FINC425 Exam 2 Multiple Choice

Which of the following does not impact the percentage of a client’s complete portfolio that should be invested optimally in the portfolio of risky assets (with the rest going into the risk-free asset)?

• Risk premium of the portfolio of risky assets

• The client’s risk aversion

• The variance of the portfolio of risky assets

• All of the above

All of the above

The weight depends on the risk premium of the risky portfolio (E[r_p] - r_f), the clients risk aversion (A), and the variance of the risky portfolio (O²_p)

If your client only wants to choose one of the two risky funds to combine with the risk-free asset to form her complete portfolio, which metric should you use to choose between the two funds?

Sharpe Ratio: the portfolio with the highest Sharpe ratio combined with the risk-free asset will give us the best combinations

An investor’s degree of risk aversion will determine her _______?

Optimal mix of the risk-free asset and risky portfolio: all investors have the same optimal risky portfolio (sharpe ratio). The risk-free rate does not differ across investors. THe capital market line does not depend on the investor’s risk aversion.

True or false? The minimum variance portfolio always invests 100% in the lowest risk asset

False: the minimum variance portfolio is the combination of assets that gives the lowest possible risk, not just the lowest-risk asset

In a portfolio diversified across a large number of assets, the portfolio’s variance will depend mainly on:

The covariances across assets: covariances impact portfolio risk in diversified portfolios

True or false: An individual asset can lie outside the efficient frontier

False

True or false: adding more assets to the consideration set can move the efficient frontier up and to the left (greater expected return for given level of risk)

True

True or false: A decrease in correlations across assets can move the efficient frontier up and to the left

True

True or false: The minimum variance portfolio is the portfolio composed of the risky assets that has the smallest standard deviation

True

What is the efficient frontier?

Set of weights in the assets that maximize expected return for each level of risk.

Risk that can be eliminated through diversification is called _____ risk

Firm-specific, unsystematic, idiosyncratic, etc.

In the single-index model, how do we estimate the stock’s beta?

Regress the stock’s excess return (Y) on the market’s excess return (X) and the coefficient on the market excess return is beta.

True or false? In a CAPM world, the market portfolio will have the highest attainable Sharpe ratio of any asset or portfolio.

True, the market portfolio is the optimal portfolio for all investors because it is the highest Sharpe ratio portfolio.

In a CAPM world, every security and portfolio (including the market portfolio) will have the same:

The risk investors care about is the covariance of asset returns with the market

In a CAPM world, the market portfolio is the portfolio:

• With the capital allocation line tangent to the efficient frontier

• With the highest sharpe ratio

• that every investor wants to hold as their risky asset portfolio

The market portfolio is the highest Sharpe ratio portfolio

What is the Capital Market Line

The portfolio with the highest Sharpe ratio, tangent capital allocation line

The arbitrage pricing theory (APT) does not assume:

The market is in equilibrium, and everyone holds the market portfolio: the APT assumes that a factor model can describe security returns, there are sufficient securities to diversify away idiosyncratic risk and there is no arbitrage (CAPM assumes the market is in equilibrium)

True or false: if there is no arbitrage in financial markets, then the price of the same security should be equal across all exchanges in which it trades

True: investors will take advantage of any price discrepancies, until prices are identical across markets

Which of the following are uses for a mutli-factor model?

• calculate a stock’s expected return

• calculate a company’s cost of equity capital

• evaluate a fund manager’s performance

• all of the above

All of the above: all are things done with a mutli-factor model