Chapter 07 Flashcards by Matt Mitchell

Market risk is also referred to as

systematic risk, nondiversifiable risk

How well did you know this?

Not at all

Perfectly

Systematic risk is also referred to as

market risk, nondiversifiable risk

How well did you know this?

Not at all

Perfectly

Nondiversifiable risk is also referred to as

systematic risk, market risk

How well did you know this?

Not at all

Perfectly

Diversifiable risk is also referred to as

unique risk, firm-specific risk

How well did you know this?

Not at all

Perfectly

Unique risk is also referred to ask

diversifiable risk, firm-specific risk

How well did you know this?

Not at all

Perfectly

Firm-specific risk is also referred to as

diversifiable risk, unique risk

How well did you know this?

Not at all

Perfectly

Nonsystematic risk is also referred to as

diversifiable risk, unique risk

How well did you know this?

Not at all

Perfectly

The risk that can be diversified away is

firm specific risk

How well did you know this?

Not at all

Perfectly

The risk that cannot be diversified away is

market risk

How well did you know this?

Not at all

Perfectly

The variance of a portfolio of risk securities

is the weighted sum of the securities’ variances and covariances

How well did you know this?

Not at all

Perfectly

The standard deviation of a portfolio of risky securities is

the square root of the weighted sum of the securities’ variances and covariances

How well did you know this?

Not at all

Perfectly

The expected return of a portfolio of risky securities

is a weighted average of the securities’ returns

How well did you know this?

Not at all

Perfectly

Other things equal, diversification is most effective when

securities’ returns are negatively correlated

How well did you know this?

Not at all

Perfectly

The efficient frontier of risky assets is

the proportion of the investment opportunity set that lies above the global minimum variance portfolio

How well did you know this?

Not at all

Perfectly

The capital allocation line provided by a risk-free security and N risky securities is

the line tangent to the efficient frontier of risky securities drawn the from the risk-free rate

How well did you know this?

Not at all

Perfectly

Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum variance portfolio has a standard deviation that is always

equal to zero

How well did you know this?

Not at all

Perfectly

Which of the following statement(s) are true regarding the variance of a portfolio of two risky securities?

I) The higher the coefficient of correlation between securities, the greater the reduction in the portfolio variance.
II) There is a linear relationship between the securities’ coefficient of correlation and the portfolio variance
III) The degree to which the portfolio variance is reduced depends on the degree of correlation between securities

III only

How well did you know this?

Not at all

Perfectly

Which of the following statement(s) are false regarding the variance of a portfolio of two risky securities?

I and II

How well did you know this?

Not at all

Perfectly

Efficient portfolios of N risky securities are portfolios that

have the highest rates of return for a given level of risk

How well did you know this?

Not at all

Perfectly

Which of the following statement(s) is(are) true regarding the selection of a portfolio from those that lie on the capital allocation line?

I) Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors
II) More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors
III) Investors choose the portfolio that maximises their expected utility

II and III

How well did you know this?

Not at all

Perfectly

Which of the following statement(s) is(are) false regarding the selection of a portfolio from those that lie on the capital allocation line?

I only

How well did you know this?

Not at all

Perfectly

Consider the following probability distribution for stocks A and B:

State - Probability - Return on Stock A - Return on Stock B
1 - 0.10 - 10% - 8%
2 - 0.20 - 13% - 7%
3 - 0.20 - 12% - 6%
4 - 0.30 - 14% - 9%
5 - 0.20 - 15% - 8%

The expected rates of return of stocks A and B are … and …, respectively.

13.2%; 7.7%

How well did you know this?

Not at all

Perfectly

Consider the following probability distribution for stocks A and B:

State - Probability - Return on Stock A - Return on Stock B
1 - 0.10 - 10% - 8%
2 - 0.20 - 13% - 7%
3 - 0.20 - 12% - 6%
4 - 0.30 - 14% - 9%
5 - 0.20 - 15% - 8%
The standard deviation of stocks A and B are … and …, respecitvely

1.5%; 1.1%

How well did you know this?

Not at all

Perfectly

Consider the following probability distribution for stocks A and B:

State - Probability - Return on Stock A - Return on Stock B
1 - 0.10 - 10% - 8%
2 - 0.20 - 13% - 7%
3 - 0.20 - 12% - 6%
4 - 0.30 - 14% - 9%
5 - 0.20 - 15% - 8%

The variances of stocks A and B are … and …, respectively

2.2%; 1.2%

How well did you know this?

Not at all

Perfectly

0.46 covA,B = 0.1(10-13.2)(8-7.7) + 0.2(13-13.2)(7-7.7) + 0.2(12-13.2)(6-7.7) + 0.3(14-13.2)(9-7.7) + 0.2(15-13.2)(8-7.7) = 0.76; rA,B = 0.76 / [(1.1)(1.5)] = 0.46

Consider the following probability distribution for stocks A and B: State - Probability - Return on Stock A - Return on Stock B 1 - 0.10 - 10% - 8% 2 - 0.20 - 13% - 7% 3 - 0.20 - 12% - 6% 4 - 0.30 - 14% - 9% 5 - 0.20 - 15% - 8% If you invest 40% of your money in A and 60% in B, what would be your portfolio\s expected rate of return and standard deviation?

9.9%; 1.1% E(R) = 0.4(13.2) + 0.6(7.7) SD = [(0.4)^2(1.5)^2 + (0.6)^2(1.1)^2 + 2(0.4)(0.6)(1.5)(1.1)(0.46)]^0.5

0.23; 0.77 W.A = [(1.1)^2-(1.5)(1.1)(0.46)]/(1.5)^2+(1.1)^2-2(1.5)(1.1)(0.46)] = 0.23 W.B = 1 - 0.23 = 0.77

Consider the following probability distribution for stocks A and B: State - Probability - Return on Stock A - Return on Stock B 1 - 0.10 - 10% - 8% 2 - 0.20 - 13% - 7% 3 - 0.20 - 12% - 6% 4 - 0.30 - 14% - 9% 5 - 0.20 - 15% - 8% The expected rate of return and standard deviation of the global minimum variance portfolio, G, are ... and ..., respectively.

8.97%; 1.05% E(R) = 0.23(13.2) + 0.77(7.7) SD = [(0.23)^2(1.5)^2 + (0.77)^2(1.1)^2 + 2(0.23)(0.77)(1.5)(0.46)]^0.5 v= 1.05%

Consider the following probability distribution for stocks A and B: State - Probability - Return on Stock A - Return on Stock B 1 - 0.10 - 10% - 8% 2 - 0.20 - 13% - 7% 3 - 0.20 - 12% - 6% 4 - 0.30 - 14% - 9% 5 - 0.20 - 15% - 8% Which of the following portfolio(s) is (are) on the efficient frontier? A. The portfolio with 20% in A and 80% in B B. The portfolio with 15% in A and 85% in B C. The portfolio with 26% in A and 74% in B. D. The portfolio wi9th 10% in A and 90% in B. E. A and B are both on the efficient frontier

C. Portfolio with 26% in A and 74% in B It has the greatest mean-variance criterion

Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 10% and a standard deviation of 16%. B has an expected rate of return of 8% and a standard deviation of 12%. The weights of A and B in the global minimum variance portfolio are ... and ..., respectively.

0.43; 0.57 W.A = 12/(16+12) W.B = 1-0.4286

Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 10% and a standard deviation of 16%. B has an expected rate of return of 8% and a standard deviation of 12%. The risk-free portfolio that can be formed with the two securities will earn _____ rate of return. Weights in global minimum variance portfolio are 0.43 and 0.57

8.9% E(R) = 0.43(10%) + 0.57(8%)

Given an optimal risky portfolio with expected return of 6% and standard deviation of 23% and a risk free rate of 3%, what is the slope of the best feasible CAL?

0.13 (6-3)/23

An investor who wishes to form a portfolio that lies to the right of the optimal risky portfolio on the capital allocation line must

borrow some money at the risk-free rate and invest in the optimal risky portfolio and invest only in risky securities

Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz? Portfolio - Expected Return - SD W - 9% - 21% X - 5% - 7% Y - 15% - 36% Z - 12% - 15%

Only portfolio W cannot lie on the efficient frontier. It lies below the efficient frontier. It has a higher SD than Z with a lower expected return

Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz? Portfolio - Expected Return - SD A - 10% - 12% B - 5% - 7% C - 15% - 20% D - 12% - 25%

Only portfolio D cannot lie on the efficient frontier. Only D lies below the efficient frontier. It has a higher standard deviation than C with a lower expected return.

Portfolio theory as described by Markowitz is most concerned with

the effect of diversification on portfolio risk

The measure of risk in a Markowitz efficient frontier is

standard deviation of returns

A statistic that measures how the returns of two risky assets move together is

covariance and correlation

The unsystematic risk of a specific security

results from factors unique to the firm

Which statement about portfolio diversification is correct?

Typically, as more securities are added to a portfolio, total risk would be expected to decrease at a decreasing rate.

The individual investor's optimal portfolio is designated by

The point of tangency with the indifference curve and the capital allocation line

For a two-stock portfolio, what would be the preferred correlation coefficient between the two stocks?

-1.00 Maximises diversification benefits

In a two-security minimum variance portfolio where the correlation between securities is greater than -1.0

the security with the higher standard deviation will be weighted less heavily

Which of the following is not a source of systematic risk?

Personnel changes

The global minimum variance portfolio formed from two risky securities will be diskless when the correlation coefficient between the two securities is

-1.0

Security X has expected return of 12% and standard deviation of 18%. Security Y has expected return of 15% and standard deviation of 26%. If the two securities have a correlation coefficient of 0.7, what is their covariance?

0.033 Cov = (0.7)(0.18)(0.26)

When two risky securities that are positively correlated but not perfectly correlated are held in a portfolio,

the portfolio standard deviation will be less than the weighted average of the individual security standard deviations

The line representing all combinations of portfolio expected returns and standard deviation that can be constructed from two available assets is called the

portfolio opportunity set

Given an optimal risky portfolio with expected return of 12% and standard deviation of 26% and a risk free rate of 5%, what is the slope of the best feasible CAL?

0.27 (12-5)/26

Given an optimal risky portfolio with expected return of 20% and standard deviation of 24% and a risk free rate of 7%, what is the slope of the best feasible CAL?

0.54 (20-7)/24

The risk that can be diversified away in a portfolio is referred to as ... I) diversifiable risk II) unique risk III) systematic risk IV) firm-specific risk

I, II and IV

As the number of securities in a portfolio is increased, what happens to the average portfolio standard deviation?

It decreases at a decreasing rate

In words, the covariance considers the probability of each scenario happening and the interaction between

securities' returns relative to their mean returns

The standard deviation of a two-asset portfolio is a linear function of the assets' weights when

the assets have a correlation coefficient equal to one

A two-asset portfolio with a standard deviation of zero can be formed when

the assets have a correlation coefficient equal to negative one

When borrowing and lending at a risk-free rate are allowed, which capital allocation line (CAL) should the investor choose to combine with the efficient frontier? I) The one with the highest reward-to-volatility ratio II) The one that will maximise his utility III) The one with the steepest slope IV) The one with the lowest slope

I, II and III

Given an optimal risky portfolio with expected return of 13% and standard deviation of 26% and a risk free rate of 5%, what is the slope of the best feasible CAL?

0.31 (13-5)/26

The separation property refers to the conclusion that

the determination of the best risky portfolio is objective and the choice of the best complete portfolio is subjective

Consider the following probability distribution for stocks A and B: State - Probability - Return on Stock A - Return on Stock B 1 - 0.15 - 8% - 8% 2 - 0.20 - 113% - 7% 3 - 0.15 - 12% - 6% 4 - 0.30 - 14% - 9% 5 - 0.20 - 16% - 11% The expected rates of return on stocks A and B are ... and ..., respectively.

13%; 8.4%

Consider the following probability distribution for stocks A and B: State - Probability - Return on Stock A - Return on Stock B 1 - 0.15 - 8% - 8% 2 - 0.20 - 113% - 7% 3 - 0.15 - 12% - 6% 4 - 0.30 - 14% - 9% 5 - 0.20 - 16% - 11% The standard deviation of stocks A and B are ... and ..., respectively.

2.45%; 1.66%

0.590 Cov = 0.15(8-13)(8-8.4) + 0.2(13-13)(7-8.4) + 0.15(12-13)(6-8.4) + 0.3(14-13)(9-8.4) + 0.2(16-13)(11-8.4) = 2.40 2.40 / [(2.45)(1.66)] = 0.590

Consider the following probability distribution for stocks A and B: State - Probability - Return on Stock A - Return on Stock B 1 - 0.15 - 8% - 8% 2 - 0.20 - 113% - 7% 3 - 0.15 - 12% - 6% 4 - 0.30 - 14% - 9% 5 - 0.20 - 16% - 11% If you invest 35% of your money in A and 65% in B, what would be your portfolio's expected rate of return and standard deviation?

10%; 1.7% E(R) = 0.35(13%) + 0.65(8.4) = 10.01 SD = [(0.35)^2(2.45%)^2+(0.65)^2(1.66)^2 + 2(0.35)(0.65)(2.45)(0.590)]^0.5 = 1.7%

Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 12% and a standard deviation of 17%. B has an expected rate of return of 9% and a standard deviation of 14%. The weights of A and B in the global minimum variance portfolio are ... and ..., respectively.

0.45; 0.55 W.A = 14/(17+14) = 0.45 W.B = 1-0.45

Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 12% and a standard deviation of 17%. B has an expected rate of return of 9% and a standard deviation of 14%. The risk-free portfolio that can be formed with the two securities will earn ... rate of return.

10.4% E(R) = 0.45(12%) + 0.55(9%) = 10.35%

Security X has expected return of 14% and standard deviation of 22%. Security Y has expected return of 16% and standard deviation of 28%. If the two securities have a correlation coefficient of 90.8, what is their covariance?

0.049 Cov = (0.8)(0.22)(0.28)

Given an optimal risky portfolio with expected return of 16% and standard deviation of 20% and a risk-free rate of 4%. What is the slope of the best feasible CAL?

0.60 (16-4)/20

Given an optimal risky portfolio with expected return of 12% and standard deviation of 26% and a risk free rate of 3%, what is the slope of the best feasible CAL?

0.35 (12-3)/26

Consider the following probability distribution for stocks C and D: State - Probability - Return on Stock C - Return on Stock D 1 - 0.30 - 7% - -9% 2 - 0.50 - 11% - 14% 3 - 0.20 - -16% - 26% The expected rates of return of stocks C and D are ... and ... respectively.

4.4% and 9.5%

Consider the following probability distribution for stocks C and D: State - Probability - Return on Stock C - Return on Stock D 1 - 0.30 - 7% - -9% 2 - 0.50 - 11% - 14% 3 - 0.20 - -16% - 26% The standard deviation of stocks C and D are ... and ..., respectively.

10.35% and 12.93%

-0.50 CovC,D = 0.30(7% - 4.4%)(-9% - 9.5%) + 0.50(11% - 4.4%)(14% - 9.5%) + 0.20(-16% - 4.4%)(26% - 9.5%) = -66.9; ρA,B = -66.90/[(10.35)(12.93)] = -0.50.

Consider the following probability distribution for stocks C and D: State - Probability - Return on Stock C - Return on Stock D 1 - 0.30 - 7% - -9% 2 - 0.50 - 11% - 14% 3 - 0.20 - -16% - 26% If you invest 25% of your money in C and 75% in D, what would be your portfolio's expected rate of return and standard deviation?

8.225% and 8.70% E(R.P) = 0.25(4.4%) + 0.75(9.5%) = 8.225%; s.P = [(0.25)2(10.35)2 + (0.75)2(12.93)2 + 2(0.25)(0.75)(10.35)(12.93)(-0.50)]1/2 = 8.70%.

Consider two perfectly negatively correlated risky securities, K and L. K has an expected rate of return of 13% and a standard deviation of 19%. L has an expected rate of return of 10% and a standard deviation of 16%. The weights of K and L in the global minimum variance portfolio are _____ and _____, respectively.

0.46; 0.54 w.K = 1 - 0.54 = 0.46 w.L = 19/(19+16)

Consider two perfectly negatively correlated risky securities, K and L. K has an expected rate of return of 13% and a standard deviation of 19%. L has an expected rate of return of 10% and a standard deviation of 16%. The risk-free portfolio that can be formed with the two securities will earn ... rate of return

11.4% E(R) = 0.46(13%) + 0.54(10%) = 11.38%

Security M has expected return of 17% and standard deviation of 32%. Security S has expected return of 13% and standard deviation of 19%. If the two securities have a correlation coefficient of 0.78, what is their covariance?

0.047 Cov = (0.78)(0.32)(0.19)

Security X has expected return of 7% and standard deviation of 14%. Security Y has expected return of 11% and standard deviation of 22%. If the two securities have a correlation coefficient of -0.45, what is their covariance?

-0.0139 Cov = (-0.45)(0.14)(0.22)