Chapter 7 Capital Allocation Between The Risky Asset and The Risk-Free Asset

Chapter 7 Capital Allocation Between the Risky Asset and the Risk-Free
Asset
Multiple Choice Questions
1. The Capital Allocation Line can be described as the

A) investment opportunity set formed with a risky asset and a risk-free asset.
B) investment opportunity set formed with two risky assets.
C) line on which lie all portfolios that offer the same utility to a particular investor.
D) line on which lie all portfolios with the same expected rate of return and different
standard deviations.
E) none of the above.
Answer: A Difficulty: Moderate
Rationale: The CAL has an intercept equal to the risk-free rate. It is a straight line
through the point representing the risk-free asset and the risky portfolio, in expected-
return/standard deviation space.
2. Which of the following statements regarding the Capital Allocation Line (CAL) is
false?
A) The CAL shows risk-return combinations.
B) The slope of the CAL equals the increase in the expected return of a risky
portfolio per unit of additional standard deviation.
C) The slope of the CAL is also called the reward-to-variability ratio.
D) The CAL is also called the efficient frontier of risky assets in the absence of a
risk-free asset.
E) Both A and D are true.
Answer: D Difficulty: Moderate
Rationale: The CAL consists of combinations of a risky asset and a risk-free asset
whose slope is the reward-to-variability ratio; thus, all statements except d are true.
3. Given the capital allocation line, an investor's optimal portfolio is the portfolio that
A) maximizes her expected profit.
B) maximizes her risk.
C) minimizes both her risk and return.
D) maximizes her expected utility.
Rationale: By maximizing expected utility, the investor is obtaining the best risk-
return relationships possible and acceptable for her.
Bodie, Investments, Sixth Edition 1

4. An investor invests 30 percent of his wealth in a risky asset with an expected rate of
return of 0.15 and a variance of 0.04 and 70 percent in a T-bill that pays 6 percent. His
portfolio's expected return and standard deviation are __________ and __________,
respectively.
A) 0.114; 0.12
B) 0.087;0.06
C) 0.295; 0.12
D) 0.087; 0.12
E) none of the above
Answer: B Difficulty: Moderate
Rationale: E(rP) = 0.3(15%) + 0.7(6%) = 8.7%; sP = 0.3(0.04)1/2 = 6%.
Use the following to answer questions 5-8:
You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard
deviation of 0.15 and a T-bill with a rate of return of 0.05.
5. What percentages of your money must be invested in the risky asset and the risk-free
asset, respectively, to form a portfolio with an expected return of 0.09?
A) 85% and 15%
B) 75% and 25%
C) 67% and 33%
D) 57% and 43%
E) cannot be determined
Rationale:9% = w1(12%) + (1 - w1)(5%);

9% = 12%w1 + 5% - 5%w1;
4% = 7%w1;
w1 = 0.57;
1 - w1 = 0.43;
0.57(12%) + 0.43(5%) = 8.99% .
6. What percentages of your money must be invested in the risk-free asset and the risky
asset, respectively, to form a portfolio with a standard deviation of 0.06?
A) 30% and 70%
B) 50% and 50%
C) 60% and 40%
D) 40% and 60%
Answer: C Difficulty: Moderate
2 Bodie, Investments, Sixth Edition

Asset
Rationale: 0.06 = x(0.15);

x = 40% in risky asset.
7.A portfolio that has an expected outcome of $115 is formed by

A) investing $100 in the risky asset.
B) investing $80 in the risky asset and $20 in the risk-free asset.
C) borrowing $43 at the risk-free rate and investing the total amount ($143) in the
risky asset.
D) investing $43 in the risky asset and $57 in the riskless asset.
E) Such a portfolio cannot be formed.
Answer: C Difficulty: Difficult
Rationale: For $100,

(115-100)/100=15%;
0.15 = w1(.12) + (1 - w1)(.05);
0.15 = .12w1 + .05 - .05w1;
0.10 = 0.07w1;
w1 = 1.43($100) = $143;
(1 - w1)$100 = -$43.
8. The slope of the Capital Allocation Line formed with the risky asset and the risk-free
asset is equal to
A) 0.4667.
B) 0.8000.
C) 2.14.
D) 0.41667.
E) Cannot be determined.
Rationale: (0.12 - 0.05)/0.15 = 0.4667.
9. Consider a T-bill with a rate of return of 5 percent and the following risky securities:
Security A: E(r) = 0.15; Variance = 0.04

Security B: E(r) = 0.10; Variance = 0.0225
Security C: E(r) = 0.12; Variance = 0.01
Security D: E(r) = 0.13; Variance = 0.0625
From which set of portfolios, formed with the T-bill and any one of the 4 risky
securities, would a risk-averse investor always choose his portfolio?
A) The set of portfolios formed with the T-bill and security A.

B) The set of portfolios formed with the T-bill and security B.
C) The set of portfolios formed with the T-bill and security C.
D) The set of portfolios formed with the T-bill and security D.
Rationale: Security C has the highest reward-to-volatility ratio.

Asset
You are considering investing $1,000 in a T-bill that pays 0.05 and a risky portfolio, P,
constructed with 2 risky securities, X and Y. The weights of X and Y in P are 0.60 and 0.40,
respectively. X has an expected rate of return of 0.14 and variance of 0.01, and Y has an
expected rate of return of 0.10 and a variance of 0.0081.
10. If you want to form a portfolio with an expected rate of return of 0.11, what
percentages of your money must you invest in the T-bill and P, respectively?
A) 0.25; 0.75
B) 0.19; 0.81
C) 0.65; 0.35
D) 0.50; 0.50
Rationale: E(rP) = 0.6(14%) + 0.4(10%) = 12.4%;

11% = 5%x + 12.4%(1 - x);
x = 0.189 (T-bills)
(1-x) = 0.811 (risky asset).
11. If you want to form a portfolio with an expected rate of return of 0.10, what
percentages of your money must you invest in the T-bill, X, and Y, respectively if you
keep X and Y in the same proportions to each other as in portfolio P?
A) 0.25; 0.45; 0.30
B) 0.19; 0.49; 0.32
C) 0.32; 0.41; 0.27
D) 0.50; 0.30; 0.20
Rationale: E(rP) = 10% = 5%w + 12.4%(1 - w);

10%=5%w+ 12.4%-12.4W
2.4%=7.4w
x = 0.32 (weight of T-bills);
As composition of X and Y are 0.6 and 0.4 of P, respectively, then for 0.68 weight in P, the
respective weights must be 0.41 and 0.27;
0.6(.68) = 41%;
0.4(.68) = 27%

12. What would be the dollar values of your positions in X and Y, respectively, if you
decide to hold 40% percent of your money in the risky portfolio and 60% in T-bills?
A) $240; $360
B) $360; $240
C) $100; $240
D) $240; $160
E) Cannot be determined
Rationale: 1000*0.4=400
$400(0.6) = $240 in X;
$400(0.4) = $160 in Y.
13. What would be the dollar value of your positions in X, Y, and the T-bills, respectively,
if you decide to hold a portfolio that has an expected outcome of $1,200?
A) Cannot be determined
B) $54; $568; $378
C) $568; $54; $378
D) $378; $54; $568
E) $108; $514; $378
Answer: B Difficulty: Difficult
Rationale: ($1,200 - $1,000)/$1,000 = 12%;

(0.6)14% + (0.4)10% = 12.4%; (P)
12% = w5% + 12.4%(1 - w);
w=0.054;
1-w=0.946;
w = 0.054($1,000) = $54 (T-bills);
1 - w = 1 - 0.054 = 0.946($1,000) = $946;
$946 x 0.6 = $568 in X;
$946 x 0.4 = $378 in Y.
14. A reward-to-volatility ratio is useful in:

A) measuring the standard deviation of returns.
B) understanding how returns increase relative to risk increases.
C) analyzing returns on variable rate bonds.
D) assessing the effects of inflation.
Rationale: B is the only choice relevant to the reward-to-volatility ratio (risk and
return).

Asset

15. The change from a straight to a kinked capital allocation line is a result of:
A) reward-to-volatility ratio increasing.
B) borrowing rate exceeding lending rate.
C) an investor's risk tolerance decreasing.
D) increase in the portfolio proportion of the risk-free asset.
Rationale: The linear capital allocation line assumes that the investor may borrow and
lend at the same rate (the risk-free rate), which obviously is not true. Relaxing this
assumption and incorporating the higher borrowing rates into the model results in the
kinked capital allocation line.
16. The first major step in asset allocation is:

A) assessing risk tolerance.
B) analyzing financial statements.
C) estimating security betas.
D) identifying market anomalies.
Rationale: A should be the first consideration in asset allocation. B, C, and D refer to

security selection.
17. Based on their relative degrees of risk tolerance

A) investors will hold varying amounts of the risky asset in their portfolios.
B) all investors will have the same portfolio asset allocations.
C) investors will hold varying amounts of the risk-free asset in their portfolios.
D) A and C.
Answer: D Difficulty: Easy
Rationale: By determining levels of risk tolerance, investors can select the optimum
portfolio for their own needs; these asset allocations will vary between amounts of
risk-free and risky assets based on risk tolerance.

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18. Passive investing

A) may be accomplished by investing in index mutual funds.
B) involves considerable security selection.
C) involves considerable transaction costs.
D) A and C.
E) B and C.
Answer: A Difficulty: Easy
Rationale: Passive investing involves virtually no security selection and minimal

transaction costs if accomplished via investing in index mutual funds.
19. Asset allocation

A) may involve the decision as to the allocation between a risk-free asset and a risky
asset.
B) may involve the decision as to the allocation among different risky assets.
C) may involve considerable security analysis.
D) A and B.
E) A and C.
Rationale: A and B are possible steps in asset allocation. C is related to security

selection.
20. In the mean-standard deviation graph, the line that connects the risk-free rate and the
optimal risky portfolio, P, is called ______________.
A) the Security Market Line
B) the Capital Allocation Line
C) the Indifference Curve
D) the investor's utility line
Rationale: The Capital Allocation Line (CAL) illustrates the possible combinations of
a risk-free asset and a risky asset available to the investor.

21. Treasury bills are commonly viewed as risk-free assets because
A) their short-term nature makes their values insensitive to interest rate fluctuations.
B) the inflation uncertainty over their time to maturity is negligible.
C) their term to maturity is identical to most investors' desired holding periods.
D) Both A and B are true.
E) Both B and C are true.
Rationale: Treasury bills do not exactly match most investor's desired holding periods,
but because they mature in only a few weeks or months they are relatively free of
interest rate sensitivity and inflation uncertainty.
22. When a portfolio consists of only a risky asset and a riskless asset, increasing the
fraction of the overall portfolio invested in the risky asset will
A) increase the expected return on the portfolio.
B) increase the standard deviation of the portfolio.
C) not change the risk-reward ratio.
D) Neither A, B nor C is true.
E) A, B and C are all true.
Answer: E Difficulty: Easy
Rationale: All three statements correctly describe a portfolio invested in a combination

of a risky asset and a riskless asset.
23. In a top-down analysis of portfolio construction

A) decisions about which executives will manage the portfolio are made first, then
capital allocation decisions are made.
B) decisions about asset allocation are made first, then specific securities are chosen.
C) decisions about specific securities are made first, then asset allocation decisions
are made.
D) all securities transactions must be approved by upper-level management.
E) an investor's first decision would be about how much to hold in her favorite stock.
Rationale: This is the approach most often used by institutional investors. Individual
investors typically follow a less-structured approach.

Asset
24. When wealth is shifted from the risky portfolio to the risk-free asset, what happens to
the relative proportions of the various risky assets within the risky portfolio?
A) They all decrease.
B) Some increase and some decrease.
C) They all increase.
D) They are not changed.
E) The answer depends on the specific circumstances.
Rationale: A shift in the proportion of the investor's portfolio that is held in the risky
portfolio (variable in the text) changes only the proportion held in the risk-free asset
(1-y). The composition of the underlying portfolio of risky assets remains unchanged.
Your client, Bo Regard, holds a complete portfolio that consists of a portfolio of risky assets
(P) and T-Bills. The information below refers to these assets.
E (R p) 1 2 .0 0 %
S ta n d a rd D e v ia tio n o f P 7 .2 0 %
T -B ill ra te 3 .6 0 %
P ro p o rtio n o f C o m p le te P o rtfo lio in P 80%

P ro p o rtio n o f C o m p le te P o rtfo lio in T -B ills 20%
C o m p o s itio n o f P :
S to c k A 4 0 .0 0 %
S to c k B 2 5 .0 0 %
S to c k C 3 5 .0 0 %
T o ta l 1 0 0 .0 0 %
25. What is the expected return on Bo's complete portfolio?

A) 10.32%
B) 5.28%
C) 9.62%
D) 8.44%
E) 7.58%
Rationale: E(rC) = 0.8*12.00% + 0.2*3.6% = 10.32%

26. What is the standard deviation of Bo's complete portfolio?
A) 7.20%
B) 5.40%
C) 6.92%
D) 4.98%
E) 5.76%
Answer: E Difficulty: Easy
Rationale: Std. Dev. of C = 0.8*7.20% = 5.76%
27. What is the equation of Bo's Capital Allocation Line?

A) E(rC) = 7.2 + 3.6 * Standard Deviation of C
B) E(rC) = 3.6 + 1.167 * Standard Deviation of C
C) E(rC) = 3.6 + 12.0 * Standard Deviation of C
D) E(rC) = 0.2 + 1.167 * Standard Deviation of C
E) E(rC) = 3.6 + 0.857 * Standard Deviation of C
Rationale: The intercept is the risk-free rate (3.60%) and the slope is (12.00%-
3.60%)/7.20% = 1.167.
28. What are the proportions of Stocks A, B, and C, respectively in Bo's complete
portfolio?
A) 40%, 25%, 35%
B) 8%, 5%, 7%
C) 32%, 20%, 28%
D) 16%, 10%, 14%
E) 20%, 12.5%, 17.5%
Rationale: Proportion in A = 0.8 * 40% = 32%; proportion in B = 0.8 * 25% = 20%;

proportion in C =0.8 * 35% = 28%.

Asset
29. To build an indifference curve we can first find the utility of a portfolio with 100% in
the risk-free asset, then
A) find the utility of a portfolio with 0% in the risk-free asset.
B) change the expected return of the portfolio and equate the utility to the standard
deviation.
C) find another utility level with 0% risk.
D) change the standard deviation of the portfolio and find the expected return the
investor would require to maintain the same utility level.
E) change the risk-free rate and find the utility level that results in the same standard
deviation.
Answer: D Difficulty: Difficult
Rationale: This references the procedure described on page 207-208 of the text. The
authors describe how to trace out indifference curves using a spreadsheet.
30. The Capital Market Line
I) is a special case of the Capital Allocation Line.

II) represents the opportunity set of a passive investment strategy.
III) has the one-month T-Bill rate as its intercept.
IV) uses a broad index of common stocks as its risky portfolio.
A) I, III, and IV
B) II, III, and IV
C) III and IV
D) I, II, and III
E) I, II, III, and IV
Answer: E Difficulty: Moderate
Rationale: 'The Capital Market Line is the Capital Allocation Line based on the one-
month T-Bill rate and a broad index of common stocks. It applies to an investor
pursuing a passive management strategy.

respectively.
A) 0.114; 0.112
B) 0.087; 0.063
C) 0.096; 0.126
D) 0.087; 0.144
Rationale: E(rP) = 0.4(18%) + 0.6(4%) = 9.6%;

sP = 0.4(0.10)1/2 = 12.6%.
respectively.
A) 0.086; 0.242
B) 0.087; 0.267
C) 0.295; 0.123
D) 0.087; 0.182
Rationale: E(rP) = 0.7(11%) + 0.3(3%) = 8.6%;

sP = 0.7(0.12)1/2 = 24.2%.
A) 85% and 15%
B) 75% and 25%
C) 62.5% and 37.5%
D) 57% and 43%

Asset
Rationale: 8% = w1(11%) + (1 - w1)(3%);

8% = 11%w1 + 3% - 3%w1;
5% = 8%w1;
w1 = 0.625;
1 - w1 = 0.375;
0.625(11%) + 0.375(3%) = 8.0%.
A) 30% and 70%
B) 50% and 50%
C) 60% and 40%
D) 40% and 60%
Rationale: 0.08 = x(0.20); x = 40% in risky asset.
asset is equal to
A) 0.47
B) 0.80
C) 2.14
D) 0.40
Rationale: (0.11 - 0.03)/0.20 = 0.40.

A) 53.8% and 46.2%
B) 75% and 25%
C) 62.5% and 37.5%
D) 46.1% and 53.8%
Rationale: 11% = w1(17%) + (1 - w1)(4%);

11% = 17%w1 + 4% - 4%w1;
7% = 13%w1;
w1 = 0.538;
1 - w1 = 0.461;
0.538(17%) + 0.462(4%) = 11.0%.
A) 30% and 70%
B) 50% and 50%
C) 60% and 40%
D) 40% and 60%
Rationale: 0.20 = x(0.40); x = 50% in risky asset.
asset is equal to
A) 0.325.
B) 0.675.
C) 0.912.
D) 0.407.
Rationale: (0.17 - 0.04)/0.40 = 0.325.

Asset
Short Answer Questions
39. Discuss the differences between the asset allocation decision and the security
selection decision.
Answer: The asset allocation decision involves the choice of the proportion of the
overall portfolio to be invested in broad general asset categories. In general, this
decision should be the first step in the portfolio management process (after
determining the investor's level of risk tolerance. The security selection decision
describes the choice of which specific securities to hold within each broad asset
classification group.
As asset allocation and security selection are the two major components of portfolio
formation, it is important that the student is able to distinguish between the two, and to
understand the roles of each in portfolio management.
Difficulty: Easy
40. Discuss the characteristics of indifference curves, and the theoretical value of these
curves in the portfolio building process
Answer: Indifference curves represent the trade-off between two variables. In

portfolio building, the choice is between risk and return. The investor is indifferent
between all possible portfolios lying on one indifference curve. However, indifference
curves are contour maps, with all curves parallel to each other. The curve plotting in
the most northwest position is the curve offering the greatest utility to the investor.
However, this most desirable curve may not be attainable in the market place. The
point of tangency between an indifference curve (representing what is desirable) and
the capital allocation line (representing what is possible). is the optimum portfolio for
that investor.
This question is designed to ascertain that the student understands the concepts of
utility, what is desirable by the investor, what is possible in the market place, and how
to optimize an investor's portfolio, theoretically.
Difficulty: Moderate

41. Describe how an investor may combine a risk-free asset and one risky asset in order to
obtain the optimal portfolio for that investor.
Answer: The investor may combine a risk-free asset (U. S. T-bills or a money market
mutual fund and a risky asset, such as an indexed mutual fund in the proper portions to
obtain the desired risk-return relationship for that investor. The investor must realize
that the risk-return relationship is a linear one, and that in order to earn a higher return,
the investor must be willing to assume more risk. The investor must first determine
the amount of risk that he or she can tolerate (in terms of the standard deviation of the
total portfolio, which is the product of the proportion of total assets invested in the
risky asset and the standard deviation of the risky asset). One minus this weight is the
proportion of total assets to be invested in the risk-free asset. The portfolio return is
the weighted averages of the returns on the two respective assets. Such an asset
allocation plan is probably the easiest, most efficient, and least expensive for the
individual investor to build an optimal portfolio.
This question is designed to insure that the student understands how using the simple
strategy of combining two mutual funds, the investor can build an optimal portfolio,
based on the investor's risk tolerance.
42. The optimal proportion of the risky asset in the complete portfolio is given by the
equation y* = [E(rP)-rf] / (.01A*Variance of P). For each of the variables on the right
side of the equation, discuss the impact the variable's effect on y* and why the nature
of the relationship makes sense intuitively. Assume the investor is risk averse.
Answer: The optimal proportion in y is the one that maximizes the investor's utility.
Utility is positively related to the risk premium [E(rP)-rf]. This makes sense because
the more expected return an investor gets, the happier he is. The variable “A”
represents the degree of risk aversion. As risk aversion increases, “A” increases. This
causes y* to decrease because we are dividing by a higher number. It makes sense that
a more risk-averse investor would hold a smaller proportion of his complete portfolio
in the risky asset and a higher proportion in the risk-free asset. Finally, the standard
deviation of the risky portfolio is inversely related to y*. As P's risk increases, we are
again dividing by a larger number, making y* smaller. This corresponds with the risk-
averse investor's dislike of risk as measured by standard deviation.

Asset
This allows the students to explore the nature of the equation that was derived by
maximizing the investor's expected utility. The student can illustrate an understanding
of the variables that supercedes the application of the equation in calculating the
optimal proportion in P. Difficulty: Difficult
43. You are evaluating two investment alternatives. One is a passive market portfolio with
an expected return of 10% and a standard deviation of 16%. The other is a fund that is
actively managed by your broker. This fund has an expected return of 15% and a
standard deviation of 20%. The risk-free rate is currently 7%. Answer the questions
below based on this information.
a. What is the slope of the Capital Market Line?
b. What is the slope of the Capital Allocation Line offered by your broker's fund?
c. Draw the CML and the CAL on one graph.
d. What is the maximum fee your broker could charge and still leave you as well off
as if you had invested in the passive market fund? (Assume that the fee would be
a percentage of the investment in the broker's fund, and would be deducted at the
end of the year.)
e. How would it affect the graph if the broker were to charge the full amount of the
fee?
Answer:
a. The slope of the CML is (10-7)/16 = 0.1875.
b. The slope of the CAL is (15-7)/20= 0.40.
c. On the graph, both the CML and the CAL have an intercept equal to
the risk-free rate (7%). The CAL, with a slope of 0.40, is steeper than the CML,
with a slope of 0.1875.
d. To find the maximum fee the broker can charge, the equation (15-7-
fee)/20 = 0.1875 is solved for “fee”. The resulting fee is 4.25%.
e. If the broker charges the full amount of the fee, the CAL's slope
would also be 0.1875, so it would rotate down and be identical to the CML.
This question tests both the application of CAL/CML calculations and the concepts
involved.
Difficulty: Difficult

Multiple Choice Questions
1. Market risk is also referred to as

A) systematic risk, diversifiable risk.
B) systematic risk, nondiversifiable risk.
C) unique risk, nondiversifiable risk.
D) unique risk, diversifiable risk.
Answer: B Difficulty: Easy
Rationale: Market, systematic, and nondiversifiable risk are synonyms referring to the
risk that cannot be eliminated from the portfolio. Diversifiable, unique,
nonsystematic, and firm-specific risks are synonyms referring to the risk that can be
eliminated from the portfolio by diversification.
2. Beta is the measure of

A) firm specific risk.
B) diversifiable risk.
C) market risk.
D) unique risk.
Answer: C Difficulty: Easy
Rationale: Beta is a measure of the market risk (or systematic or nondiversifiable risk)
and cannot be eliminated from the portfolio. A, B, and D are synonyms referring to
the risk that can be eliminated by diversification.
3. The risk that can be diversified away is

A) firm specific risk.
B) beta.
C) systematic risk.
D) market risk.
Rationale: See explanations for 1 and 2 above.

Asset
4. The variance of a portfolio of risky securities

A) is a weighted sum of the securities' variances.
B) is the sum of the securities' variances.
C) is the weighted sum of the securities' variances and covariances.
D) is the sum of the securities' covariances.
Rationale: The variance of a portfolio of risky securities is a weighted sum taking into
account both the variance of the individual securities and the covariances between
securities.
5. Other things equal, diversification is most effective when

A) securities' returns are uncorrelated.
B) securities' returns are positively correlated.
C) securities' returns are high.
D) securities' returns are negatively correlated.
E) B and C.
Rationale: Negative correlation among securities results in the greatest reduction of

portfolio risk, which is the goal of diversification.
6. The efficient frontier of risky assets is

A) the portion of the investment opportunity set that lies above the global minimum
variance portfolio.
B) the portion of the investment opportunity set that represents the highest standard
deviations.
C) the portion of the investment opportunity set which includes the portfolios with
the lowest standard deviation.
D) the set of portfolios that have zero standard deviation.
E) both A and B are true.
Rationale: Portfolios on the efficient frontier are those providing the greatest expected
return for a given amount of risk. Only those portfolios above the global minimum
variance portfolio meet this criterion.

7. The Capital Allocation Line provided by a risk-free security and N risky securities is
A) the line that connects the risk-free rate and the global minimum-variance portfolio
of the risky securities.
B) the line that connects the risk-free rate and the portfolio of the risky securities that
has the highest expected return on the efficient frontier.
C) the line tangent to the efficient frontier of risky securities drawn from the risk-free
rate.
D) the horizontal line drawn from the risk-free rate.
Rationale: The Capital Allocation Line represents the most efficient combinations of
the risk-free asset and risky securities. Only C meets that definition.
8. 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
A) greater than zero.
B) equal to zero.
C) equal to the sum of the securities' standard deviations.
D) equal to -1.
Rationale: If two securities were perfectly negatively correlated, the weights for the
minimum variance portfolio for those securities could be calculated, and the standard
deviation of the resulting portfolio would be zero.

Asset
9. Which of the following statements is (are) true regarding the variance of a portfolio of
two risky securities?
A) The higher the coefficient of correlation between securities, the greater the
reduction in the portfolio variance.
B) There is a linear relationship between the securities' coefficient of correlation and
the portfolio variance.
C) The degree to which the portfolio variance is reduced depends on the degree of
correlation between securities.
D) A and B.
E) A and C.
Rationale: The lower the correlation between the returns of the securities, the more
portfolio risk is reduced.
10. Efficient portfolios of N risky securities are portfolios that

A) are formed with the securities that have the highest rates of return regardless of
their standard deviations.
B) have the highest rates of return for a given level of risk.
C) are selected from those securities with the lowest standard deviations regardless of
their returns.
D) have the highest risk and rates of return and the highest standard deviations.
E) have the lowest standard deviations and the lowest rates of return.
Rationale: Portfolios that are efficient are those that provide the highest expected
return for a given level of risk.

11. Which of the following statement(s) is (are) true regarding the selection of a portfolio
from those that lie on the Capital Allocation Line?
A) Less risk-averse investors will invest more in the risk-free security and less in the
optimal risky portfolio than more risk-averse investors.
B) More risk-averse investors will invest less in the optimal risky portfolio and more
in the risk-free security than less risk-averse investors.
C) Investors choose the portfolio that maximizes their expected utility.
D) A and C.
E) B and C.
Rationale: All rational investors select the portfolio that maximizes their expected
utility; for investors who are relatively more risk-averse, doing so means investing less
in the optimal risky portfolio and more in the risk-free asset.
Consider the following probability distribution for stocks A and B:
S ta te P ro b a b ility R e tu rn o n S to c k A R e tu rn o n S to c k B
1 0 .1 0 10% 8%
2 0 .2 0 13% 7%
3 0 .2 0 12% 6%
4 0 .3 0 14% 9%
5 0 .2 0 15% 8%
12. The expected rates of return of stocks A and B are _____ and _____ , respectively.
A) 13.2%; 9%
B) 14%; 10%
C) 13.2%; 7.7%
D) 7.7%; 13.2%
Rationale: E(RA) = 0.1(10%) + 0.2(13%) + 0.2(12%) + 0.3(14%) + 0.2(15%) =

13.2%; E(RB) = 0.1(8%) + 0.2(7%) + 0.2(6%) + 0.3(9%) + 0.2(8%) = 7.7%.

Asset
13. The standard deviations of stocks A and B are _____ and _____, respectively.
A) 1.5%; 1.9%
B) 2.5%; 1.1%
C) 3.2%; 2.0%
D) 1.5%; 1.1%
Rationale: sA = [0.1(10% - 13.2%)2 + 0.2(13% - 13.2%)2 + 0.2(12% - 13.2%)2 +

0.3(14% - 13.2%)2 + 0.2(15% - 13.2%)2]1/2 = 1.5% ;
sB = [0.1(8% - 7.7%)2 + 0.2(7% - 7.7%)2 + 0.2(6% - 7.7%)2 + 0.3(9% - 7.7%)2 +

0.2(8% - 7.7%)2 = 1.1%.
14. The coefficient of correlation between A and B is

A) 0.47.
B) 0.60.
C) 0.58
D) 1.20.
Answer: A Difficulty: Difficult
Rationale: 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)] = 0.47.
15. 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?
A) 9.9%; 3%
B) 9.9%; 1.1%
C) 11%; 1.1%
D) 11%; 3%
Rationale: E(RP) = 0.4(13.2%) + 0.6(7.7%) = 9.9%;

sP = [(0.4)2(1.5)2 + (0.6)2(1.1)2 + 2(0.4)(0.6)(1.5)(1.1)(0.46)]1/2 = 1.1%.

16. Let G be the global minimum variance portfolio. The weights of A and B in G are
__________ and __________, respectively.
A) 0.40; 0.60
B) 0.66; 0.34
C) 0.34; 0.66
D) 0.76; 0.24
E) 0.24; 0.76
Answer: E Difficulty: Difficult
Rationale: wA = [(1.1)2 - (1.5)(1.1)(0.46)]/[(1.5)2 + (1.1)2 - (2)(1.5)(1.1)(0.46) = 0.23;

wB = 1 - 0.23 = 0.77.Note that the above solution assumes the solutions obtained in
question 13 and 14.
17. The expected rate of return and standard deviation of the global minimum variance
portfolio, G, are __________ and __________, respectively.
A) 10.07%; 1.05%
B) 9.04%; 2.03%
C) 10.07%; 3.01%
D) 9.04%; 1.05%
Rationale: E(RG) = 0.23(13.2%) + 0.77(7.7%) = 8.97% 0.9%;
sG = [(0.23)2(1.5)2 + (0.77)2(1.1)2 + (2)(0.23)(0.77)(1.5)(1.1)(0.46)]1/2 = 1.05%.
18. Which of the following portfolio(s) is (are) on the efficient frontier?

A) The portfolio with 20 percent in A and 80 percent in B.
B) The portfolio with 15 percent in A and 85 percent in B.
C) The portfolio with 26 percent in A and 74 percent in B.
D) The portfolio with 10 percent in A and 90 percent in B.
E) A and B are both on the efficient frontier.
Rationale: The Portfolio's E(Rp), sp, Reward/volatility ratios are 20A/80B: 8.8%,
1.05%, 8.38; 15A/85B: 8.53%, 1.06%, 8.07; 26A/74B: 9.13%, 1.05%, 8.70; 10A/90B:
8.25%, 1.07%, 7.73. The portfolio with 26% in A and 74% in B dominates all of the
other portfolios by the mean-variance criterion.

Asset
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%.
19. The weights of A and B in the global minimum variance portfolio are _____ and
_____, respectively.j
A) 0.24; 0.76
B) 0.50; 0.50
C) 0.57; 0.43
D) 0.43; 0.57
E) 0.76; 0.24
Rationale: wA = 12 /(16 + 12) = 0.4286;

wB = 1 - 0.4286 = 0.5714.
20. The risk-free portfolio that can be formed with the two securities will earn _____ rate
of return.
A) 8.5%
B) 9.0%
C) 8.9%
D) 9.9%
Rationale: E(RP) = 0.43(10%) + 0.57(8%) = 8.86%.
21. Which of the following portfolio(s) is (are) most efficient?

A) 45 percent in A and 55 percent in B.
B) 65 percent in A and 35 percent in B.
C) 35 percent in A and 65 percent in B.
D) A and B are both efficient.
E) A and C are both efficient.
Answer: D Difficulty: Difficult
Rationale: The Portfolio E(RP), sp, and Reward/volatility ratios are

45A/55B: 8.9%, 0.6%, 14.83;
65A/35B: 9.3%, 6.2%, 1.5;

35A/65B: 8.7%, 2.2%, 3.95.
Both A and B are efficient according to the mean-variance criterion. A has a much higher
Reward/volatility ratio.

Asset
22. An investor who wishes to form a portfolio that lies to the right of the optimal risky
portfolio on the Capital Allocation Line must:
A) lend some of her money at the risk-free rate and invest the remainder in the
optimal risky portfolio.
B) borrow some money at the risk-free rate and invest in the optimal risky portfolio.
C) invest only in risky securities.
D) such a portfolio cannot be formed.
E) B and C
Rationale: The only way that an investor can create portfolios to the right of the
Capital Allocation Line is to create a borrowing portfolio (buy stocks on margin). In
this case, the investor will not hold any of the risk-free security, but will hold only
risky securities.
23. Which one of the following portfolios cannot lie on the efficient frontier as described
by Markowitz?
Portfoli Expected Return Standard Deviation

o
W 9% 21%
X 5% 7%
Y 15% 36%
Z 12% 15%
A) Only portfolio W cannot lie on the efficient frontier.

B) Only portfolio X cannot lie on the efficient frontier.
C) Only portfolio Y cannot lie on the efficient frontier.
D) Only portfolio Z cannot lie on the efficient frontier.
E) Cannot tell from the information given.
Rationale: When plotting the above portfolios, only W lies below the efficient frontier
as described by Markowitz. It has a higher standard deviation than Z with a lower
expected return.

24. Portfolio theory as described by Markowitz is most concerned with:
A) the elimination of systematic risk.
B) the effect of diversification on portfolio risk.
C) the identification of unsystematic risk.
D) active portfolio management to enhance returns.
Rationale: Markowitz was concerned with reducing portfolio risk by combining risky
securities with differing return patterns.
25. The measure of risk in a Markowitz efficient frontier is:

A) specific risk.
B) standard deviation of returns.
C) reinvestment risk.
D) beta.
Rationale: Markowitz was interested in eliminating diversifiable risk (and thus

lessening total risk) and thus was interested in decreasing the standard deviation of the
returns of the portfolio.
26. A statistic that measures how the returns of two risky assets move together is:
A) variance.
B) standard deviation.
C) covariance.
D) correlation.
E) C and D.
Rationale: Covariance measures whether security returns move together or in

opposition; however, only the sign, not the magnitude, of covariance may be
interpreted. Correlation, which is covariance standardized by the product of the
standard deviations of the two securities, may assume values only between +1 and -1;
thus, both the sign and the magnitude may be interpreted regarding the movement of
one security's return relative to that of another security.

Asset
27. The unsystematic risk of a specific security

A) is likely to be higher in an increasing market.
B) results from factors unique to the firm.
C) depends on market volatility.
D) cannot be diversified away.
Rationale: Unsystematic (or diversifiable or firm-specific) risk refers to factors unique

to the firm. Such risk may be diversified away; however, market risk will remain.
28. Which statement about portfolio diversification is correct?

A) Proper diversification can reduce or eliminate systematic risk.
B) The risk-reducing benefits of diversification do not occur meaningfully until at
least 50-60 individual securities have been purchased.
C) Because diversification reduces a portfolio's total risk, it necessarily reduces the
portfolio's expected return.
D) Typically, as more securities are added to a portfolio, total risk would be expected
to decrease at a decreasing rate.
E) None of the above statements are correct.
Rationale: Diversification can eliminate only nonsystematic risk; relatively few

securities are required to reduce this risk, thus diminishing returns result quickly.
Diversification does not necessarily reduce returns.
29. The individual investor's optimal portfolio is designated by:

A) The point of tangency with the indifference curve and the capital allocation line.
B) The point of highest reward to variability ratio in the opportunity set.
C) The point of tangency with the opportunity set and the capital allocation line.
D) The point of the highest reward to variability ratio in the indifference curve.
E) None of the above.
Rationale: The indifference curve represents what is acceptable to the investor; the
capital allocation line represents what is available in the market. The point of
tangency represents where the investor can obtain the greatest utility from what is
available.

30. For a two-stock portfolio, what would be the preferred correlation coefficient between
the two stocks?
A) +1.00.
B) +0.50.
C) 0.00.
D) -1.00.
Rationale: The correlation coefficient of -1.00 provides the greatest diversification

benefits.
31. In a two-security minimum variance portfolio where the correlation between securities
is greater than -1.0
A) the security with the higher standard deviation will be weighted more heavily.
B) the security with the higher standard deviation will be weighted less heavily.
C) the two securities will be equally weighted.
D) the risk will be zero.
E) the return will be zero.
Rationale: The security with the higher standard deviation will be weighted less
heavily to produce minimum variance. The return will not be zero; the risk will not be
zero unless the correlation coefficient is -1.
32. In its simplest form, the CAPM

A) assumes equal borrowing and lending rates.
B) prohibits borrowing.
C) assumes borrowing rates are higher than lending rates.
D) uses the risk-free rate as a surrogate for both borrowing and lending rates.
E) A and D.
Rationale: In its simplest form, the CAPM assumes that investors can borrow and lend
at the same rate, and uses the risk-free rate as a surrogate for this rate.

Asset
33. The CAPM can easily be modified to represent a more realistic picture of the world by
A) incorporating different rates for borrowing and lending.
B) allowing non-systematic risk to be priced.
C) assuming that investors do not use margin.
D) A and B.
E) A and C.
Rationale: In order to obtain the higher returns, the investor must be willing to buy
stocks on margin; however, obviously the margin rate is higher than the risk-free rate.
Non-systematic risk is not priced in the model.
34. In recent years, investment vehicles offering maximum diversification for portfolios
invested in U.S. blue chips included
A) European blue chips.
B) small European companies.
C) gold stocks.
D) both A and B.
E) both B and C.
Rationale: See text box page 228.
35. According to a 1991 study by Brinson, Singer and Beebower the policy that explained
more than 90% of asset returns was
A) security selection
B) asset allocation
C) good management
D) market timing
Rationale: See text box page 234.

36. Which of the following is not a source of systematic risk?
A) the business cycle.
B) interest rates.
C) personnel changes
D) the inflation rate.
E) exchange rates.
Rationale: Personnel changes are a firm-specific event that is a component of non-

systematic risk. The others are all sources of systematic risk.
37. The global minimum variance portfolio formed from two risky securities will be
riskless when the correlation coefficient between the two securities is
A) 0.0
B) 1.0
C) 0.5
D) -1.0
E) negative
Rationale: The global minimum variance portfolio will have a standard deviation of
zero whenever the two securities are perfectly negatively correlated.
38. Security X has expected return of 12% and standard deviation of 20%. Security Y has
expected return of 15% and standard deviation of 27%. If the two securities have a
correlation coefficient of 0.7, what is their covariance?
A) 0.038
B) 0.070
C) 0.018
D) 0.013
E) 0.054
Rationale: Cov(rX, rY) = (.7)(.20)(.27) = .0378

Asset
39. When two risky securities that are positively correlated but not perfectly correlated are
held in a portfolio,
A) the portfolio standard deviation will be greater than the weighted average of the
individual security standard deviations.
B) the portfolio standard deviation will be less than the weighted average of the
C) the portfolio standard deviation will be equal to the weighted average of the
D) the portfolio standard deviation will always be equal to the securities' covariance.
E) none of the above are true.
Rationale: Whenever two securities are less than perfectly positively correlated, the
standard deviation of the portfolio of the two assets will be less than the weighted
average of the two securities' standard deviations. There is some benefit to
diversification in this case.
40. The line representing all combinations of portfolio expected returns and standard
deviations that can be constructed from two available assets is called the
A) risk/reward tradeoff line
B) Capital Allocation Line
C) efficient frontier
D) portfolio opportunity set
E) Security Market Line
Rationale: The portfolio opportunity set is the line describing all combinations of
expected returns and standard deviations that can be achieved by a portfolio of risky
assets.
41. Given an optimal risky portfolio with expected return of 14% and standard deviation
of 22% and a risk free rate of 6%, what is the slope of the best feasible CAL?
A) 0.64
B) 0.14
C) 0.08
D) 0.33
E) 0.36
Rationale: Slope = (14-6)/22 = .3636

Asset
42. 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
A) I, III, and IV
B) II, III, and IV
C) III and IV
D) I, II, and IV
E) I, II, III, and IV
Rationale: All of these terms are used interchangeably to refer to the risk that can be
removed from a portfolio through diversification.
43. As the number of securities in a portfolio is increased, what happens to the average
portfolio standard deviation?
A) It increases at an increasing rate.
B) It increases at a decreasing rate.
C) It decreases at an increasing rate.
D) It decreases at a decreasing rate.
E) It first decreases, then starts to increase as more securities are added.
Rationale: Statman's study, as referenced on page 224 and 225 showed that the risk of
the portfolio would decrease as random stocks were added. At first the risk decreases
quickly, but then the rate of decrease slows substantially, as shown in Figure 8.2. The
minimum portfolio risk in the study was 19.2%.

44. In words, the covariance considers the probability of each scenario happening and the
interaction between
A) securities' returns relative to their variances.
B) securities' returns relative to their mean returns.
C) securities' returns relative to other securities' returns.
D) the level of return a security has in that scenario and the overall portfolio return.
E) the variance of the security's return in that scenario and the overall portfolio
variance.
Rationale: As written in equation 8.3, page 226, the covariance of the returns between
two securities is the sum over all scenarios of the product of three things. The first
item is the probability that the scenario will happen. The second and third terms
represent the deviations of the securities' returns in that scenario from their own
expected returns.
45. The standard deviation of a two-asset portfolio is a linear function of the assets'
weights when
A) the assets have a correlation coefficient less than zero.
B) the assets have a correlation coefficient equal to zero.
C) the assets have a correlation coefficient greater than zero.
D) the assets have a correlation coefficient equal to one.
E) the assets have a correlation coefficient less than one.
Rationale: When there is a perfect positive correlation (or a perfect negative

correlation), the equation for the portfolio variance simplifies to a perfect square, as
shown on page 227. The result is that the portfolio's standard deviation is linear
relative to the assets' weights in the portfolio.

Asset
46. A two-asset portfolio with a standard deviation of zero can be formed when
A) the assets have a correlation coefficient less than zero.
B) the assets have a correlation coefficient equal to zero.
C) the assets have a correlation coefficient greater than zero.
D) the assets have a correlation coefficient equal to one.
E) the assets have a correlation coefficient equal to negative one.
Rationale: When there is a perfect negative correlation, the equation for the portfolio
variance simplifies to a perfect square, as shown on page 229. The result is that the
portfolio's standard deviation equals |wAsA - wBsB|, which can be set equal to zero. The
solution wA = sB/(sA + sB) and wB = 1 - wA will yield a zero-standard deviation
portfolio.
47. 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) with the highest reward-to-variability ratio.

II) that will maximize his utility.
III) with the steepest slope.
IV) with the lowest slope.
A) I and III
B) I and IV
C) II and IV
D) I only
E) I, II, and III
Answer: E Difficulty: Difficult
Rationale: The optimal CAL is the one that is tangent to the efficient frontier, as
discussed in relation to Figures 8.6 (page 235) and 8.7 (page 236). This CAL offers
the highest reward-to-variability ratio, which is the slope of the CAL. It will also
allow the investor to reach his highest feasible level of utility, as depicted in Figure 8.8
(page 239).

48. Which Excel tool can be used to find the points along an efficient frontier?
A) Regression
B) Solver
C) Scenarios
D) Goal Seek
E) Data Analysis
Rationale: Even if the student isn't familiar with Excel's Solver tool, he should
recognize it from the discussion on pages 246-247. The authors discuss the procedure
in detail on these pages.
49. The separation property refers to the conclusion that

A) the determination of the best risky portfolio is objective and the choice of the best
complete portfolio is subjective.
B) the choice of the best complete portfolio is objective and the determination of the
best risky portfolio is objective.
C) the choice of inputs to be used to determine the efficient frontier is objective and
the choice of the best CAL is subjective.
D) the determination of the best CAL is objective and the choice of the inputs to be
used to determine the efficient frontier is subjective.
E) investors are separate beings and will therefore have different preferences
regarding the risk-return tradeoff.
Answer: A Difficulty: Difficult
Rationale: The separation property is discussed on page 251-253. The determination

of the optimal risky portfolio is purely technical and can be done by a manager. The
complete portfolio, which consists of the optimal risky portfolio and the risk-free
asset, must be chosen by each investor based on preferences.
Consider the following probability distribution for stocks A and B:
State Probabilit Return on Stock A Return on Stock B

y
1 0.15 8% 8%
2 0.20 13% 7%
3 0.15 12% 6%
4 0.30 14% 9%
5 0.20 16% 11%

Asset
50. The expected rates of return of stocks A and B are _____ and _____, respectively.
A) 13.2%; 9%.
B) 13%; 8.4%
C) 13.2%; 7.7%
D) 7.7%; 13.2%
Answer: B Difficulty: Easy
Rationale: E(RA) = 0.15(8%) + 0.2(13%) + 0.15(12%) + 0.3(14%) + 0.2(16%) = 13%;

E(RB) = 0.15(8%) + 0.2(7%) + 0.15(6%) + 0.3(9%) + 0.2(11%) = 8.4%.
51. The standard deviations of stocks A and B are _____ and _____, respectively.
A) 1.56%; 1.99%
B) 2.45%; 1.68%
C) 3.22%; 2.01%
D) 1.54%; 1.11%
Rationale: sA = [0.15(8% - 13%)2 + 0.2(13% - 13%)2 + 0.15(12% - 13%)2 + 0.3(14% -

13%)2 + 0.2(16% - 13%)2]1/2 = 2.449%; sB = [0.15(8% - 8.4%)2 + 0.2(7% - 8.4%)2 +
0.15(6% - 8.4%)2 + 0.3(9% - 8.4%)2 + 0.2(11% - 8.4%)2 = 1.676%.
52. The coefficient of correlation between A and B is

A) 0.474.
B) 0.612.
C) 0.583.
D) 1.206.
Rationale: covA,B = 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; rA,B = 2.40/[(2.45)(1.68)] = 0.583.

53. 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?
A) 9.9%; 3%
B) 9.9%; 1.1%
C) 10%; 1.7%
D) 10%; 3%
Rationale: E(RP) = 0.35(13%) + 0.65(8.4%) = 10.01%; sP = [(0.35)2(2.45%)2 +

(0.65)2(1.68)2 + 2(0.35)(0.65)(2.45)(1.68)(0.583)]1/2 = 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%.
54. The weights of A and B in the global minimum variance portfolio are _____ and
_____, respectively.
A) 0.24; 0.76
B) 0.50; 0.50
C) 0.57; 0.43
D) 0.45; 0.55
E) 0.76; 0.24
Rationale: wA = 14 /(17 + 14) = 0.45; wB = 1 - 0.45 = 0.55.
55. The risk-free portfolio that can be formed with the two securities will earn _____ rate
of return.
A) 9.5%
B) 10.4%
C) 10.9%
D) 9.9%
Rationale: E(RP) = 0.45(12%) + 0.55(9%) = 10.35%.

Asset
correlation coefficient of 0.8, what is their covariance?
A) 0.038
B) 0.049
C) 0.018
D) 0.013
E) 0.054
Rationale: Cov(rX, rY) = (.8)(.22)(.28) = .04928
correlation coefficient of -0.4, what is their covariance?
A) 0.0388
B) 0.0706
C) 0.0184
D) -0.0133
E) -0.1512
Rationale: Cov(rX, rY) = (-.4)(.18)(.21) = -.01512
A) 0.60
B) 0.14
C) 0.08
D) 0.36
E) 0.36
Rationale: Slope = (16-4)/20 = .6

A) 0.64
B) 0.14
C) 0.08
D) 0.35
E) 0.36
Rationale: Slope = (12-3)/26 = .346
Short Answer Questions
60. Theoretically, the standard deviation of a portfolio can be reduced to what level?
Explain. Realistically, is it possible to reduce the standard deviation to this level?
Explain.
Answer: Theoretically, if one could find two securities with perfectly negatively
correlated returns (correlation coefficient = -1), one could solve for the weights of
these securities that would produce the minimum variance portfolio of these two
securities. The standard deviation of the resulting portfolio would be equal to zero.
However, in reality, securities with perfect negative correlations do not exist.
The rationale for this question is to ascertain whether or not the student understands
the concept of the minimum variance portfolio, the theoretical zero risk portfolio, and
the probability of obtaining a zero risk portfolio.

Asset
61. Discuss how the investor can use the separation theorem and utility theory to produce
an efficient portfolio suitable for the investor's level of risk tolerance.
Answer: One can identify the optimum risky portfolio as the portfolio at the point of
tangency between a ray extending from the risk-free rate and the efficient frontier of
risky securities. Below the point of tangency on this ray from the risk-free rate, the
efficient portfolios consist of both the optimum risky portfolio and risk-free
investments (T-bills); above the point of tangency, the efficient portfolios consist of
the optimum risky portfolio purchased on margin. If the investor's indifference curve,
which reflects that investor's preferences regarding risk and return, is superimposed on
the ray from the risk-free rate, the resulting point of tangency represents the
appropriate combination of the optimum risky portfolio and either risk-free assets or
margin buying for that investor. Thus, the separation theorem separates the investing
and financing decisions. That is, all investors will invest in the same optimal risky
portfolio, and adjust the risk level of the portfolio by either lending (investing in U. S.
Treasuries, i.e., lending to the U. S. government) or borrowing (buying risky securities
on margin).
The purpose of this question is to ascertain whether the student understands the basic
principles of utility theory, the optimal risky portfolio, and the separation theorem, as
these concepts relate to constructing the ideal portfolio for a particular investor.
62. Explain how the linear risk-return relationship as depicted by the basic version of the
CAPM is unrealistic and how the assumptions behind this linear relationship can be
relaxed, making the model more realistic.
Answer: The linear-risk return relationship of the CAPM assumes that all investors
can borrow at the risk-free rate. Obviously, such an assumption is unrealistic.
However, if one incorporates a higher borrowing (margin) rate in the model, a more
realistic, although not strictly linear, model results.
This question is designed to reinforce that models are based on restricting,

simplifying, generalizing assumptions. However, often, as in the above example,
these assumptions can be relaxed relatively easily, thus making the model more
realistic.

63. Draw graphs that represent each of the following situations:
 Investors face an efficient frontier of risky assets. There is no borrowing or
lending allowed at a risk-free rate. Using indifference curves, show an example of
the optimal portfolio choice for Investor A, who has a strong aversion to risk, and
one for Investor B, who is much less risk-averse. Label points A and B clearly.
 Investors face an efficient frontier of risky assets. Borrowing and lending at a risk-
free rate are allowed. Using indifference curves, show an example of Investor C,
who chooses to put 100% of his investment in the optimal risky portfolio. Show
an example of Investor D, who chooses to put 75% of her investment in the
optimal risky portfolio. Label points C and D clearly.
 Investors face an efficient frontier of risky assets. Lending at a risk-free rate is
allowed, and investors can borrow at a slightly higher rate. Using an indifference
curve, show an example of Investor E, who chooses to borrow. Label this point E.
On the same graph show where the investor's indifference curve would be if she
could borrow at the lending rate. Label this point F.
Answer: The graph of investors A and B should resemble Figure 8-15 on page 254.
The graph of investors C and D should look like Figure 8-8 on page 239, with C lying
to the left of P and point D to the right of P. The graph with points E and F is similar
to Figure 8-16 on page 255.
The students should be able to illustrate their grasp of the chapter's concepts through
these graphs. An additional discussion portion may be added to the question.
64. State Markowitz's mean-variance criterion. Give some numerical examples of how
the criterion would be applied.
Answer: The mean-variance criterion states that asset A dominates asset B if and only
if E(RA) is greater than or equal to E(RB) and the standard deviation of A's returns is
less than or equal to the standard deviation of B's returns, with at least one strict
inequality holding. Students can give examples of securities dominating others on the
basis of expected return or standard deviation, and can also give examples of
comparisons where neither security is inefficient.
The mean-variance criterion is the basis of the chapter material. It is essential that
students have a firm grasp of this material.
Difficulty: Easy

Asset
65. Draw a graph of a typical efficient frontier. Explain why the efficient frontier is
shaped the way it is.
Answer: The efficient frontier has a curved appearance, as shown throughout the
chapter. Figure 8-5 on page 233 shows several correlation values and the
corresponding shapes of the frontier. The typical shape results from the fact that
assets' returns are not perfectly (positively or negatively) correlated.
This question relates to the fundamentals of assets' relationships and their impact on
the efficient frontier. Sometimes students get used to seeing the efficient frontier as it
is depicted in subsequent graphs and forget its origin.

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Chapter 7 Capital Allocation Between the Risky Asset and the Risk-Free

Multiple Choice Questions

1. The Capital Allocation Line can be described as the

Answer: A Difficulty: Moderate

Answer: D Difficulty: Moderate

Answer: D Difficulty: Moderate

Bodie, Investments, Sixth Edition 1

Answer: B Difficulty: Moderate

Rationale: E(rP) = 0.3(15%) + 0.7(6%) = 8.7%; sP = 0.3(0.04)1/2 = 6%.

Use the following to answer questions 5-8:

Answer: D Difficulty: Moderate

Rationale:9% = w1(12%) + (1 - w1)(5%);

0.57(12%) + 0.43(5%) = 8.99% .

Answer: C Difficulty: Moderate

2 Bodie, Investments, Sixth Edition

Rationale: 0.06 = x(0.15);

7.A portfolio that has an expected outcome of $115 is formed by

Answer: C Difficulty: Difficult

Rationale: For $100,

Answer: A Difficulty: Moderate

Rationale: (0.12 - 0.05)/0.15 = 0.4667.

Security A: E(r) = 0.15; Variance = 0.04

Bodie, Investments, Sixth Edition 3

Answer: C Difficulty: Difficult

Rationale: Security C has the highest reward-to-volatility ratio.

4 Bodie, Investments, Sixth Edition

Use the following to answer questions 10-13:

Answer: B Difficulty: Moderate

Rationale: E(rP) = 0.6(14%) + 0.4(10%) = 12.4%;

Answer: C Difficulty: Difficult

Rationale: E(rP) = 10% = 5%w + 12.4%(1 - w);

Bodie, Investments, Sixth Edition 5

Answer: D Difficulty: Moderate

Answer: B Difficulty: Difficult

Rationale: ($1,200 - $1,000)/$1,000 = 12%;

14. A reward-to-volatility ratio is useful in:

Answer: B Difficulty: Moderate

6 Bodie, Investments, Sixth Edition

Bodie, Investments, Sixth Edition 7

Answer: B Difficulty: Difficult

16. The first major step in asset allocation is:

Answer: A Difficulty: Moderate

Rationale: A should be the first consideration in asset allocation. B, C, and D refer to

17. Based on their relative degrees of risk tolerance

Answer: D Difficulty: Easy

8 Bodie, Investments, Sixth Edition

18. Passive investing

Answer: A Difficulty: Easy

Rationale: Passive investing involves virtually no security selection and minimal

19. Asset allocation

Answer: D Difficulty: Easy

Rationale: A and B are possible steps in asset allocation. C is related to security

Answer: B Difficulty: Moderate

Bodie, Investments, Sixth Edition 9

Answer: D Difficulty: Easy

Answer: E Difficulty: Easy

Rationale: All three statements correctly describe a portfolio invested in a combination

23. In a top-down analysis of portfolio construction

Rationale: E(rC) = 0.812.00% + 0.23.6% = 10.32%