Possible mid-term questions – chapters 1 to 8.

6. Underlying all investments is the tradeoff between:

a. expected return and actual return
b. low risk and high risk
c. actual return and high risk
d. expected return and risk

7. Most investors are risk averse which means:

a. they will assume more more only if they are compensated by higher
expected return.
b. they will always invest in the investment with the lowest possible risk.
c. they actively seek to minimize their risks.
d. they avoid the stock market due to the high degree of risk.

18. Investment decision making traditionally consists of two steps:

a. investment banking and security analysis
b. buying and selling
c. risk and expected return.
d. security analysis and portfolio management

22. Emerging markets are often characterized as:

a. low risk, low return markets.
b. low risk, high return markets.
c. high risk, low return markets.
d. high risk, high return markets.

6. Bonds trade on an accrual interest basis. This means an investor:

a. can sell a bond at any time without losing the interest that has accrued.
b. can buy a bond at any time and gain the interest accrued from the time of
the last payment.
c. can sell a bond at any time and retain the interest portion of the bond.
d. buy a bond at any time and receive an immediate interest check.

22. Interest on bonds is typically paid:

a. monthly
b. quarterly
c. semiannually
d. annually

4. An impending recession is an example of:

a. interest rate risk
b. inflation risk
c. market risk
d. financial risk
9. A major difference between real and nominal returns is that:
a. real returns adjust for inflation and nominal returns do not.
b. real returns use actual cashflows and nominal returns use expected
cashflows
c. real returns adjust for commissions and nominal returns do not.
d. real returns show the highest possible return and nominal returns show the
lowest possible return.

15. The equity risk premium is:

a. the difference between stocks and bonds
b. the difference between high-grade stocks and low-grade stocks.
c. the difference between stocks and the risk-free rate.
d. the difference between a stock market index and the inflation rate.

17. Systematic risk is also known as:

a. non-market risk.
b. event risk.
c. nondiversifiable risk.
d. issuer risk.

26. If interest rates rose, you would expect ------------ to also rise.
a. business risk.
b. financial risk.
c. liquidity risk.
d. inflation risk.

2. Portfolio weights are found by:

a. dividing standard deviation by expected value.
b. calculating the percentage each asset is to the total portfolio value.
c. calculating the return of each asset to total portfolio return.
d. dividing expected value by the standard deviation

3. Which of the following statements regarding expected return of a portfolio

is true?
a. It can be higher than the weighted average expected return of individual
assets.
b. It can be lower than the weighted average return of the individual assets.
c. It can never be higher or lower than the weighted average expected return
of individual assets.
d. Expected return of a portfolio is impossible to calculate.
4. In order to determine the expected return of a portfolio, all of the
following must be known except:
a. probabilities of expected returns of individual assets.
b. weight of each individual asset to total portfolio value.
c. expected return of each individual asset.
d. All of the above must be known in order to determine the expected return
of a portfolio.

6. Which of the following statements regarding the correlation coefficient is

not true?
a. It is a statistical measure.
b. It measure the relationship between two securities’ returns.
c. It determines the causes of the relationship between two securities’ returns.
d. All of the above are true.

8. Security A and Security B have a correlation coefficient of 0. If Security

A’s return is expected to increase by 10 percent,
a. Security B’s return should also increase by 10 percent.
b. Security B’s return should decrease by 10 percent.
c. Security B’s return should be zero.
d. Security B’s return is impossible to determine from the above information.

10. The major difference between the correlation coefficient and the
covariance is that:
a. the correlation coefficient can be positive, negative or zero while the
covariance is always positive.
b. the correlation coefficient measures relationship between securities and
the covariance measures relationships between a security and the market.
c. the correlation coefficient is a relative measure showing association between
security returns and the covariance is an absolute measure showing association
between security returns.
d. the correlation coefficient is a geometric measure and the covariance is a
statistical measure.

12. Portfolios having the smallest portfolio risk at some level of expected
return or having the highest expected return at some level of risk are
called:
a. risk-free portfolios.
b. high-return portfolios.
c. dominated portfolios.
d. efficient portfolios.
13. Under Markowitz analysis, the only variable that can be manipulated are
the:
a. expected returns
b. portfolio weights
c. standard deviations
d. correlation coefficients

14. Which of the following statements regarding portfolio risk and number of
stocks is generally true?
a. Adding more stocks increases risk.
b. Adding more stocks decreases risk but does not eliminate it.
c. Adding more stocks has no effect on risk.
d. Adding more stocks increases only systematic risk.

16. When returns are perfectly positively correlated, the risk of the portfolio
is:
a. zero.
b. the weighted average of the individual securities risk.
c. equal to the correlation coefficient between the securities.
d. infinite.

8. According to Markowitz, an efficient portfolio is one that has the

a. largest expected return for the smallest level of risk.
b. largest expected return and zero risk.
c. largest expected return for a given level of risk.
d. smallest level of risk.

10. Portfolios lying on the upper right portion of the efficient frontier are
likely to be chosen by
a. aggressive investors.
b. conservative investors.
c. risk-averse investors.
d. defensive investors.

17. Choose the portfolio from the following set that is NOT on the efficient
frontier.
a. A: expected return of 10 percent ; standard deviation of 8 percent.
b. B: expected return of 18 percent; standard deviation of 13 percent
c. C: expected return of 38 percent; standard deviation of 38 percent.
d. D: expected return of 15 percent; standard deviation of 14 percent.
23. Based on recent research, approximately _______ securities are needed to
ensure adequate diversification.
a. 8
b. 30
c. 70
d. 100

4. Which of the following regarding investors and the CAPM is true?

a. Investors recognize that all the assumptions of the CAPM are unrealistic.
b. Investors recognize that all of the CAPM assumptions are not unrealistic.
c. Investors are not aware of the assumptions of the CAPM model.
d. Investors recognize the CAPM is useless for individual investors.

6. What does it mean when the CAPM is called "robust?"

a. The CAPM requires no assumptions.
b. Even if most of the assumptions of the CAPM are relaxed, most of the
conclusions will still hold.
c. The CAPM is based on realistic assumptions.
d. No other model can represent stock returns better than the CAPM.

9. Which of the following statements about the difference between the SML
and the CML is TRUE? The
a. intercept of the CML is the origin while the intercept of the SML is RF.
b. CML consists of efficient portfolios, while the SML is concerned with all
portfolios or securities.
c. CML could be downward sloping while that is impossible for the SML.
d. CML and the SML are essentially the same except in terms of the
securities represented.

12. The separation theorem states that:

a. systematic risk is separate from unsystematic risk.
b. individual security risk is separate from portfolio risk.
c. the investment decision is separate from the financing decision.
d. borrowing portfolio is separate from the lending portfolio.

14. Select the correct statement regarding the market portfolio. It

a. is readily and precisely observable.
b. should include all risky assets.
c. is the lowest point of tangency between the risk-free rate and the efficient
frontier.
d. should be composed of stocks or bonds.
16. The slope of the CML is the:
a. standard deviation
b. market price of risk
c. risk-free rate
d. risk premium for the market portfolio

20. The _________ is a plot of __________.

a. CML . . . individual stocks and efficient portfolios
b. CML . . . both efficient and inefficient portfolios, only
c. SML . . . individual securities and efficient portfolios
d. SML . . . individual securities, inefficient portfolios, and efficient
portfolios.

27. If a certain stock has a beta greater than 1.0, it means that
a. the stock's return is more volatile than that of the market portfolio.
b. an investor can eliminate the risk by combining it with another stock that
has a negative beta.
c. an investor will earn a higher return on his stock than that on the market
portfolio.
d. the stock is less risky than the market portfolio.
13. In an efficient market, prices of securities reflect their economic value.
(T, moderate, p. 12)

12. The return on a zero-coupon bond is derived from the difference between
the price paid and par value.
(T, difficult, p. 30)

13. The deeper the discount on a zero-coupon bond, the lower the effective
return.
(F, moderate, p. 30)

14. If a bond has a coupon greater than the current market yield, it is selling at
a premium.
(T, difficult, p. 30)

16. More callable bonds would likely be called in if interest rates rose.
(F, moderate, p. 31)

20. Bond ratings are primarily used to assess interest rate risk.
(F, moderate, p. 35)

4. It would be expected that most security prices would fall if interest rates
rose.
(T, moderate, p. 143)

8. Under the Markowitz model, the risk of a portfolio is measured by the

standard deviation .
(T, moderate, p. 201)
Briefly explain the difference between expected returns and realized
returns and between ex ante returns an ex post returns.
Answer: Expected returns are mean returns based on probability distributions
dealing with the future. Realized returns are the returns that actually
occurred in the past. Ex ante returns are in the future. Ex post returns are
in the past.

Are T-bills totally risk-free? Explain.

Answer: No. T-bills are assumed free of default risk since the U.S. government
has always paid its debts. But T-bills are still subject to interest rate and inflation risk
since their prices may fluctuate if interest rates or inflation
changes.

Considering the Efficient Market Hypothesis, how does new economic

information affect securities’ prices?
Answer: The price adjusts quickly as new economic information is received and
is assessed by the market.

1. What are two other names for systematic risk? For unsystematic risk?
Answer: Systematic risk is also called market risk and nondiversifiable risk.
Unsystematic is also called specific risk and diversifiable risk.

8. Why do U. S. Treasury bills have a standard deviation in Table 6-5 if they

are considered to be risk-free?
Answer: Treasury bills are considered to be free of default risk. There is a
little interest rate risk if they are sold before maturity. Over the 70-year
time period in the table the returns varied from year-to-year, even if held
to maturity. Thus, there is a standard deviation of returns over the period.

1. Are the expected returns and standard deviation of a portfolio both

weighted averages of the individual securities expected returns and
standard deviations? If not, what other factors are required?
Answer: The expected return is a weighted average. The portfolio standard
deviation is not a weighted average but also requires correlation
coefficients among the securities.

4. Give an example of two industries that might exhibit low correlation of

returns. Give an example that might exhibit high correlation.
Answer: Low correlation might be found between large appliances and
retail food markets in that retail food is somewhat steady through
economic ups and downs, while appliances tend to fall off during
economic slow downs. High correlation might be found between auto
manufacturers and steel manufacturers.
8. What does a security’s beta measure in the market model? How is
the portfolio’s beta related to the individual securities’ betas?
Answer: A security’s beta measures its risk relative to the market. The
market’s beta is defined as 1.00. Higher betas indicate more risk; lower
betas indicate less risk than the market. The portfolio beta is the weighted
average of the securities’ betas.
1. The expected return for the market is 12 percent, with a standard deviation
of 20 percent. The expected risk-free rate is 8 percent. Information is
available for three mutual funds, all assumed to be efficient, as follows:
Mutual Funds SD(%)
Affiliated 15
Omega 17
Ivy 19
(a) Based on the CML, calculate the market price of risk.
(b) Calculate the expected return on each of these portfolios.
Solution:
(a) Slope of CML = (12 - 8)/20 = .20
(b) Affiliated 8 + .2(15) = 11 percent
Omega 8 + .2(17) = 11.4 percent
Ivy 8 + .2(19) = 11.8 percent

5. Given the following information:

E(RM) = 12 percent σM = 10 percent
RF = 4 percent σA = 12 percent
ρA,B = 0.70 σB = 14 percent
ρA,M = 0.95
ρB,M = 0.42
(a) Calculate the betas for A and B.
(b) Determine the equation for the security market line.
(c) Calculate the required rates of return for the two stocks.
(d) Assume that an investor puts 70 percent in the market portfolio and 40
percent in the risk-free asset. What would the expected return and
standard deviation of the portfolio be?
Solution:
(a) σA,M = ρA,MσAσM = 0.95(12)(10) = 114
σB,M = ρB,MσBσM = 0.42(14) (10) = 58.8
σM2 = (10%)2 = 100
βA = σA,M/σM2 = 114/100 = 1.14
βB = σB,M/σM2 = 58.8/100 = 0.59
(b) SML Equation: ki = RF + βi [E(RM) - RF]
Required Rate for security i = 4% + βi [12 - 4] = 4 + 8βi
(c) Required rate for A = 4% + (1.14)[12 - 4] = 13.12%
Required Rate for B = 4% + (0.59)[12 - 4] = 8.72 %
(d) E(Rp) = WRFRF + (1 - WRF)E(RX) = .3(4) + .7(12) = 9.6 %
σp = (1 - WRF)σp , since σRF = 0 = (.7) (10) = 7 %