Deck 6: Efficient Diversification

Question 1

Which of the following statistics cannot be negative?

A)Covariance
B)Variance
C)E[r]
D)Correlation coefficient

Answer 1

B

Question 2

Diversification is most effective when security returns are ________.

A)high
B)negatively correlated
C)positively correlated
D)uncorrelated

Answer 2

B

Question 3

Asset A has an expected return of 20% and a standard deviation of 25%. The risk-free rate is 10%. What is the reward-to-variability ratio?

A).40
B).50
C).75
D).80

Answer 3

A

Question 4

Market risk is also called ________ and ________.

A)systematic risk, diversifiable risk
B)systematic risk, nondiversifiable risk
C)unique risk, nondiversifiable risk
D)unique risk, diversifiable risk

Question 5

An investor's degree of risk aversion will determine their ________.

A)optimal risky portfolio
B)risk-free rate
C)optimal mix of the risk-free asset and risky asset
D)capital allocation line

Question 6

Which one of the following share return statistics fluctuates the most over time?

A)Covariance of returns
B)Variance of returns
C)Average return
D)Correlation coefficient

Question 7

The ________ is equal to the square root of the systematic variance divided by the total variance.

A)covariance
B)correlation coefficient
C)standard deviation
D)reward-to-variability ratio

Question 8

The expected rate of return of a portfolio of risky securities is ________.

A)the sum of the securities' covariances
B)the sum of the securities' variances
C)the weighted sum of the securities' expected returns
D)the weighted sum of the securities' variances

Question 9

The ________ decision should take precedence over the ________ decision.

A)asset allocation, share selection
B)bond selection, mutual fund selection
C)share selection, asset allocation
D)share selection, mutual fund selection

Question 10

Beta is a measure of security responsiveness to ________.

A)firm-specific risk
B)diversifiable risk
C)market risk
D)unique risk

Question 11

Harry Markowitz is best known for his Nobel prize-winning work on ________.

A)strategies for active securities trading
B)techniques used to identify efficient portfolios of risky assets
C)techniques used to measure the systematic risk of securities
D)techniques used in valuing securities options

Question 12

Firm-specific risk is also called ________ and ________.

A)systematic risk, diversifiable risk
B)systematic risk, non-diversifiable risk
C)unique risk, non-diversifiable risk
D)unique risk, diversifiable risk

Question 13

The correlation coefficient between two assets is equal to ________.

A)their covariance divided by the product of their variances
B)the product of their variances divided by their covariance
C)the sum of their expected returns divided by their covariance
D)their covariance divided by the product of their standard deviations

Question 14

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

A)unique
B)firm-specific
C)diversifiable
D)all of the above

Question 15

You put half of your money in a share portfolio that has an expected return of 14% and a standard deviation of 24%. You put the rest of you money in a risky bond portfolio that has an expected return of 6% and a standard deviation of 12%. The share and bond portfolio have a correlation 0.55. The standard deviation of the resulting portfolio will be ________.

A)more than 18% but less than 24%
B)equal to 18%
C)more than 12% but less than 18%
D)equal to 12%

Question 16

Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would prefer a portfolio using the risk-free asset and ________.

A)asset A
B)asset B
C)no risky asset
D)can't tell from the data given

Question 17

Based on the outcomes in the table below choose which of the statements is/are correct: I. The covariance of Security A and Security B is zero
II) The correlation coefficient between Security A and C is negative
III) The correlation coefficient between Security B and C is positive

A)I only
B)I and II only
C)II and III only
D)I, II and III

Question 18

Suppose that a share portfolio and a bond portfolio have a zero correlation. This means that ________.

A)the returns on the share and bond portfolio tend to move inversely
B)the returns on the share and bond portfolio tend to vary independently of each other
C)the returns on the share and bond portfolio tend to move together
D)the covariance of the share and bond portfolio will be positive

Question 19

Adding additional risky assets to the investment opportunity set will generally move the efficient frontier ________ and to the ________.

A)up, right
B)up, left
C)down, right
D)down, left

Question 20

The risk that can be diversified away is ________.

A)beta
B)firm-specific risk
C)market risk
D)systematic risk

Question 21

The standard deviation of return on investment A is .10 while the standard deviation of return on investment B is .04. If the correlation coefficient between the returns on A and B is -.50, the covariance of returns on A and B is ________.

A)-.0447
B)-.0020
C).0020
D).0447

Question 22

A measure of the riskiness of an asset held in isolation is ________.

A)beta
B)standard deviation
C)covariance
D)semi-variance

Question 23

An investor can design a risky portfolio based on two shares, A and B. Share A has an expected return of 18% and a standard deviation of return of 20%. Share B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is 0.50. The risk-free rate of return is 10%. The standard deviation of return on the optimal risky portfolio is ________.

A)0%
B)5%
C)7%
D)20%

Question 24

An investor can design a risky portfolio based on two shares, A and B. Share A has an expected return of 18% and a standard deviation of return of 20%. Share B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is 0.50. The risk-free rate of return is 10%. The expected return on the optimal risky portfolio is ________.

A)14.0%
B)15.6%
C)16.4%
D)18.0%

Question 25

A share has a correlation with the market of 0.45. The standard deviation of the market is 21% and the standard deviation of the share is 35%. What is the share's beta?

A)1.00
B)0.75
C)0.60
D)0.55

Question 26

An investor can design a risky portfolio based on two shares, A and B. The standard deviation of return on Share A is 24% while the standard deviation on Share B is 14%. The correlation coefficient between the return on A and B is 0.35. The expected return on Share A is 25% while on Share B it is 11%. The proportion of the minimum variance portfolio that would be invested in Share B is approximately ________.

A)45%
B)67%
C)85%
D)92%

Question 27

An investor can design a risky portfolio based on two shares, A and B. The standard deviation of return on Share A is 20% while the standard deviation on Share B is 15%. The expected return on Share A is 20% while on Share B it is 10%. The correlation coefficient between the return on A and B is 0%. The expected return on the minimum variance portfolio is approximately ________.

A)10.00%
B)13.60%
C)15.00%
D)19.41%

Question 28

Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of return of 16% and a standard deviation of return of 20%. B has an expected rate of return of 10% and a standard deviation of return of 30%. The weight of Security B in the minimum variance portfolio is ________.

A)10%
B)20%
C)40%
D)60%

Question 29

The term excess-return refers to ________.

A)returns earned illegally by means of insider trading
B)the difference between the rate of return earned and the risk-free rate
C)the difference between the rate of return earned on a particular security and the rate of return earned on other securities of equivalent risk
D)the portion of the return on a security which represents tax liability and therefore cannot be reinvested

Question 30

On a standard expected return vs. standard deviation graph investors will prefer portfolios that lie to the ________ of the current investment opportunity set.

A)left and above
B)left and below
C)right and above
D)right and below

Question 31

The term 'complete portfolio' refers to a portfolio consisting of ________.

A)the risk-free asset combined with at least one risky asset
B)the market portfolio combined with the minimum variance portfolio
C)securities from domestic markets combined with securities from foreign markets
D)common shares combined with bonds

Question 32

The standard deviation of return on investment A is .10 while the standard deviation of return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation coefficient between the returns on A and B is ________.

A).12
B).36
C).60
D).77

Question 33

An investor can design a risky portfolio based on two shares, A and B. Share A has an expected return of 18% and a standard deviation of return of 20%. Share B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is 0.50. The risk-free rate of return is 10%. The proportion of the optimal risky portfolio that should be invested in Share A is ________.

A)0%
B)40%
C)60%
D)100%

Question 34

A portfolio is composed of two shares, A and B. Share A has a standard deviation of return of 24% while Share B has a standard deviation of return of 18%. Share A comprises 60% of the portfolio while Share B comprises 40% of the portfolio. If the variance of return on the portfolio is .0380, the correlation coefficient between the returns on A and B is ________.

A)0.583
B)0.225
C)0.327
D)0.128

Question 35

Which risk can be diversified away as additional securities are added to a portfolio?
I) Total risk
II) Systematic risk
III) Firm-specific risk

A)I only
B)I and II only
C)I, II, and III
D)I and III

Question 36

The values of beta coefficients of securities are ________.

A)always positive
B)always negative
C)always between positive 1 and negative 1
D)usually positive, but are not restricted in any particular way

Question 37

An investor can design a risky portfolio based on two shares, A and B. The standard deviation of return on Share A is 20% while the standard deviation on Share B is 15%. The correlation coefficient between the return on A and B is 0%. The standard deviation of return on the minimum variance portfolio is ________.

A)0%
B)6%
C)12%
D)17%

Question 38

Reward-to-variability ratios are ________ on the ________ capital market line.

A)lower; steeper
B)higher; flatter
C)higher; steeper
D)the same; flatter

Question 39

The part of a share's return that is systematic is a function of which of the following variables?
I) Volatility in excess returns of the share market
II) The sensitivity of the share's returns to changes in the share market
III) The variance in the share's returns that is unrelated to the overall share market

A)I only
B)I and II only
C)II and III only
D)I, II and III

Question 40

Share A has a beta of 1.2 and Share B has a beta of 1. The returns of Share A are ________ sensitive to changes in the market as the returns of Share B.

A)20% more
B)slightly more
C)20% less
D)slightly less

Question 41

Which share is riskier to a non-diversified investor who puts all his money in only one of these shares?

A)Share A is riskier
B)Share B is riskier
C)Both shares are equally risky
D)You cannot tell from the information given.

Question 42

Some diversification benefits can be achieved by combining securities in a portfolio as long as the correlation between the securities is ________.

A)1
B)less than 1
C)between 0 and 1
D)less than or equal to 0

Question 43

In order to construct a riskless portfolio using two risky shares, one would need to find two shares with a correlation coefficient of ________.

A)1.0
B)0.5
C)0
D)-1.0

Question 44

You find that the annual standard deviation of a share's returns is equal to 25%. For a 3-year holding period the standard deviation of your total return would equal ________.

A)75%
B)25%
C)43%
D)55%

Question 45

Which share is likely to further reduce risk for an investor currently holding his portfolio in a well-diversified portfolio of common share?

A)Share A
B)Share B
C)There is no difference between A or B
D)You cannot tell from the information given The figures below show plots of monthly excess returns for two shares plotted against excess returns for a market index.

Question 46

If you want to know the portfolio standard deviation for a three share portfolio you will have to ________.

A)calculate two covariances and one trivariance
B)calculate only two covariances
C)calculate three covariances
D)average the variances of the individual shares

Question 47

What is the standard deviation of a portfolio of two shares given the following data?
Share A has a standard deviation of 18%. Share B has a standard deviation of 14%. The portfolio contains 40% of Share A and the correlation coefficient between the two shares is -.23.

A)9.7%
B)12.2%
C)14.0%
D)15.6%

Question 48

You are considering adding a new security to your portfolio. In order to decide whether you should add the security you need to know the security's ________.
I) expected return
II) standard deviation
III) correlation with your portfolio

A)I only
B)I and II only
C)I and III only
D)I, II and III

Question 49

Which of the following provides the best example of a systematic risk event?

A)A strike by union workers hurts a firm's quarterly earnings.
B)Cattle disease in Queensland hurts local farmers and buyers of beef.
C)The Reserve Bank increases interest rates 50 basis points.
D)A senior executive at a firm embezzles $10 million and escapes to South America.

Question 50

A project has a 60% chance of doubling your investment in one year and a 40% chance of losing half your money. What is the standard deviation of this investment?

A)25%
B)50%
C)62%
D)73%

Question 51

If an investor does not diversify their portfolio and instead puts all of their money in one share, the appropriate measure of security risk for that investor is the ________.

A)share's standard deviation
B)variance of the market
C)share's beta
D)covariance with the market index

Question 52

Decreasing the number of shares in a portfolio from 50 to 10 would likely ________.

A)increase the systematic risk of the portfolio
B)increase the unsystematic risk of the portfolio
C)increase the return of the portfolio
D)decrease the variation in returns the investor faces in any one year

Question 53

Which of the following statements is true regarding time diversification?
I) The standard deviation of the average annual rate of return over several years will be smaller than the one-year standard deviation. II. For a longer time horizon, uncertainty compounds over a greater number of years.
III. Time diversification does not reduce risk.

A)I only
B)None of these answers are correct
C)II and III only
D)I, II and III

Question 54

As you lengthen the time horizon of your investment period and decide to invest for multiple years you will find that ________.
I) the average risk per year may be smaller over longer investment horizons
II) the overall risk of your investment will compound over time
III) your overall risk on the investment will fall

A)I only
B)I and II only
C)III only
D)I, II and III

Question 55

A project has a 50% chance of doubling your investment in one year and a 50% chance of losing half your money. What is the expected return on this investment project?

A)0%
B)25%
C)50%
D)75%

Question 56

Diversification can reduce or eliminate ________ risk.

A)all
B)systematic
C)non-systematic
D)only an insignificant