Online Quiz

Part I (Easy questions)

1. Risk that can be eliminated through diversification is called ________ risk.

A) non-systematic
B) systematic
C) aggregate
D) macro
E) financial

Answer: A

2. When selecting assets to form a portfolio, rational, risk-averse investors should consider
______.
I. the correlation between different assets
II. the expected returns of assets
III. the variance of assets
A) I and II
B) I and III
C) II and III
D) I, II, and III
E) II only

Answer: D

3. A stock X has an expected rate of return of 12% and a beta of 1. The risk-free rate is 2%, and
the market expected rate of return is 12%. According to the capital asset pricing model, security
X is ________.
A) fairly priced
B) overpriced
C) underpriced

Answer: A
Explanation: Expected return implied by CAPM, E(rX) = 2% + 1(12% - 2%) = 12%.

4. You put half of your money in a stock portfolio that has an expected return of 10% and a
standard deviation of 20%. You put the rest of your money in a risky bond portfolio that has an
expected return of 5% and a standard deviation of 8%. The stock and bond portfolios have a
correlation of .2. The standard deviation of the resulting portfolio will be ________.
A) more than 8% but less than 14%
B) equal to 14%
C) more than 14% but less than 20%
D) equal to 15%
E) None of the options is correct.

Answer: A
Two methods:
(1) if their correlation = 1, then the portfolio has a std of 0.5*20%+0.5*8% = 14%. Since
rho=0.2, given the diversification benefits, the portfolio std must be less than 14%. But since the
portfolio invests positively in both assets, its std must be between the std of two assets (8% and
20%). Therefore, the portfolio std is between 8% and 14%.
(2) σp = sqrt[(0.52)(0.22) + (0.52)(0.082) + 2(0.5)(0.5)(0.2)(0.08)(0.2)] = 0.1149

5. Assume securities markets are in a CAPM equilibrium. Which of the following statements
must be true:
I. Investors have no preference towards any specific portfolio combination along the
Capital Market Line (CML) because all portfolios on CML have the same Sharpe
ratio.
II. The Capital Market Line is the line with the steepest slope that connects the risk-free
rate to the efficient frontier of risky assets.

A) I only
B) II only
C) I and II
D) Neither I nor II is true
E) Not enough information to answer the question

Answer: B
I: False. Investors choose their complete portfolios based on their risk aversion.

6. Assume a single index model. Stock X has a greater systematic risk than Stock Y. Which of
the following statements is TRUE?
A) Stock X has a higher total risk than Stock Y.
B) Stock X must have a higher realized return than stock Y.
C) Stock X has a steeper slope than Stock Y in terms of the security characteristic line.
D) When Stock Y has a positive return, Stock X must have a positive return as well.
E) None of the above.
Answer: (C)

7. The optimal risky portfolio can be identified by finding:

I. The minimum variance portfolio

II. The maximum return portfolio
III. The tangency point of the capital market line and the efficient frontier of risky assets
IV. The portfolio provides the highest Sharpe ratio
A) I and II only
B) II and III only
C) II and IV only
D) II, III and IV only
E) III and IV

Answer: E

8. According to two-fund separation, portfolio choice can be separated into two independent
tasks consisting of ________ and ________.
A) identifying all investors’ constraints; identifying the set of securities that conform to the
investor's constraints and offer the best risk-return trade-offs
B) identifying the investor's degree of risk aversion; choosing securities from the safest assets
C) identifying the optimal risky portfolio; constructing a complete portfolio from the risk-free
asset and the optimal risky portfolio based on the investor's degree of risk aversion
D) choosing which risky assets an investor prefers according to the investor's risk-aversion level;
minimizing the CAL by lending at the risk-free rate
E) identifying the investor's degree of risk aversion; choosing securities to satisfy the expected
return requirement

Answer: C

9. You invest $600 in security A with a beta of 1 and $400 in security B with a beta of 0.9. The
beta of this portfolio is ________.
A) 0.98
B) 0.97
C) 0.96
D) 0.95
E) 0.94

Answer: C
Explanation: βp = 1*600/1000 + 0.9*400/1000 = 0.96

10. The beta coefficients of securities ________.

A) are always positive
B) are always negative
C) are always between positive 1 and negative 1
D) are non-zero
E) could be any values

Answer: E

11. Consider a CAPM world. The risk-free rate is 2%. The expected return on the market
portfolio is 8%, and the standard deviation of the return on the market portfolio is 20%. Consider
a portfolio XYZ with an expected return of 14% and a standard deviation of 50%. What's the
idiosyncratic risk of XYZ?
A) 0.06
B) 0.08
C) 0.09
D) 0.1
E) None of the options is correct.

Answer: C
From CAPM, E(ri) = rf + βi[E(rM) – rf]
That is, 14% = 2% + beta * [8%-2%], so beta = 2.
Its systematic risk = 𝛽 𝜎 = 2*2*0.2*0.2 = 0.16 and idiosyncratic risk = 0.5*0.5 – 0.16 = 0.09.

12. An investor would like to do which of the following for stocks with negative alphas?
A) go long
B) sell short
C) buy quickly now
D) do nothing
E) buy on margin

Answer: B

13. The risk-free asset has a beta of ________.

A) -1
B) 0
C) .5
D) 1
E) -2

Answer: B

14. Beta is a measure of security responsiveness to ________.

A) firm-specific risk
B) diversifiable risk
C) market risk
D) macro risk
E) industry risk

Answer: C
 Part 2 (Difficult questions)

15. Consider a portfolio (P) formed by two risky assets (A and B). Assume A and B are perfectly
positively correlated. Which of the following statements must be true?
I. P has a smaller standard deviation than A or B, given the diversification benefits.
II. P, A, and B must have the same Sharpe ratio.
III. P has the highest expected return.

A) I is correct.
B) II is correct.
C) Both I and II are correct.
D) All statements are incorrect.
E) III is correct.

Answer: D
In the expected return-standard deviation diagram, P, A, and B are on a straight line. The Sharpe
ratio of A is the slope of a straight line connecting the risk-free rate (rf) and Point A. So, P, A,
and B would have different Sharpe ratios unless P, A, B, and rf are on the same line.

16. Assume the Fama-French five-factor model is the correct model of expected returns. If an
analyst applies CAPM to evaluate an asset, this analyst will find ______.
I. alpha > 0
II. alpha < 0
III. alpha = 0

A) I only
B) II only
C) I and II only
D) I and III only
E) I, II, and III are all possible

Answer: (E)
III is possible, e.g., if the test asset is the market portfolio.
17. In a simple CAPM world which of the following statements is (are) correct?

I. All investors will choose to hold the market portfolio, which includes all risky assets in the
world.
II. Investors' complete portfolio will vary depending on their risk aversion.
III. The return per unit of systematic risk will be identical for all individual assets.
IV. The market portfolio will be on the efficient frontier, and it will be the optimal risky
portfolio.
A) I, II, and III only
B) II, III, and IV only
C) I, III, and IV only
D) I, II, III, and IV
E) II, III, and IV

Answer: D

18. Consider a CAPM world. The risk-free rate is 2%. The expected return on the market
portfolio is 8%, and the standard deviation of the return on the market portfolio is 20%. Consider
a portfolio XYZ with an expected return of 5% and assume that XYZ is on the efficient frontier.
What's the variance of XYZ?
A) 0.004
B) 0.01
C) 0.02
D) 0.04
E) None of the options is correct.

Answer: B
Pay attention to the settings: (1) when there are only risky assets available, the efficient frontier
is a hyperbola. (2) when there are risky assets + risk-free asset, the efficient frontier is CML (not
the hyperbola).
In the setting of CAPM, the efficient frontier is CML (since there is a risk-free asset). This
means XYZ is located on CML, not on the hyperbola.
From CAPM, E(ri) = rf + βi[E(rM) – rf]
That is, 5% = 2% + beta * [8%-2%], so beta = 0.5.
Since this portfolio is on the efficient frontier, there is no idiosyncratic risk. Hence, its variance =
𝛽 𝜎 = 0.5*0.5*0.2*0.2 = 0.01
19. Assume that both X and Y are well-diversified portfolios and the risk-free rate is 2%.
Portfolio X has an expected return of 10% and a beta of 1. Portfolio Y has an expected return of
14% and a beta of 2. In this situation, you would conclude that ________.
A) portfolios X and Y are in equilibrium
B) relative to Y, X is overpriced
C) portfolios X and Y are both underpriced
D) relative to Y, X is underpriced
E) portfolios X and Y are both overpriced

Answer: D
Risk compensation per unit of beta, X =(10%-2%)/1= 8% ; Y=(14%-2%)/2=7%.
Thus, relative to X, Y is overpriced (or, relative to Y, X is underpriced).

20. In a simple CAPM world which of the following statements is (are) correct?

I. The return per unit of risk will be identical for all individual assets.
II. Since the idiosyncratic risk does not affect expected returns, the idiosyncratic risk is
negligible, i.e., the idiosyncratic risk of an asset is always less than its systematic risk.
III. The return per unit of systematic risk will be identical for all individual assets.
IV. Investors with different risk aversion levels choose the same market portfolio to form their
complete portfolios, therefore the market risk premium is independent of investors’ risk aversion.
A) III only
B) III and IV only
C) II and III only
D) II, III, and IV
E) I and IV

Answer: A
Here is the logic. First, in the end, risk premium of any asset depends on the risk aversion. Look
at the market portfolio first. The average risk aversion in an economy determines the market risk
premium. In the past 94 years, US markets have a risk premium of 8.7%. This is the risk
compensation required by the risk averse investors for taking the systematic risk (a standard
deviation of 20%). Remember the last open-end question of Lecture 2 exactly talks about the link
between market risk premium, risk aversion, and market risk. You see the market premium
depends on the risk aversion.

Second, for the risk premium of individual asset, you know it depends on the systematic risk
only and the price of systematic risk again is given by the Sharpe ratio of market portfolio (e.g.,
from CAPM). So the risk premium of any asset depends on the risk aversion.
Third, market equilibrium is a competitive result from lots of risk averse investors. Their
collective actions pin down the price of systematic risk (each investor is atomic and a price
taker). That’s where market premium comes.

Fourth, assuming the expected returns and covariances are given, we derive the tangent portfolio.
We say that all investors choose the same tangent portfolio as their optimal risky portfolio. This
doesn’t mean the risk premium of the tangent portfolio is independent of risk aversion, because
we need the expected returns and covariances to derive the tangent portfolio and both are linked
to the risk aversion.