Portfolio Management

Question 1

Which of the following is generally the first general step in the portfolio management process?
A) Develop an investment strategy.
B) Write a policy statement.
C) Specify capital market expectations.

Answer 1

B) Write a policy statement.
The policy statement is the foundation of the entire portfolio management process. Here, both risk and return are integrated to determine the investor�s goals and constraints.

Question 2

Which of the following is NOT an assumption of capital market theory?
A) The capital markets are in equilibrium.
B) Investors can lend at the risk-free rate, but borrow at a higher rate.
C) Interest rates never change from period to period.

Answer 2

B) Investors can lend at the risk-free rate, but borrow at a higher rate.
Capital market theory assumes that investors can borrow or lend at the risk-free rate. The other statements are basic assumptions of capital market theory.

Question 3

An investor has a two-stock portfolio (Stocks A and B) with the following characteristics:
 σA = 55%
 σB = 85%
 CovarianceA,B = 0.09
 WA = 70%
 WB = 30%
The variance of the portfolio is closest to:
A) 0.25
B) 0.39
C) 0.54

Answer 3

A was correct!

The formula for the variance of a 2-stock portfolio is:
s2 = [WA2σA2 + WB2σB2 + 2WAWBσAσBrA,B]
Since σAσBrA,B = CovA,B, then
s2 = [(0.72 � 0.552) + (0.32 � 0.852) + (2 � 0.7 � 0.3 � 0.09)] = [0.1482 + 0.0650 + 0.0378] = 0.2511.

Question 4

Which of the following statements about risk and return is NOT correct?
A) Return-only objectives provide a more concise and efficient way to measure performance for investment managers.
B) Return objectives should be considered in conjunction with risk preferences.
C) Return objectives may be stated in dollar amounts.

Answer 4

A was correct!

Return-only objectives may actually lead to unacceptable behavior on the part of investment managers, such as excessive trading (churning) to generate excessive commissions.

Question 5

In the context of the CML, the market portfolio includes:
A) 12-18 stocks needed to provide maximum diversification.
B) the risk-free asset.
C) all existing risky assets.

Answer 5

C) all existing risky assets.
The market portfolio has to contain all the stocks, bonds, and risky assets in existence. Because this portfolio has all risky assets in it, it represents the ultimate or completely diversified portfolio.

Question 6

Which of the following statements about the optimal portfolio is NOT correct? The optimal portfolio:
A) lies at the point of tangency between the efficient frontier and the indifference curve with the highest possible utility.
B) may be different for different investors.
C) is the portfolio that gives the investor the maximum level of return.

Answer 6

C) is the portfolio that gives the investor the maximum level of return.
This statement is incorrect because it does not specify that risk must also be considered.

Question 7

Which of the following statements about risk is NOT correct? Generally, greater:
A) insurance coverage allows for greater risk.
B) existing wealth allows for greater risk.
C) spending needs allows for greater risk.

Answer 7

C) spending needs allows for greater risk.
Greater spending needs usually allow for lower risk because there is a definite need to ensure that the return may adequately fund the spending needs (a fixed cost)

Question 8

Adding a stock to a portfolio will reduce the risk of the portfolio if the correlation coefficient is less than which of the following?
A) 0.00.
B) +1.00.
C) +0.50.

Answer 8

B) +1.00.
Adding any stock that is not perfectly correlated with the portfolio (+1) will reduce the risk of the portfolio.

Question 9

An analyst gathered the following data for Stock A and Stock B:
Time Period/ Stock A Returns/ Stock B Returns
1 10% 15%
2 6% 9%
3 8% 12%

A) 12.
B) 3.
C) 6.

Answer 9

C) 6.
The formula for the covariance for historical data is:
cov1,2 = {Σ[(Rstock A − Mean RA)(Rstock B − Mean RB)]} / (n − 1)
Mean RA = (10 + 6 + 8) / 3 = 8, Mean RB = (15 + 9 + 12) / 3 = 12
Here, cov1,2 = [(10 − 8)(15 − 12) + (6 − 8)(9 − 12) + (8 − 8)(12 − 12)] / 2 = 6

Question 10

The standard deviation of the rates of return is 0.25 for Stock J and 0.30 for Stock K. The covariance between the returns of J and K is 0.025. The correlation of the rates of return between J and K is:
A) 0.33.
B) 0.10.
C) 0.20.

Answer 10

A was correct!

CovJ,K = (rJ,K)(SDJ)(SDK), where r = correlation coefficient and SDx = standard deviation of stock x
Then(rJ,K) = CovJ,K / (SDJ × SDK) = 0.025 / (0.25 × 0.30) = 0.333
This question tested from Session 12, Reading 52, LOS c.

Question 11

The slope of the capital market line (CML) is a measure of the level of:
A) expected return over the level of inflation.
B) excess return per unit of risk.
C) risk over the level of excess return.

Answer 11

B) excess return per unit of risk.

The slope of the CML indicates the excess return (expected return less the risk-free rate) per unit of risk.

Question 12

When the market is in equilibrium:
A) all assets plot on the CML.
B) investors own 100% of the market portfolio.
C) all assets plot on the SML.

Answer 12

C) all assets plot on the SML.

When the market is in equilibrium, expected returns equal required returns. Since this means that all assets are correctly priced, all assets plot on the SML.

By definition, all stocks and portfolios other than the market portfolio fall below the CML. (Only the market portfolio is efficient.

Question 13

What is the risk measure associated with the CML?
A) Standard deviation.
B) Beta.
C) Market risk.

Answer 13

A was correct!

In the context of the CML, the measure of risk (x-axis) is total risk, or standard deviation. Beta (systematic risk) is used to measure risk for the security market line (SML).

Question 14

Which of the following best describes the importance of the policy statement? It:
A) states the standards by which the portfolio’s performance will be judged.
B) outlines the best investments.
C) limits the risks taken by the investor.

Answer 14

A was correct!

The policy statement should state the performance standards by which the portfolio’s performance will be judged and specify the benchmark that represents the investors risk preferences.

Question 15

Which of the following statements about portfolio diversification is CORRECT?
A) The efficient frontier represents individual securities.
B) As the correlation coefficient moves from +1 to zero, the potential for diversification diminishes.
C) When a risk-averse investor is confronted with two investment opportunities having the same expected return, the investor will take the opportunity with the lower risk.

Answer 15

C) When a risk-averse investor is confronted with two investment opportunities having the same expected return, the investor will take the opportunity with the lower risk.

The other statements are false. The lower the correlation coefficient; the greater the potential for diversification. Efficient portfolios lie on the efficient frontier.

Question 16

Which of the following inputs is least likely required for the Markowitz efficient frontier? The:
A) covariation between all securities.
B) level of risk aversion in the market.
C) expected return of all securities.

Answer 16

B) level of risk aversion in the market.

The level of risk aversion in the market is not a required input. The model requires that investors know the expected return and variance of each security as well as the covariance between all securities.

Question 17

In the Markowitz framework, an investor should most appropriately evaluate a potential investment based on its:
A) intrinsic value compared to market value.
B) effect on portfolio risk and return.
C) expected return.

Answer 17

B) effect on portfolio risk and return.

Modern portfolio theory concludes that an investor should evaluate potential investments from a portfolio perspective and consider how the investment will affect the risk and return characteristics of an investors portfolio as a whole.

Question 18

The manager of the Fullen Balanced Fund is putting together a report that breaks out the percentage of the variation in portfolio return that is explained by the target asset allocation, security selection, and tactical variations from the target, respectively. Which of the following sets of numbers was the most likely conclusion for the report?
A) 50%, 25%, 25%.
B) 33%, 33%, 33%.
C) 90%, 6%, 4%.

Answer 18

C) 90%, 6%, 4%.

Several studies support the idea that approximately 90% of the variation in a single portfolios returns can be explained by its target asset allocations, with security selection and tactical variations from the target (market timing) playing a much less significant role. In fact, for actively managed funds, actual portfolio returns are slightly less than those that would have been achieved if the manager strictly maintained the target allocation, thus illustrating the difficultly of improving returns through security selection or market timing

Question 19

Which of the following statements about systematic and unsystematic risk is least accurate?
A) Total risk equals market risk plus firm-specific risk.
B) As an investor increases the number of stocks in a portfolio, the systematic risk will remain constant.
C) The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms in the same industry.

Answer 19

C) The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms in the same industry.

This statement should read, “The unsystematic risk for a specific firm is not similar to the unsystematic risk for other firms in the same industry.” Thus, other terms for this risk are firm-specific, or unique, risk.
Systematic risk is not diversifiable. As an investor increases the number of stocks in a portfolio the unsystematic risk will decrease at a decreasing rate. Total risk equals systematic (market) plus unsystematic (firm-specific) risk

Question 20

The expected rate of return is 2.5 times the 12% expected rate of return from the market. What is the beta if the risk-free rate is 6%?
A) 5.
B) 3.
C) 4.

Answer 20

C) 4.

30 = 6 + β (12 - 6)
24 = 6β
β = 4

Question 21

An analyst has developed the following data for two companies, PNS Manufacturing (PNS) and InCharge Travel (InCharge). PNS has an expected return of 15% and a standard deviation of 18%. InCharge has an expected return of 11% and a standard deviation of 17%. PNS�s correlation with the market is 75%, while InCharge�s correlation with the market is 85%. If the market standard deviation is 22%, which of the following are the betas for PNS and InCharge?

Beta of PNS Beta of InCharge
A) 0.66 0.61

B) 0.92 1.10

C) 0.61 0.66

Answer 21

C) 0.61 0.66

Betai = (si/sM) * rI, M
BetaPNS = (0.18/0.22) *0.75 = 0.6136
BetaInCharge = (0.17/0.22) * 0.85 = 0.6568

Question 22

The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return is 6%, what is the expected return of Stock A?
A) 13.8%.
B) 14.2%.
C) 15.6%.

Answer 22

A) 13.8

RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate
Here,

RRStock = 6 + (12 - 6) × 1.3
= 6 + 7.8 = 13.8%

Question 23

Stock A has a standard deviation of 10.00. Stock B also has a standard deviation of 10.00. If the correlation coefficient between these stocks is - 1.00, what is the covariance between these two stocks?
A) 1.00.
B) -100.00.
C) 0.00.

Answer 23

B) -100.00.

Covariance = correlation coefficient × standard deviationStock 1 × standard deviationStock 2 = (- 1.00)(10.00)(10.00) = - 100.00.

Question 24

As the correlation between the returns of two assets becomes lower, the risk reduction potential becomes:
A) smaller.
B) greater.
C) decreased by the same level.

Answer 24

B) greater

Perfect positive correlation (r = +1) of the returns of two assets offers no risk reduction, whereas perfect negative correlation (r = -1) offers the greatest risk reduction

Question 25

The ratio of a portfolios standard deviation of return to the average standard deviation of the securities in the portfolio is known as the: A) diversification ratio. B) Sharpe ratio. C) relative risk ratio.

Answer 25

A was correct! The diversification ratio is calculated by dividing a portfolios standard deviation of returns by the average standard deviation of returns of the individual securities in the portfolio.

Question 26

The expected rate of return is 1.5 times the 16% expected rate of return from the market. What is the beta if the risk free rate is 8%? A) 3. B) 2. C) 4.

Answer 26

B) 2. 24 = 8 + β (16 − 8) 24 = 8 + 8β 16 = 8β 16 / 8 = β β = 2

Question 27

Brian Nebrik, CFA, meets with a new investment management client. They compose a statement that defines each of their responsibilities concerning this account and choose a benchmark index with which to evaluate the account�s performance. Which of these items should be included in the client�s Investment Policy Statement (IPS)? A) Neither of these items. B) Only one of these items. C) Both of these items.

Answer 27

C) Both of these items. Two of the major components of an IPS should be a statement of the responsibilities of the investment manager and the client, and a performance evaluation benchmark.

Question 28

When preparing a strategic asset allocation, how should asset classes be defined with respect to the correlations of returns among the securities in each asset class? A) Low correlation within asset classes and high correlation between asset classes. B) High correlation within asset classes and low correlation between asset classes. C) Low correlation within asset classes and low correlation between asset classes.

Answer 28

B) High correlation within asset classes and low correlation between asset classes. The portfolio diversification benefits from strategic asset allocation result from low correlations of returns between asset classes. Asset classes should consist of assets with similar characteristics and investment performance, which means correlations within an asset class are relatively high

Question 29

Consider a stock selling for $23 that is expected to increase in price to $27 by the end of the year and pay a $0.50 dividend. If the risk-free rate is 4%, the expected return on the market is 8.5%, and the stock�s beta is 1.9, what is the current valuation of the stock? The stock: A) is correctly valued. B) is overvalued. C) is undervalued.

Answer 29

C) is undervalued. The required return based on systematic risk is computed as: ERstock = Rf + (ERM * Rf) × Betastock, or 0.04 + (0.085 * 0.04) × 1.9 = 0.1255, or 12.6%. The expected return is computed as: (P1 * P0 + D1) / P0, or ($27 * $23 + $0.50) / $23 = 0.1957, or 19.6%. The stock is above the security market line ER > RR, so it is undervalued.

Question 30

Portfolios that represent combinations of the risk-free asset and the market portfolio are plotted on the: A) capital asset pricing line. B) capital market line. C) utility curve.

Answer 30

B) capital market line The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is called the capital market line (CML). Investors at point Rf have 100% of their funds invested in the risk-free asset. Investors at point M have 100% of their funds invested in market portfolio M. Between Rf and M, investors hold both the risk-free asset and portfolio M. To the right of M, investors hold more than 100% of portfolio M. All investors have to do to get the risk and return combination that suits them is to simply vary the proportion of their investment in the risky portfolio M and the risk-free asset.

Question 31

The optimal portfolio is determined by the point of tangency between: A) a line connecting the risk-free rate and the current market return on the efficient frontier. B) the efficient frontier and the individual's utility curve with the highest possible utility. C) the capital allocation line and the investor's utility curve.

Answer 31

B) the efficient frontier and the individual's utility curve with the highest possible utility. The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. The optimal portfolio is the portfolio that gives the investor the greatest possible utility.

Question 32

An investor is evaluating the following possible portfolios. Which of the following portfolios would least likely lie on the efficient frontier? Portfolio /Expected Return/ Standard Deviation A 26% 28% B 23% 34% C 14% 23% D 18% 14% E 11% 8% F 18% 16% A) C, D, and E. B) A, B, and C. C) B, C, and F.

Answer 32

C) B, C, and F. Portfolio B cannot lie on the frontier because its risk is higher than that of Portfolio A's with lower return. Portfolio C cannot lie on the frontier because it has higher risk than Portfolio D with lower return. Portfolio F cannot lie on the frontier cannot lie on the frontier because its risk is higher than Portfolio D.

Question 33

Over the long term, the annual returns and standard deviations of returns for major asset classes have shown: A) a negative relationship. B) a positive relationship. C) no clear relationship.

Answer 33

B) a positive relationship. In most markets and for most asset classes, higher average returns have historically been associated with higher risk (standard deviation of returns).

Question 34

An asset manager�s portfolio had the following annual rates of return: Year Return 20X7 +6% 20X8 -37% 20X9 +27% The manager states that the return for the period is −5.34%. The manager has reported the: A) arithmetic mean return B) holding period return. C) geometric mean return.

Answer 34

C) geometric mean return. Holding period return = (1 + 0.06)(1 − 0.37)(1 + 0.27) − 1 = −15.2% Arithmetic mean return = (6% − 37% + 27%) / 3 = −1.33%.

Question 35

Luis Green is an investor who uses the security market line to determine whether securities are properly valued. He is evaluating the stocks of two companies, Mia Shoes and Video Systems. The stock of Mia Shoes is currently trading at $15 per share, and the stock of Video Systems is currently trading at $18 per share. Green expects the prices of both stocks to increase by $2 in a year. Neither company pays dividends. Mia Shoes has a beta of 0.9 and Video Systems has a beta of (-0.30). If the market return is 15% and the risk-free rate is 8%, which trading strategy will Green employ? Mia Shoes/Video Systems A) Buy Sell B) Buy Buy C) Sell Buy

Answer 35

C) Sell Buy The required return for Mia Shoes is 0.08 + 0.9 � (0.15-0.08) = 14.3%. The forecast return is $2/$15 = 13.3%. The stock is overvalued and the investor should sell it. The required return for Video Systems is 0.08 - 0.3 � (0.15-0.08) = 5.9%. The forecast return is $2/$18 = 11.1%. The stock is undervalued and the investor should buy it.

Question 36

According to capital market theory, which of the following represents the risky portfolio that should be held by all investors who desire to hold risky assets? A) Any point on the efficient frontier and to the left of the point of tangency between the CML and the efficient frontier. B) The point of tangency between the capital market line (CML) and the efficient frontier. C) Any point on the efficient frontier and to the right of the point of tangency between the CML and the efficient frontier.

Answer 36

B) The point of tangency between the capital market line (CML) and the efficient frontier. Capital market theory suggests that all investors should invest in the same portfolio of risky assets, and this portfolio is located at the point of tangency of the CML and the efficient frontier of risky assets. Any point below the CML is suboptimal, and points above the CML are not feasible

Question 37

A measure of how well the returns of two risky assets move together is the: A) covariance. B) standard deviation. C) range.

Answer 37

A was correct! This is a correct description of covariance. A positive covariance means the returns of the two securities move in the same direction.� A negative covariance means that the returns of two securities move in opposite directions.� A zero covariance means there is no relationship between the behaviors of two stocks. The magnitude of the covariance depends on the magnitude of the individual stock�s standard deviations and the relationship between their co-movements.� The covariance is an absolute measure of movement and is measured in return units squared.�

Question 38

Which of the following would be assessed first in a top-down valuation approach? A) Fiscal policy. B) Industry return on equity (ROE). C) Industry risks.

Answer 38

A was correct! In the top-down valuation approach, the investor should analyze macroeconomic influences first, then industry influences, and then company influences. Fiscal policy, as part of the macroeconomic landscape, should be analyzed first.

Question 39

Which of the following is an assumption of capital market theory? All investors: A) select portfolios that lie above the efficient frontier to optimize the risk-return relationship. B) see the same risk/return distribution for a given stock. C) have multiple-period time horizons.

Answer 39

B) see the same risk/return distribution for a given stock. All investors select portfolios that lie along the efficient frontier, based on their utility functions. All investors have the same one-period time horizon, and have the same risk/return expectations.

Question 40

Risk aversion means that if two assets have identical expected returns, an individual will choose the asset with the: A) lower risk level. B) higher standard deviation. C) shorter payback period.

Answer 40

A was correct! Investors are risk averse.� Given a choice between assets with equal rates of expected return, the investor will always select the asset with the lowest level of risk.� This means that there is a positive relationship between expected returns (ER) and expected risk (Es) and the risk return line (capital market line [CML] and security market line [SML]) is upward sloping.

Question 41

Which of the following statements about the efficient frontier is NOT correct? A) The efficient frontier line bends backwards due to less than perfect correlation between assets. B) A portfolio to the left of the efficient frontier is not attainable, while a portfolio to the right of the efficient frontier is inefficient. C) The slope of the efficient frontier increases steadily as one moves up the curve.

Answer 41

C) The slope of the efficient frontier increases steadily as one moves up the curve. This statement should read, "The slope of the efficient frontier decreases steadily as one moves up the curve." The other statements are true.

Question 42

Given the following data, what is the correlation coefficient between the two stocks and the Beta of stock A? - standard deviation of returns of Stock A is 10.04% - standard deviation of returns of Stock B is 2.05% - standard deviation of the market is 3.01% - covariance between the two stocks is 0.00109 - covariance between the market and stock A is 0.002 Correlation Coefficient/ Beta (stock A) A) 0.5296 2.20 B) 0.6556 2.20 C) 0.5296 0.06

Answer 42

A was correct! correlation coefficient = 0.00109 / (0.0205)(0.1004) = 0.5296. beta of stock A = covariance between stock and the market / variance of the market Beta = 0.002 / 0.03012 = 2.2

Question 43

Which of the following statements is NOT consistent with the assumption that individuals are risk averse with their investment portfolios? A) Higher betas are associated with higher expected returns. B) There is a positive relationship between expected returns and expected risk. C) Many individuals purchase lottery tickets.

Answer 43

C) Many individuals purchase lottery tickets. Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk and the risk return line (capital market line [CML] and security market line [SML]) is upward sweeping. However, investors can be risk averse in one area and not others, as evidenced by their purchase of lottery tickets.

Question 44

Which of the following should least likely be included as a constraint in an investment policy statement (IPS)? A) Constraints put on investment activities by regulatory agencies. B) Any unique needs or preferences an investor may have. C) How funds are spent after being withdrawn from the portfolio.

Answer 44

C) How funds are spent after being withdrawn from the portfolio. How funds are spent after withdrawal would not be a constraint of an IPS

Question 45

If the standard deviation of returns for stock A is 0.60 and for stock B is 0.40 and the covariance between the returns of the two stocks is 0.009 what is the correlation between stocks A and B? A) 0.0020. B) 0.0375. C) 26.6670.

Answer 45

B) 0.0375. CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x Then,�(rA,B) = CovA,B / (SDA � SDB) = 0.009 / (0.600 � 0.400) = 0.0375

Question 46

What is the variance of a two-stock portfolio if 15% is invested in stock A (variance of 0.0071) and 85% in stock B (variance of 0.0008) and the correlation coefficient between the stocks is �0.04? A) 0.0020. B) 0.0026. C) 0.0007.

Answer 46

C) 0.0007. The variance of the portfolio is found by: [W12 σ12 + W22 σ22 + 2W1W2σ1σ2r1,2], or [(0.15)2(0.0071) + (0.85)2(0.0008) + (2)(0.15)(0.85)(0.0843)(0.0283)(�0.04)] = 0.0007.

Question 47

Assets A (with a variance of 0.25) and B (with a variance of 0.40) are perfectly positively correlated. If an investor creates a portfolio using only these two assets with 40% invested in A, the portfolio standard deviation is closest to: A) 0.3742. B) 0.3400. C) 0.5795.

Answer 47

C) 0.5795. The portfolio standard deviation = [(0.4)2(0.25) + (0.6)2(0.4) + 2(0.4)(0.6)1(0.25)0.5(0.4)0.5]0.5 = 0.5795

Question 48

Betsy Minor is considering the diversification benefits of a two stock portfolio. The expected return of stock A is 14 percent with a standard deviation of 18 percent and the expected return of stock B is 18 percent with a standard deviation of 24 percent. Minor intends to invest 40 percent of her money in stock A, and 60 percent in stock B. The correlation coefficient between the two stocks is 0.6. What is the variance and standard deviation of the two stock portfolio? A) Variance = 0.03836; Standard Deviation = 19.59%. B) Variance = 0.02206; Standard Deviation = 14.85%. C) Variance = 0.04666; Standard Deviation = 21.60%.

Answer 48

A was correct! (0.40)2(0.18)2 + (0.60)2(0.24)2 + 2(0.4)(0.6)(0.18)(0.24)(0.6) = 0.03836. 0.038360.5 = 0.1959 or 19.59%.

Question 49

Which one of the following portfolios cannot lie on the efficient frontier? Portfolio/ Expected Return/ Standard Deviation A 20% 35% B 11% 13% C 8% 10% D 8% 9% A) Portfolio D. B) Portfolio A. C) Portfolio C.

Answer 49

C) Portfolio C. Portfolio C cannot lie on the frontier because it has the same return as Portfolio D, but has more risk.

Question 50

The expected rate of return is twice the 12% expected rate of return from the market. What is the beta if the risk-free rate is 6%? A) 2. B) 4. C) 3.

Answer 50

C) 3 24 = 6 + β (12 − 6) 18 = 6β β = 3

Question 51

Based on Capital Market Theory, an investor should choose the: A) portfolio with the highest return on the Capital Market Line. B) portfolio that maximizes his utility on the Capital Market Line. C) market portfolio on the Capital Market Line.

Answer 51

B) portfolio that maximizes his utility on the Capital Market Line. Given the Capital Market Line, the investor chooses the portfolio that maximizes his utility. That portfolio may be exactly the market portfolio or it may be some combination of the risk-free asset and the market portfolio

Question 52

For an investor to move further up the Capital Market Line than the market portfolio, the investor must: A) diversify the portfolio even more. B) reduce the portfolio's risk below that of the market. C) borrow and invest in the market portfolio.

Answer 52

C) borrow and invest in the market portfolio. Portfolios that lie to the right of the market portfolio on the capital market line ("up" the capital market line) are created by borrowing funds to own more than 100% of the market portfolio (M). The statement, "diversify the portfolio even more" is incorrect because the market portfolio is fully diversified.

Question 53

All portfolios on the capital market line are: A) unrelated except that they all contain the risk-free asset. B) distinct from each other. C) perfectly positively correlated.

Answer 53

C) perfectly positively correlated. The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is called the capital market line (CML). Since the line is straight, the math implies that any two assets falling on this line will be perfectly, positively correlated with each other. Note: When ra,b = 1, then the equation for risk changes to sport = WAsA + WBsB, which is a straight line.

Question 54

what is the expected return of the market? A) +3.0%. B) +3.5%. C) -1.0%.

Answer 54

C) -1.0%. RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate A bit of algebraic manipulation results in: RMarket = [RRStock − Rf − (BetaStock × Rf)] / BetaStock = [8 − 5 − (-0.5 × 5)] / -0.5 = 0.5 / -0.5 = -1%

Question 55

Which of the following statements regarding the covariance of rates of return is least accurate? A) It is a measure of the degree to which two variables move together over time. B) If the covariance is negative, the rates of return on two investments will always move in different directions relative to their means. C) It is not a very useful measure of the strength of the relationship, there is absent information about the volatility of the two variables.

Answer 55

B) If the covariance is negative, the rates of return on two investments will always move in different directions relative to their means. Negative covariance means rates of return will tend to move in opposite directions on average. For the returns to always move in opposite directions, they would have to be perfectly negatively correlated. Negative covariance by itself does not imply anything about the strength of the negative correlation

Question 56

Given the following information, what is the required rate of return on Bin Co? - inflation premium = 3% - real risk-free rate = 2% - Bin Co. beta = 1.3 - market risk premium = 4% A) 7.6%. B) 10.2%. C) 16.7%.

Answer 56

B) 10.2%. Use the capital asset pricing model (CAPM) to find the required rate of return. The approximate risk-free rate of interest is 5% (2% real risk-free rate + 3% inflation premium).

Question 57

An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by how much (expressed as percentage return). The analyst gathers the following information on the stock: - Market standard deviation = 0.70 - Covariance of Dover with the market = 0.85 - Dovers current stock price (P0) = $35.00 - The expected price in one year (P1) is $39.00 - Expected annual dividend = $1.50 - 3-month Treasury bill yield = 4.50%. - Historical average S&P 500 return = 12.0%. Dover Holdings stock is: A) undervalued by approximately 2.1%. B) overvalued by approximately 1.8%. C) undervalued by approximately 1.8%.

Answer 57

B) overvalued by approximately 1.8%. To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).

Question 58

In the context of the capital market line (CML), which of the following statements is CORRECT? A) The two classes of risk are market risk and systematic risk. B) Firm-specific risk can be reduced through diversification. C) Market risk can be reduced through diversification.

Answer 58

B) Firm-specific risk can be reduced through diversification. The other statements are false. Market risk cannot be reduced through diversification; market risk = systematic risk. The two classes of risk are unsystematic risk and systematic risk