Deck 7: Portfolio Theory

Question 1

Probability distributions:

A)are always discrete.
B)are always continuous.
C)can be either discrete or continuous.
D)are inverse to interest rates.

Answer 1

C

Question 2

Security A and Security B have a correlation coefficient of 0.If Security A's return is expected to increase by 10 percent,

A)Security B's return should also increase by 10 percent
B)Security B's return should decrease by 10 percent
C)Security B's return should be zero
D)Security B's return is impossible to determine from the above information

Answer 2

D

Question 3

The relevant risk for a well-diversified portfolio is:

A)interest rate risk
B)inflation risk
C)business risk
D)market risk

Answer 3

D

Question 4

Company specific risk is also known as:

A)market risk
B)systematic risk
C)non-diversifiable risk
D)idiosyncratic risk

Question 5

The major difference between the correlation coefficient and the covariance is that:

A)the correlation coefficient can be positive,negative or zero while the covariance is always positive
B)the correlation coefficient measures relationship between securities and the covariance measures relationships between a security and the market
C)the correlation coefficient is a relative measure showing association between security returns and the covariance is an absolute measure showing association between security returns
D)the correlation coefficient is a geometric measure and the covariance is a statistical measure

Question 6

Which of the following statements regarding expected return of a portfolio is true?

A)It can be higher than the weighted average expected return of individual assets
B)It can be lower than the weighted average return of the individual assets
C)It can never be higher or lower than the weighted average expected return of individual assets
D)Expected return of a portfolio is impossible to calculate

Question 7

The expected value is the:

A)inverse of the standard deviation
B)correlation between a security's risk and return.
C)weighted average of all possible outcomes.
D)same as the discrete probability distribution.

Question 8

Two stocks with perfect negative correlation will have a correlation coefficient of:

A)+1.0
B)-2.0
C)0
D)-1.0

Question 9

In order to determine the expected return of a portfolio,all of the following must be known,except:

A)probabilities of expected returns of individual assets
B)weight of each individual asset to total portfolio value
C)expected return of each individual asset
D)variance of return of each individual asset and correlation of returns between assets

Question 10

Portfolio weights are found by:

A)dividing standard deviation by expected value
B)calculating the percentage each asset's value to the total portfolio value
C)calculating the return of each asset to total portfolio return
D)dividing expected value by the standard deviation

Question 11

The bell-shaped curve,or normal distribution,is considered:

A)discrete.
B)downward sloping
C)linear
D)continuous

Question 12

-------------------is concerned with the interrelationships between security returns as well as the expected returns and variances of those returns.

A)random diversification.
B)correlating diversification
C)Friedman diversification
D)Markowitz diversification

Question 13

Which of the following would be considered a random variable:

A)expected value.
B)correlation coefficient between two assets
C)one-period rate of return for an asset.
D)beta.

Question 14

When returns are perfectly positively correlated,the risk of the portfolio is:

A)zero
B)the weighted average of the individual securities risk
C)equal to the correlation coefficient between the securities
D)infinite

Question 15

Which of the following is true regarding random diversification?

A)Investment characteristics are considered important in random diversification
B)The benefits of random diversification eventually no longer continue as more securities are added
C)Random diversification,if done correctly,can eliminate all risk in a portfolio
D)Random diversification eventually removes all company specific risk from a portfolio

Question 16

Which of the following is true regarding the expected return of a portfolio?

A)It is a weighted average only for stock portfolios
B)It can only be positive
C)It can never be above the highest individual asset return
D)It is always below the highest individual asset return

Question 17

Which of the following portfolios has the least reduction of risk?

A)A portfolio with securities all having positive correlation with each other
B)A portfolio with securities all having zero correlation with each other
C)A portfolio with securities all having negative correlation with each other
D)A portfolio with securities all having skewed correlation with each other

Question 18

Which of the following statements regarding the correlation coefficient is not true?

A)It is a statistical measure
B)It measure the relationship between two securities' returns
C)It determines the causes of the relationship between two securities' returns
D)It is greater than or equal to -1 and less than or equal to +1

Question 19

With a continuous probability distribution,:

A)a probability is assigned to each possible outcome.
B)possible outcomes are constantly changing.
C)an infinite number of possible outcomes exist.
D)there is no variance.

Question 20

Which of the following statements regarding portfolio risk and number of stocks is generally true?

A)Adding more stocks increases risk
B)Adding more stocks decreases risk but does not eliminate it
C)Adding more stocks has no effect on risk
D)Adding more stocks increases only systematic risk

Question 21

Portfolio risk is a weighted average of the individual security risks.

Question 22

In the case of a four-security portfolio,there will be 8 covariances.

Question 23

According to the Law of Large Numbers,the larger the sample size,the more likely it is that the sample mean will be close to the population expected value.

Question 24

Portfolio risk is most often measured by professional investors using the:

A)expected value
B)portfolio beta
C)weighted average of individual risk
D)standard deviation

Question 25

Throwing a dart at the WSJ and selecting stocks on this basis would be considered random diversification.

Question 26

A change in the correlation coefficient of the returns of two securities in a portfolio causes a change in

A)both the expected return and the risk of the portfolio
B)only the expected return of the portfolio
C)only the risk level of the portfolio
D)neither the expected return nor the risk level of the portfolio

Question 27

Owning two securities instead of one will not reduce the risk taken by an investor if the two securities are

A)perfectly positively correlated with each other
B)perfectly independent of each other
C)perfectly negatively correlated with each other
D)of the same category,
E)g.blue chips

Question 28

A negative correlation coefficient indicates that the returns of two securities have a tendency to move in opposite directions.

Question 29

If an analyst uses ex post data to calculate the correlation coefficient and covariance and uses them in the Markowitz model,the assumption is that past relationships will continue in the future.

Question 30

When the covariance is positive,the correlation will be:

A)positive
B)negative
C)zero
D)impossible to determine

Question 31

In a portfolio consisting of two perfectly negatively correlated securities,the highest attainable expected return will consist of a portfolio containing 100% of the asset with the highest expected return.

Question 32

Calculate the risk (standard deviation)of the following two-security portfolio if the correlation coefficient between the two securities is equal to 0.5.
$\begin{array}{lll}\underline{\text { Variance } }&&\underline{ \text { Weight (in the portfolio) }}\\\text { Security A } & 10 & 0.3 \\\text { Security B } & 20 & 0.7\end{array}$

A)17.0 percent
B)5.4 percent
C)2.0 percent
D)3.7 percent

Question 33

The correlation coefficient explains the cause in the relative movement in returns between two securities.

Question 34

Portfolio risk can be reduced by reducing portfolio weights for assets with positive correlations.

Question 35

A probability distribution shows the likely outcomes that may occur and the probabilities associated with these likely outcomes.

Question 36

With a discrete probability distribution:

A)a probability is assigned to each possible outcome
B)possible outcomes are constantly changing
C)an infinite number of possible outcomes exist
D)there is no variance

Question 37

Markowitz's main contribution to portfolio theory is:

A)that risk is the same for each type of financial asset
B)that risk is a function of credit,liquidity and market factors
C)risk is not quantifiable
D)insight about the relative importance of variance and covariance in determining portfolio risk

Question 38

Investments in commodities such as precious metals may provide additional
diversification opportunities for portfolios consisting primarily of stocks and bonds.

Question 39

Standard deviations for well-diversified portfolios are reasonably steady over time.

Question 40

The major problem with the Markowitz model is its:

A)lack of accuracy
B)predictability flaws
C)complexity
D)inability to handle large number of inputs

Question 41

Are the expected returns and standard deviation of a portfolio both weighted averages of the individual securities expected returns and standard deviations? If not,what other factors are required?

Question 42

Calculate the expected return and risk (standard deviation)for General Fudge for 200X,given the following information:
$\begin{array} { l l l l l } \text { Probabilities } & 0.20 & 0.15 & 0.50 & 0.15 \end{array}$
$\begin{array} { l l l l l } \text { Possible Outcomes } & 20 \% & 15 \% & 11 \% & - 5 \% \end{array}$

Question 43

Why was the Markowitz model impractical for commercial use when it was first introduced in 1952? What has changed by the 1990s?

Question 44

The major problem with Markowitz diversification model is that it requires a full set of ________________________ between the returns of all securities being considered in order to calculate portfolio variance.

Question 45

Markowitz diversification,also called _____________ diversification,removes _________________ risk from the portfolio.

Question 46

A portfolio consisting of two securities with perfect negative correlation in the proper proportions can be shown to have a standard deviation of zero.What makes this riskless portfolio impossible to achieve in the real world?

Question 47

The number of covariances in the Markowitz model is ________ ; the number of unique covariances is [n (n-1)]/2.

Question 48

When constructing a portfolio,standard deviations,expected returns,and correlation coefficients are typically calculated from historical data.Why may that be a problem?

Question 49

Conventional wisdom has long held that diversification of a stock portfolio should be across industries.Does the correlation coefficient indirectly recommend the same thing?

Question 50

Provide an example of two industries that might have low correlation with one another.Give an example that might exhibit high correlation.

Question 51

How is the correlation coefficient important in choosing among securities for a portfolio?

Question 52

Why is more Difficult to put Markowitz diversification into effect than random diversification?

Question 53

An efficiently diversified portfolio still has _____________________ risk.