D

Question 12

Which of the following statements is false?
A) We say a portfolio is long those stocks that have negative portfolio weights.
B) The efficient portfolios are those portfolios offering the highest possible expected return for a given level of volatility.
C) When two stocks are perfectly negatively correlated, it becomes possible to hold a portfolio that bears absolutely no risk.
D) The lower the correlation of the securities in a portfolio the lower the volatility we can obtain.

Answer 12

A

Question 13

Which of the following statements is false?
A) A short sale is a transaction in which you buy a stock that you do not own and then agree to sell that stock back in the future.
B) The efficient portfolios are those portfolios offering the lowest possible level of volatility for a given level of expected return.
C) A positive investment in a security can be referred to as a long position in the security.
D) It is possible to invest a negative amount in a stock or security call a short position.

Answer 13

A

Question 14

Which of the following statements is false?
A) Graphically, the efficient portfolios are those on the northeast edge of the set of possible portfolios, an area which we call the efficient frontier.
B) To arrive at the best possible set of risk and return opportunities, we should keep adding stocks until all investment opportunities are represented.
C) We say a portfolio is short those stocks that have negative portfolio weights.
D) Adding new investment opportunities allows for greater diversification and improves the efficient frontier.

Answer 14

A

Question 15

Which of the following statements is false?
A) A portfolio that consists of a long position in the risk-free investment is known as a levered portfolio.
B) The optimal portfolio will not depend on the investor’s personal tradeoff between risk and return.
C) The volatility of the risk-free investment is zero.
D) Our total volatility is only a fraction of the volatility of the efficient portfolio, based on the amount we invest in the risk free asset.

Answer 15

A

Question 16

Which of the following statements is false?
A) Margin investing is a risky investment strategy.
B) Because our return on the risk-free investments is fixed and does not move with (or against) our portfolio, the correlation between the risk-free investment and the portfolio is always equal to one.
C) Short selling the risk free investment is equivalent to borrowing money at the risk-free interest rate through a standard loan.
D) Margin investing can provide higher expected returns than investing in the efficient portfolio using only the funds we have available.

Answer 16

B

Question 17

Which of the following statements is false?
A) The Sharpe ratio measures the ratio of volatility-to-reward provided by a portfolio.
B) Borrowing money to invest in stocks is referred to as buying stocks on margin.
C) The Sharpe ratio is the number of stand deviations the portfolio’s return would have to fall to under-perform the risk-free investment.
D) The slope of the line through a given portfolio is often referred to as the Sharpe ratio of the portfolio.

Answer 17

A

Question 18

Which of the following statements is false?
A) If we increase the fraction invested in the efficient portfolio beyond 100%m we are short selling the risk-free investment.
B) As we increase the fraction invested in the efficient portfolio, we increase our risk premium but not our risk proportionately.
C) To earn the highest possible expected return for any level of volatility we must find the portfolio that generates the steepest possible line when combined with the risk-free investment.
D) Every investor should invest in the tangent portfolio independent of his or her taste for risk.

Answer 18

B

Question 19

Which of the following statements is false?
A) An investor’s preferences will determine only how much to invest in the tangent or efficient portfolio versus the risk-free investment.
B) Conservative investors will invest a small amount in the tangent or efficient portfolio, choosing a portfolio on the line near the risk-free investment
C) Only aggressive investors will choose to hold the portfolio of risky assets, the tangent or efficient portfolio.
D) Aggressive investors will invest more in the tangent portfolio choosing a portfolio that is near the tangent portfolio or even beyond it by buying stocks on margin.

Answer 19

C

Question 20

The Efficient Portfolio and Required Returns
1) Which of the following statements is false?
A) A portfolio is efficient if it has the highest possible Sharpe ratio; that is it is efficient if it provides the largest increase in expected return possible for a given increase in volatility.
B) The required return for an investment is equal to a risk premium that is equal to the risk premium of the investor’s current portfolio scaled by .
C) Increasing the investment in investment I will increase the Sharpe ratio of portfolio P if its expected return E[Ri] exceeds the required return ri, which is given by ri = rf + × (E[Rp] - rf).
D) If a security i’s expected return is less than the required return ri, we should reduce our holding of security i.

Answer 20

B

Question 21

Which of the following statements is false?
A) Because all other risk is diversifiable, it is an investment’s beta with respect to the efficient portfolio that measures its sensitivity to systematic risk, and therefore determines its cost of capital.
B) If a security’s expected return exceeds its required return given our current portfolio, then we can improve the performance of our portfolio by adding more of the security.
C) The appropriate risk premium for an investment can be determined from its beta with the efficient portfolio.
D) As we buy shares of a security i, its correlation with our portfolio P will increase, ultimately raising its required return until E[Ri] = Rp.

Answer 21

D

Question 22

Which of the following statements is false?
A) Because all investors should hold the 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 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 22

C

Question 23

Which of the following is not an assumption used in deriving the Capital Asset Pricing Model (CAPM)?
A) Investors have homogeneous expectations regarding the volatilities, correlation, and expected returns of securities.
B) Investors have homogeneous risk adverse preferences toward taking on risk.
C) Investors hold only efficient portfolios of traded securities that are portfolios that yield the maximum expected return for the given level of volatility.
D) Investors can buy and sell all securities at competitive market prices without incurring taxes or transactions cost and can borrow and lend at the risk-free interest rate

Answer 23

B

Question 24

Which of the following statements is false?
A) Short-term margin loans from a broker are often 1% to 2% lower than the rates paid on short-term Treasury securities.
B) In the real world investors have different information and expectations regarding securities.
C) The SML is still valid when interest rates differ.
D) When borrowing and lending occur at different rates there are different tangent portfolios

Answer 24

A

Question 25

Which of the following statements is false?
A) A combination of portfolios on the efficient frontier of risky investments is also on the efficient frontier of risky investments.
B) The conclusion of the CAPM that investors should hold the market portfolio combined with the risk-free investment depends on the quality of an investor’s information.
C) The SML holds with some rate r* between rs and rb in place of rf, where r* depends on the proportion of savers and borrowers in the economy.
D) In reality, investors have different information and spend varying amounts of effort on research for assorted stocks.

Answer 25

B

Question 26

Which of the following statements is false?
A) When an investor chooses her optimal portfolio, she will do so by finding the tangent line using the risk-free rate that corresponds to her investment horizon.
B) If the market portfolio is not efficient, savvy investors who recognize that the market portfolio is not optimal will push prices and expected returns back into balance.
C) Even though different investors may research different stocks, their information will not impact the market portfolio since there is no way to share this information with other investors.
D) In the real world borrowers pay higher interest rates than savers receive.

Answer 26

C

Question 27

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 tend to perform will when the rest of the market is doing poorly.

Answer 27

A

Question 28

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 28

B

Question 29

Which of the following statements is false?
A) To improve the performance of their portfolios, investors who are holding the market portfolio will compare the expected return of each security with its required return from the security market line.
B) The Sharpe ratio of a portfolio will increase if we sell stocks with positive alphas.
C) When a stock’s alpha is not zero, investors can improve upon the performance of the market portfolio.
D) When the market portfolio is efficient, all stocks are on the security market line and have an alpha of zero.
Answer: B

Answer 29

B

Question 30

Which of the following statements is false?
A) We can improve the performance of our portfolio by selling stocks with negative alphas.
B) The market portfolio is on the SML, and according to the CAPM, since all other portfolios are inefficient they will not fall on the SML.
C) The difference between a stock’s expected return and its required return according to the security market line is called the stock’s alpha.
D) The risk premium for any security is proportional to its beta with the market.

Answer 30

B

Question 31

Which of the following statements is false?
A) The market portfolio is the efficient portfolio.
B) Many practitioners believe it is sensible to use the CAPM and the security market line as a practical means to estimate a stock’s required return and therefore a firm’s equity cost of capital.
C) If we plot individual securities according to their expected return and beta, the CAPM implies that they should all fall along the CML.
D) As savvy investors attempt to trade to improve their portfolios, they raise the price and lower the expected return of the positive alpha stocks, and they depress the price and raise the expected return of negative alpha stocks, until the stocks are once again on the security market line and the market portfolio is efficient.

Answer 31

C

Question 32

The beta for the market portfolio is closest to:
A) 1
B) 0
C) Unable to answer this question without knowing the markets expected return
D) Unable to answer this question without knowing the markets volatility

Answer 32

A

Question 33

The beta for the risk free investment is closest to:
A) 1
B) 0
C) Unable to answer this question without knowing the risk free rate
D) Unable to answer this question without knowing the markets volatility

Answer 33

B

Question 34

Which of the following statements is false?
A) Investors may have different information regarding expected returns, correlations, and volatilities, but they correctly interpret that information and the information contained in market prices and they adjust their estimates of expected returns in a rational way.
B) Investors may learn different information through their own research and observations, but as long as they understand the differences in information and learn from other investors by observing prices, the CAPM conclusions still stand.
C) Every investor, regardless of how much information he has access to, can guarantee himself an alpha of zero by holding the market portfolio.
D) The CAPM requires making the strong assumption of homogeneous expectations.

Answer 34

D

Question 35

Which of the following statements is false?
A) Because of the higher and uncompensated risk involved, no investor should choose a portfolio with a negative alpha.
B) Because the average portfolio of all investors is the market portfolio, the average alpha for all investors is zero.
C) The market portfolio can be inefficient if a significant number of investors misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha.
D) If no investor earns a positive alpha, then no investor can earn a negative alpha, and the market portfolio must be efficient.

Answer 35

A