Principles of Investment Final

Conceptual

Diversification is _____. It _____.

Diversification is the mixing of different assets within a portfolio. It reduces overall portfolio risk.

Diversification works if _____.

assets are imperfectly correlated, i.e., diversification reduces portfolio risk (standard deviation) if the correlation between assets in the portfolio is less than one.

The efficient frontier _____.

is a subset of the investment opportunity set (or feasible set). While the investment opportunity set is backward bending below the minimum variance portfolio, the efficient frontier is strictly monotonic. The efficient frontier is that part of the feasible set above the minimum variance portfolio and plots the portfolios that are not dominated by some other portfolio.

The efficient frontier is the subset of feasible portfolios that _____.

offers the maximum return for a given standard deviation or offers the minimum standard deviation for a given return.

Diversification can eliminate _____ risk.

unsystematic or specific

As different securities are added to a portfolio, the portfolio's total risk _____.

decreases

Systematic risk affects _____.

all firms

Factors that create systematic risk include _____.

Common factors that create systematic risk include inflation and interest rates, the business cycle and wars.

Unsystematic risk _____.

is eliminated in a well-diversified portfolio, affects only a single asset or small group of assets.

The systematic risk principle states that _____.

only systematic risk matters for the reward for bearing risk.

Beta measures the _____.

indication of the systematic risk of a stock: the higher the beta, the more systematic risk the stock has.

Securities whose prices move less than the market have _____ betas.

lower

The beta of the market portfolio is _____.

1

Treasury bills are assumed to have a beta of _____.

0 since they are assumed to be risk-free.

To estimate a stock's beta from historical data, we should regress the (excess) return of the stock on the (excess) return of _____.

the market portfolio

The relationship between the (excess) returns on the market portfolio and the (excess) return on an individual asset is captured by the _____.

security characteristic line

The slope of the security characteristic line equals the _____.

assets beta

In the CAPM, the line in expected return-beta space is called the _____.

security market line

According to the CAPM, individual assets plot _____ the SML, and well-diversified portfolios plot _____ the SML.

In the CAPM world, all assets, i.e., individual securities and portfolios, must plot on the SML.

The graphical representation of the CAPM is called the _____.

The security market line (SML)

The slope of the security market line equals the ____

market risk premium

Which is the best performance measurement of a portfolio if the portfolio makes up your entire investment?

The Sharpe measure is the most appropriate performance measurement if the portfolio constitutes the entire investments of an investor.

80% of drivers rating themselves as above average is an example of _____.

Overconfidence is the erroneous belief that your abilities are higher than they really are.

Managers who keep investing in previously unprofitable projects in the hope of breaking even in the future most likely suffer from _____.

The fact that the managers want to break even rather than accept the loss of their sunk costs indicates loss aversion. They may also suffer from overoptimism, hoping that the future will be much better than the past.

Investors who hold to investments that have earned them a negative return so far and do not have a high risk-adjusted expected return are likely to be influenced by _____.

loss aversion

Investors trading a lot is an example of _____.

overconfidence

Which of scenario best describes mental accounting?

Freely accessing and spending dividend returns, but refusing to sell a single stock that has a similar rate of return for the same purpose.

Correlation is the:

extent to which the returns on two assets move together.

Which one of the following is the set of portfolios that provides the maximum return for a given standard deviation?

Markowitz efficient frontier

Which one of the following distinguishes a minimum variance portfolio?

lowest risk portfolio of any possible portfolio given the same risky securities but in differing proportions.

Which one of the following is the theory which states that the value of a security is dependent upon the pure time value of money, the reward for bearing systematic risk, and the amount of systematic risk?

Capital asset pricing model

You own three stocks which have betas of 1.16, 1.34, and 1.02. You would like to add a fourth security such that your portfolio beta will match that of the market. Given this situation, the new security:

could be a 90-day U.S. Treasury bill.

Where will a security plot in relation to the security market line (SML) if it has a beta of 1.1 and is overvalued?

to the right of the overall market and below the SML

You are comparing three securities and discover they all have identical Treynor ratios. Given this information, which one of the following must be true regarding these three securities?

They earn identical rewards per unit of systematic risk.

Which of the following should generally only be used to evaluate relatively diversified portfolios rather than individual securities? \n I. Sharpe ratio \n II. Treynor ratio \n III. Jensen's alpha

Sharpe ratio only

Which metric measures how volatile a fund's returns are relative to its benchmark?

Tracking error

Which one of the following returns is the average return you expect to earn in the future on a risky asset?

expected return

What is the extra compensation paid to an investor who invests in a risky asset rather than in a risk-free asset?

risk premium

The value of an individual security divided by the total value of the portfolio is referred to as the portfolio:

weight

The principal of diversification involves investing in a variety of assets with which one of the following being the primary goal?

reducing some of the risk

The division of an investor’s portfolio dollars among various types of assets is referred to as:

asset allocation

Which one of the following is a collection of possible risk-return combinations available from portfolios consisting of individual assets?

investment opportunity set

An efficient portfolio is one that does which of the following?

offers the highest return for a given level of risk

Which one of the following is the set of portfolios that provides the maximum return for a given standard deviation?

Markowitz efficient frontier

Which of the following are affected by the probability of a state of the economy occurring? \n I. expected return of an individual security

II. expected return of a portfolio \n III. standard deviation of an individual security

IV. standard deviation of a portfolio

I, II, III, and IV

You own a portfolio of 5 stocks and have 3 expected states of the economy. You have twice as much invested in Stock A as you do in Stock E. How will the weights be determined when you compute the rate of return for each economic state?

The weights will be based on the amount invested in each stock as a percentage of the total amount invested.

Terry has a portfolio comprised of two individual securities. Which one of the following computations that he might do is NOT a weighted average?

correlation between the securities     

You own a stock which is expected to return 14% in a booming economy and 9% in a normal economy. If the probability of a booming economy decreases, your expected return will:

decrease

Which of the following will increase the expected risk premium for a security, all else constant? \n I. an increase in the security's expected return \n II. a decrease in the security's expected return \n III. an increase in the risk-free rate \n IV. a decrease in the risk-free rate

I and IV

If the future return on a security is known with absolute certainty, then the risk premium on that security should be equal to:

Zero

You own a stock that will produce varying rates of return based upon the state of the economy. Which one of the following will measure the risk associated with owning that stock?

variance of the returns given the multiple states of the economy

Which of the following affect the expected rate of return for a portfolio? \n I. weight of each security held in the portfolio \n II. the probability of various economic states occurring \n III. the variance of each individual security \n IV. the expected rate of return of each security given each economic state

I, II, and IV

As the number of individual stocks in a portfolio increases, the portfolio standard deviation:

decreases at a diminishing rate.

Which one of the following is eliminated, or at least greatly reduced, by increasing the number of individual securities held in a portfolio?

diversifiable risk

Non-diversifiable risk:

remains constant regardless of the number of securities held in a portfolio.

Which one of the following correlation coefficients can provide the greatest diversification benefit?

\-1.0

To reduce risk as much as possible, you should combine assets which have one of the following correlation relationships?

strongly negative

What is the correlation coefficient of two assets that are uncorrelated?

0

How will the returns on two assets react if those returns have a perfect positive correlation? \n I. move in the same direction \n II. move in opposite directions \n III. move by the same amount \n IV. move by either equal or unequal amounts

I and IV

If two assets have a zero correlation, their returns will:

move randomly and independently of each other.

Which one of the following correlation relationships has the potential to completely eliminate risk?

perfectly negative

Assume the returns on Stock X were positive in January, February, April, July, and November. During the other months, the returns on Stock X were negative. The returns on Stock Y were positive in January, April, May, July, August, and October, and negative the remaining months. Which one of the following correlation coefficients best describes the relationship between Stock X and Stock Y?

0

Which one of the following statements is correct?

A portfolio variance is dependent upon the portfolio's asset allocation.

A portfolio comprised of which one of the following is most apt to be the minimum variance portfolio?

30% stocks and 70% bonds

Which one of the following statements is correct concerning asset allocation?

There is an ideal asset allocation between stocks and bonds given a specified level of risk.

You currently have a portfolio comprised of 70% stocks and 30% bonds. Which one of the following must be true if you change the asset allocation?

The two portfolios could have significantly different standard deviations.

Where does the minimum variance portfolio lie in respect to the investment opportunity set?

most leftward point

Which one of the following correlation coefficients must apply to two assets if the equally weighted portfolio of those assets creates a minimum variance portfolio that has a standard deviation of zero?

\-1.0

Which one of the following statements about efficient portfolios is correct?

There are multiple efficient portfolios that can be constructed using the same two securities.

You are graphing the investment opportunity set for a portfolio of two securities with the expected return on the vertical axis and the standard deviation on the horizontal axis. If the correlation coefficient of the two securities is +1, the opportunity set will appear as which one of the following shapes?

linear with an upward slope

A portfolio that belongs to the Markowitz efficient set of portfolios will have which one of the following characteristics? Assume the portfolios are comprised of five individual securities.

the lowest risk for any given rate of return

Which one of the following is the type of risk that affects a large number of assets?

systematic

Which one of the following is the type of risk that only affects either a single firm or a small number of firms?

unsystematic

According to the systematic risk principle, the reward for bearing risk is based on which one of the following types of risk?

systematic

Which one of the following measures systematic risk?

beta

The security market line depicts the graphical relationship between which of the following pairs? \n I. expected return \n II. surprise return \n III. systematic risk \n IV. unsystematic risk

I and III

Which of the following is expressed as *E*(*RM*)*−Rƒ*?

market risk premium

Which one of the following terms is a measure of the tendency of two things to move or vary together?

covariance

Retail Specialties just announced that its Chief Operating Officer is retiring at the end of this month. This announcement will cause the firm's stock price to:

either increase, decrease, or remain constant.

Which one of the following is the best example of a risk associated with stock ownership?

One of the firm's patent applications was unexpectedly rejected.

Which one of the following announcements is most apt to cause the price of a firm's stock to increase?

An unpopular CEO unexpectedly announced he is resigning effective immediately.

Which one of the following terms is another name for systematic risk?

market risk

Which one of the following is the best example of systematic risk?

gas prices rise sharply.

Which one of the following statements applies to unsystematic risk?

It can be eliminated through portfolio diversification.

Which one of the following is the best example of unsystematic risk?

decrease in company sales

Which one of the following qualifies as diversifiable risk?

the unsystematic portion of an unexpected return

Which one of the following betas represents the greatest level of systematic risk?

1\.27

A stock with which one of the following betas has an expected return that most resembles the overall market expected rate of return?

.99

What is the beta of a risk-free security?

0

A portfolio beta is computed as which one of the following?

weighted average

You own a portfolio which is invested equally in two stocks and a risk-free security. Beta is .89 for Stock A and 1.26 for Stock B. Which one of the following will increase the portfolio beta, all else being constant?

increasing the weight of Stock, A and decreasing the weight of the risk-free security

A portfolio of securities has a beta of 1.14. Given this, you know that:

the expected return on the portfolio is greater than the expected market return.

The amount of risk premium allocated to Security A is dependent upon which one of the following?

systematic risk associated with Security A

What is the beta of an average asset?

1\.0

All else held constant, which of the following will increase the expected return on a security based on CAPM? Assume the market return exceeds the risk-free rate and both values are positive. Also assume the beta exceeds 1.0. \n I. decrease in the security beta \n II. increase in the market risk premium \n III. decrease in the risk-free rate \n IV. increase in the market rate of return

II, III, and IV

The slope of the security market line is equal to the:

market risk premium

Where will a security plot in relation to the security market line (SML) if it is considered to be a good purchase because it is underpriced?

above the SML

According to the capital asset pricing model, which of the following will increase the expected rate of return on a security that has a beta that is less than that of the market? Assume the market rate of return is greater than the risk-free rate and both rates are positive. \n I. increase in the risk-free rate \n II. decrease in the risk-free rate \n III. increase in the market risk premium \n IV. decrease in the market rate of return

I and III

Which one of the following has the highest expected risk premium?

individual stock with a beta of 1.46

Which one of the following must be equal for two individual securities with differing betas if those securities are correctly priced according to the capital asset pricing model?

reward-to-risk ratio