Deck 8: Portfolio Theory and the Capital Asset Pricing Model

Question 1

The distribution of returns, measured over long intervals, like annual returns, can be approximated by

A) Normal distribution
B) Binomial distribution
C) Lognormal distribution
D) none of the above

Answer 1

Lognormal distribution

Question 2

By combining lending and borrowing at the risk-free rate with the efficient portfolios, we can
I. extend the range of investment possibilities
II. change efficient set of portfolios from being curvilinear to a straight line.
III. provide a higher expected return for any level of risk except the tangential portfolio

A) I only
B) I and II only
C) I, II, and III
D) none of the above

Answer 2

I, II, and III

Question 3

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. If FC and MC are combined in a portfolio with 50% of the funds invested in each, calculate the expected return on the portfolio.

A) 12%
B) 10%
C) 11%
D) None of the above.

Answer 3

11%

Question 4

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: -5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the variances of return for FC and MC.

A) FC: 100 MC: 256
B) FC: 350 MC: 96
C) FC: 175 MC: 48
D) None of the above

Question 5

Suppose you invest equal amounts in a portfolio with an expected return of 16% and a standard deviation of returns of 20% and a risk-free asset with an interest rate of 4%; calculate the standard deviation of the returns on the resulting portfolio:

A) 8%
B) 10%
C) 20%
D) none of the above

Question 6

Normal and lognormal distributions are completely specified by:
I. mean
II. standard deviation
III. third moment

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

Question 7

In practice, efficient portfolios are generated using:

A) regression analysis
B) quadratic programming
C) trial and error method
D) graphical method

Question 8

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. What is the standard deviation of the portfolio with 50% of the funds invested in FC and 50% in MC?

A) 10.6%
B) 14.4%
C) 9.3%
D) None of the above

Question 9

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the covariance between the returns of FC and MC.

A) 60
B) 80
C) 40
D) None of the above

Question 10

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. What is the variance of the portfolio with 50% of the funds invested in FC and 50% in MC (approximately)?

A) 85.75
B) 111.50
C) 55.75
D) None of the above

Question 11

Suppose you borrow at the risk-free rate an amount equal to your initial wealth and invest in a portfolio with an expected return of 16% and a standard deviation of returns of 20%. The risk-free asset has an interest rate of 4%; calculate the expected return on the resulting portfolio:

A) 20%
B) 32%
C) 28%
D) none of the above

Question 12

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the standard deviation (S.D.) of return for FC and MC.

A) FC: 10% MC: 12%
B) FC: 18.7% MC: 9.8%
C) FC: 13.2% MC: 6.9%
D) None of the above

Question 13

The distribution of returns, measured over a short interval of time, like daily returns, can be approximated by:

A) Normal distribution
B) Lognormal distribution
C) Binomial distribution
D) none of the above

Question 14

Investments B and C both have the same standard deviation of 20%. If the expected return on B is 15% and that of C is 18%, then the investors would

A) Prefer B to C
B) Prefer C to B
C) Reject both B and C
D) None of the above

Question 15

The efficient portfolios:
I. have only unique risk
II. provide highest returns for a given level of risk
III. provide the least risk for a given level of returns
IV. have no risk at all

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

Question 16

Portfolio Theory was first developed by:

A) Merton Miller
B) Richard Brealey
C) Franco Modigliani
D) Harry Markowitz

Question 17

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the correlation coefficient between the return of FC and MC.

A) 0.0
B) -0.655
C) +0.655
D) None of the above

Question 18

Florida Company (FC) and Minnesota Company (MC) are both service companies. Their historical return for the past three years are: FC: - 5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the mean of returns for each company.

A) FC: 12%, MC: 6%
B) FC: 10%, MC: 12%
C) FC: 20%, MC: 32%
D) None of the above

Question 19

Suppose you invest equal amounts in a portfolio with an expected return of 16% and a standard Deviation of returns of 20% and a risk-free asset with an interest rate of 4%; calculate the expected Return on the resulting portfolio:

A) 10%
B) 4%
C) 12%
D) none of the above

Question 20

Investments A and B both offer an expected rate of return of 12%. If the standard deviation of A is 20% and that of B is 30%, then investors would:

A) Prefer A to B
B) Prefer B to A
C) Prefer a portfolio of A and B
D) Cannot answer without knowing investor's risk preferences

Question 21

If the beta of Microsoft is 1.13, risk-free rate is 3% and the market risk premium is 8%, calculate the expected return for Microsoft.

A) 12.04%
B) 15.66%
C) 13.94%
D) 8.65%

Question 22

The correlation between the efficient portfolio and the risk-free asset is:

A) +1
B) -1
C) 0
D) cannot be calculated

Question 23

Beta of Treasury bills is:

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

Question 24

Suppose you borrow at the risk-free rate an amount equal to your initial wealth and invest in a portfolio with an expected return of 20% and a standard deviation of returns of 16%. The risk-free asset has an interest rate of 4%; calculate standard deviation of the resulting portfolio:

A) 28%
B) 40%
C) 32%
D) none of the above

Question 25

Beta of the market portfolio is:

A) Zero
B) +0.5
C) -1.0
D) +1.0

Question 26

The main shortcoming of CAPM is that it

A) ignores the return on the market portfolio
B) uses too many factors
C) requires a single risk measure of systematic risk
D) ignores risk-free rate of return

Question 27

The graphical representation of CAPM (Capital Asset Pricing Model) is called:

A) Capital Market Line
B) Characteristic Line
C) Security Market Line
D) None of the above

Question 28

Sharpe ratio is defined as:

A) (rP - rf)/σP
B) (rP - rM)/σP
C) (rP - rf)/bP
D) none of the above

Question 29

Beta measure indicates:

A) The ability to diversify risk
B) The change in the rate of return on an investment for a given change in the market return
C) The actual return on an asset
D) A and C

Question 30

If the correlation coefficient between Stock A and Stock B is +0.6, what is the correlation between Stock B with Stock A?

A) +0.6
B) -0.6
C) +0.4
D) -0.4

Question 31

The capital asset pricing model (CAPM) states that:

A) The expected risk premium on an investment is proportional to its beta
B) The expected rate of return on an investment is proportional to its beta
C) The expected rate of return on an investment depends on the risk-free rate and the market rate of return
D) The expected rate of return on an investment is dependent on the risk-free rate

Question 32

The security market line (SML) is the graph of:

A) Expected rate on investment (Y-axis) vs. variance of return
B) Expected return on investment vs. standard deviation of return
C) Expected rate of return on investment vs. beta
D) A and B

Question 33

If the beta of Amazon.com is 2.2, risk-free rate is 5.5% and the market risk premium is 8%, calculate the expected rate of return for Amazon.com stock:

A) 15.8%
B) 14.3%
C) 35.2%
D) 23.1%

Question 34

If the market risk premium is (rm - rf) is 8%, then according to the CAPM, the risk premium of a stock with beta value of 1.7 must be:

A) less than 12%
B) 12%
C) greater than 12%
D) cannot be determined

Question 35

If the covariance of Stock A with Stock B is - 100, what is the covariance of Stock B with Stock A?

A) +100
B) -100
C) 1/100
D) Need additional information

Question 36

In the presence of a risk-free asset, the investor's job is to:
I. invest in the market portfolio
II. find an interior portfolio using quadratic programming
III. borrow or lend at the risk-free rate
IV. read and understand Markowitz's portfolio theory

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

Question 37

The correlation measures the:

A) Rate of movements of the return of individual stocks
B) Direction of movement of the return of individual stocks
C) Direction of movement between the returns of two stocks
D) Stock market volatility

Question 38

A stock with a beta of 1. 25 would be expected to:

A) Increase in returns 25% faster than the market in up markets
B) Increase in returns 25% faster than the market in down markets
C) Increase in returns 125% faster than the market in up markets
D) Increase in returns 125% faster than the market in down markets

Question 39

A stock with a beta of zero would be expected to:

A) Have a rate of return equal to zero
B) Have a rate of return equal to the market risk premium
C) Have a rate of return equal to the risk-free rate
D) Have a rate of return equal to the market rate of return

Question 40

If the beta of Exxon Mobil is 0.65, risk-free rate is 4% and the market rate of return is 14%, calculate the expected rate of return from Exxon:

A) 12.6%
B) 10.5%
C) 13.1%
D) 6.5%

Question 41

If a stock is under priced it would plot:

A) Above the security market line
B) Below the security market line
C) On the security market line
D) On the Y-axis

Question 42

Given the following data for a stock: beta = 1.5; risk-free rate = 4%; market rate of return = 12%; and Expected rate of return on the stock = 15%. Then the stock is:

A) overpriced
B) under priced
C) correctly priced
D) cannot be determined

Question 43

A "factor" in APT is a variable that:

A) is pure "noise"
B) correlates with risky asset returns in an unsystematic manner
C) affects the return of risky assets in a systematic manner
D) affects the return of a risky asset in a random manner

Question 44

How does an investor earn more than the return generated by the tangency portfolio and still stay on the security market line?

A) Borrow at the risk free rate and invest in the tangency portfolio.
B) Add high risk/return assets to the portfolio.
C) Adjust the weight of stock in the portfolio to include more high return stocks.
D) It cannot be done.

Question 45

If the expected return of stock A is 12% and that of stock B is 14% and both have the same variance, then investors would prefer stock B to stock A.

Question 46

If a stock is overpriced it would plot:

A) Above the security market line
B) Below the security market line
C) On the security market line
D) On the Y-axis

Question 47

The three factors in the Three-Factor Model are:
I. Market factor
II. Size factor
III. Book-to-market factor

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

Question 48

Portfolios that offer the highest expected return for a given variance or standard deviation are known as efficient portfolios.

Question 49

In theory, the CAPM requires that the market portfolio consist of all common stocks.

Question 50

Given the following data for the a stock: risk-free rate = 5%; beta (market) = 1.5; beta (size) = 0.3; beta (book-to-market) = 1.1; market risk premium = 7%; size risk premium = 3.7%; and book-to-market risk premium = 5.2%. Calculate the expected return on the stock using the Fama-French three-factor model.

A) 22.3%
B) 7.8%
C) 11.5%
D) none of the above

Question 51

Given the following data for a stock: beta = 0.5; risk-free rate = 4%; market rate of return = 12%; and Expected rate of return on the stock = 10%. Then the stock is:

A) overpriced
B) under priced
C) correctly priced
D) cannot be determined

Question 52

Given the following data for a stock: beta = 0.9; risk-free rate = 4%; market rate of return = 14%; and Expected rate of return on the stock = 13%. Then the stock is:

A) overpriced
B) under priced
C) correctly priced
D) cannot be determined

Question 53

The distribution of daily returns for a stock would be closely related to the lognormal distribution.

Question 54

If two investments offer the same expected return, most investors would prefer the one with higher variance.

Question 55

According to CAPM, all investments plot along the security market line.

Question 56

Given the following data for a stock: risk-free rate = 4%; factor-1 beta = 1.5; factor-2 beta = 0.5; factor-1 risk-premium = 8%; factor-2 risk-premium = 2%. Calculate the expected rate of return on the stock using the two-factor APT model.

A) 13%
B) 17%
C) 10%
D) none of the above

Question 57

Investors are mainly concerned with those risks that can be eliminated through diversification.

Question 58

Given the following data for the a stock: risk-free rate = 5%; beta (market) = 1.4; beta (size) = 0.4; beta (book-to-market) = -1.1; market risk premium = 7%; size risk premium = 3.7%; and book-to-market risk premium = 5.2%. Calculate the expected return on the stock using the Fama-French three-factor model.

A) 22.3%
B) 7.8%
C) 10.6%
D) none of the above

Question 59

Beta measures the marginal contribution of a stock to the risk of a well-diversified portfolio.

Question 60

The distribution of annual returns for a stock would be closely related to the normal distribution.

Question 61

Both the CAPM and the APT stress that expected return is not affected by unique risk.

Question 62

Explain the term market risk.

Question 63

The arbitrage pricing theory (APT) implies that the market portfolio is efficient.

Question 64

Briefly explain the term "market portfolio."

Question 65

According to the CAPM, market portfolio is a risky portfolio.

Question 66

Briefly explain the term "security market line."

Question 67

Briefly explain the Fama-French Three-Factor Model.

Question 68

Tests of CAPM have confirmed that Capital Asset Pricing Model holds good under all circumstances.

Question 69

Briefly explain the term "risk-free rate of interest"

Question 70

It is not possible to earn a return that is outside the efficient frontier without the existence of a risk free asset or some other asset that is uncorrelated with your portfolio assets.

Question 71

Where would under priced and overpriced securities plot on the SML (security market line)?