Chapter 07 Test Bank - Static Key

10. 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.
E. None of the options are correct.

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.
Difficulty: 2 Intermediate
Topic: Standard deviation and variance
13. 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. securities' returns are positively correlated and high.

Negative correlation among securities results in the greatest reduction of portfolio risk, which is the goal of
diversification.
Difficulty: 2 Intermediate
Topic: Diversification
14. The efficient frontier of risky assets is
A. the portion of the minimum-variance portfolio that lies above the global minimum variance portfolio.
B. the portion of the minimum-variance portfolio that represents the highest standard deviations.
C. the portion of the minimum-variance portfolio that includes the portfolios with the lowest standard deviation.
D. the set of portfolios that have zero standard deviation.

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.
Difficulty: 2 Intermediate
Topic: Efficient frontier

15. 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.

The capital allocation line represents the most efficient combinations of the risk-free asset and risky securities.
Only C meets that definition.
Difficulty: 2 Intermediate
Topic: Capital allocation line

16. 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.

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.
difficulty: 3 Challenge
Topic: Minimum-variance portfolio and frontier

19. Efficient portfolios of N risky securities are portfolios that

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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.

Portfolios that are efficient are those that provide the highest expected return for a given level of risk.
Difficulty: 2 Intermediate
Topic: Efficient frontier

20. Which of the following statement(s) is(are) true regarding the selection of a portfolio from those that lie on the
capital allocation line?
I) Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than
more risk-averse investors.
II) More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than
less risk-averse investors.
III) Investors choose the portfolio that maximizes their expected utility.
A. I only
B. II only
C. III only
D. I and III
E. II and III

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.
Difficulty: 2 Intermediate
Topic: Capital allocation line

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

wA = 12/(16 + 12) = 0.4286; wB = 1 0.4286 = 0.5714.

Difficulty: 2 Intermediate
Topic: Minimum-variance portfolio and frontier

31. Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of 10%
and a standard deviation of 16%. B has an expected rate of return of 8% and a standard deviation of 12%.
The risk-free portfolio that can be formed with the two securities will earn a(n) _____ rate of return.
A. 8.5%
B. 9.0%
C. 8.9%
D. 9.9%

E(RP) = 0.43(10%) + 0.57(8%) = 8.86%.

Difficulty: 3 Challenge
Topic: Minimum-variance portfolio and frontier

32. Given an optimal risky portfolio with expected return of 6%, standard deviation of 23%, and a risk free rate of
3%, what is the slope of the best feasible CAL?
A. 0.64
B. 0.39
C. 0.08
D. 0.13
E. 0.36

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Slope = (6 – 3)/23 = 0.1304
Difficulty: 2 Intermediate
Topic: Capital allocation line

33. 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.
B. borrow some money at the risk-free rate and invest in the optimal risky portfolio.
C. invest only in risky securities.
D. borrow some money at the risk-free rate, invest in the optimal risky portfolio, and invest only in risky
securities
E. Such a portfolio cannot be formed.

The only way that an investor can create a portfolio that lies 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.
Difficulty: 2 Intermediate
Topic: Capital allocation line

34. Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz?

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 be determined from the information given.

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.
Difficulty: 2 Intermediate
Topic: Efficient frontier

36. 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.

Markowitz was concerned with reducing portfolio risk by combining risky securities with differing return patterns.
Difficulty: 2 Intermediate
Topic: Efficient frontier

37. The measure of risk in a Markowitz efficient frontier is

A. specific risk.
B. standard deviation of returns.
C. reinvestment risk.
D. beta.

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.

Difficulty: 2 Intermediate
Topic: Efficient frontier
38. A statistic that measures how the returns of two risky assets move together is:
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A. variance.
B. standard deviation.
C. covariance.
D. correlation.
E. covariance and correlation.

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.
Difficulty: 2 Intermediate
Topic: Diversification measures

39. 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.

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.
Difficulty: 2 Intermediate
Topic: Systematic and unsystematic risk

40. Which statement about portfolio diversification is correct?

A. Proper diversification can 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 statements are correct.

Diversification can eliminate only nonsystematic risk; relatively few securities are required to reduce this risk; as diversification
increases, the total risk would approach the systematic risk and therefore decrease progressively slower until it cannot be decreased
anymore.
Difficulty: 2 Intermediate
Topic: Diversification

41. 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 options are correct.

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.
Difficulty: 2 Intermediate
Topic: Indifference curves

44. 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

Personnel changes are a firm-specific event that is a component of nonsystematic risk. The others are all
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sources of systematic risk.
Blooms: Remember
Difficulty: 1 Basic
Topic: Systematic and unsystematic risk

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

A. 0.038
B. 0.070
C. 0.018
D. 0.033
E. 0.054

Cov(r X, r Y) = (0.7)(0.18)(0.26) = 0.0327

Blooms: Apply
Difficulty: 2 Intermediate
Topic: Diversification measures

47. 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 individual security standard
deviations.
C. the portfolio standard deviation will be equal to the weighted average of the individual security standard
deviations.
D. the portfolio standard deviation will always be equal to the securities' covariance.

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.
Blooms: Understand
Difficulty: 2 Intermediate
Topic: Diversification measures

51. 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

All of these terms are used interchangeably to refer to the risk that can be removed from a portfolio through
diversification.
Blooms: Understand
Difficulty: 2 Intermediate
Topic: Systematic and unsystematic risk

52. 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.
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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.

Statman's study 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 7.2. The minimum
portfolio risk in the study was 19.2%.
Blooms: Understand
Difficulty: 2 Intermediate
Topic: Diversification

53. 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.

As written in equation 7.4, 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.

Difficulty: 3 Challenge
Topic: Diversification measures

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

A. I and III
B. I and IV
C. II and IV
D. I only
E. I, II, and III

The optimal CAL is the one that is tangent to the efficient frontier. 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.
Difficulty: 3 Challenge
Topic: Capital allocation line

58. 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.

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.
Difficulty: 3 Challenge
Topic: Optimal risky portfolio with a risk-free asset

61. Consider the following probability distribution for stocks A and B:

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i) The coefficient of correlation between A and B is
A. 0.474.
B. 0.612.
C. 0.590.
D. 1.206.
You need to calculate first expected returns and standard deviation of each stock:
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%.
SD(A) = [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%;
SD(B) = [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]1/2 = 1.655%.

COV(A, 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;
corr(A, B) = 2.40/[(2.45)(1.66)] = 0.590.

ii) 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%

E(RP) = 0.35(13%) + 0.65(8.4%) = 10.01%;

SD(P) = [(0.35)2(2.45%)2 + (0.65)2(1.66)2 +2(0.35)(0.65)(2.45)(1.66)(0.590)]1/2 = 1.7%.
Difficulty: 3 Challenge
Topic: Standard deviation and variance

67. Given an optimal risky portfolio with expected return of 12%, standard deviation of 26%, and a risk free rate of
3%, what is the slope of the best feasible CAL?
A. 0.64
B. 0.14
C. 0.08
D. 0.35
E. 0.36

Slope = (12 – 3)/26 = 0.346.

Difficulty: 2 Intermediate
Topic: Capital allocation line

68. Consider the following probability distribution for stocks C and D:

i) The expected rates of return of stocks C and D are _____ and _____, respectively.
A. 4.4%; 9.5%
B. 9.5%; 4.4%
C. 6.3%; 8.7%
D. 8.7%; 6.2%
E. None of the options are correct.
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E(RC) = 0.30(7%) + 0.5(11%) + 0.20(–16%) = 4.4%; E(RD) = 0.30(–9%) + 0.5(14%) + 0.20(26%) = 9.5%.

ii) The standard deviations of stocks C and D are _____ and _____, respectively.
A. 7.62%; 11.24%
B. 11.24%; 7.62%
C. 10.35%; 12.93%
D. 12.93%; 10.35%

sC = [0.30(7% – 4.4%)2 + 0.5(11% – 4.4%)2 + 0.20(–16% – 4.4%)2]1/2 = 10.35%; sD = [0.30(–9% – 9.5%)2 + 0.50(14% – 9.5%)2 +
0.20(26% – 9.5%)2]1/2 = 12.93%.

iii) The coefficient of correlation between C and D is

A. 0.67.
B. 0.50.
C. –0.50.
D. –0.67.
E. None of the options are correct.

Cov(C, D) = 0.30(7% – 4.4%)(–9% – 9.5%) + 0.50(11% – 4.4%)(14% – 9.5%) + 0.20(–16% – 4.4%)(26% – 9.5%) = –66.9;
Corr(A, B) = –66.90/[(10.35)(12.93)] = –0.50.

iv) If you invest 25% of your money in C and 75% in D, what would be your portfolio's expected rate of return and
standard deviation?
A. 9.891%; 8.70%
B. 9.945%; 11.12%
C. 8.225%; 8.70%
D. 10.275%; 11.12%

E(RP) = 0.25(4.4%) + 0.75(9.5%) = 8.225%; sP = [(0.25)2(10.35)2 + (0.75)2(12.93)2 + 2(0.25)(0.75)(10.35)(12.93)(-0.50)]1/2 =

8.70%.
Difficulty: 3 Challenge
Topic: Standard deviation and variance

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

A. 0.0388
B. –0.0108
C. 0.0184
D. –0.0139
E. –0.1512

Cov(r X, r Y) = (–0.45)(0.14)(0.22) = –.01386.

Blooms: Apply
Difficulty: 2 Intermediate
Topic: Diversification measures

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