Deck 8: Portfolio Theory and the Capital Asset Pricing Model

Question 1

Suppose you invest equal amounts in a portfolio with an expected return of 16 percent and a standard deviation of returns of 18 percent and a risk-free asset with an interest rate of 4 percent.Calculate the expected return on the resulting portfolio.

A)10 percent
B)4 percent
C)12 percent
D)9 percent

Answer 1

10 percent

Question 2

Florida Company (FC) and Minnesota Company (MC) are both service companies.Their stock returns for the past three years were as follows: FC: -5 percent, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent. Calculate the correlation coefficient between the returns of FC and MC.

A)0.000
B)-0.655
C)+0.655
D)+0.500

Answer 2

+0.655

Question 3

IInvestments A and B both offer an expected rate of return of 12.The standard deviation of A is 30 percent and that of B is 20 percent.If an investor wishes to invest in either A or B, then the investor should

A)prefer A to B.
B)prefer B to A.
C)prefer a portfolio including both A and B.
D)The answer cannot be determined without knowing investors' risk preferences.

Answer 3

prefer B to A.

Question 4

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 percent and a standard deviation of returns of 20 percent.The risk-free asset has an interest rate of 4 percent.Calculate the expected return on the resulting portfolio.

A)20 percent
B)32 percent
C)28 percent
D)12 percent

Question 5

In practice, one would generate efficient portfolios using

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

Question 6

Who first developed portfolio theory?

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

Question 7

Florida Company (FC) and Minnesota Company (MC) are both service companies.Their stock returns for the past three years were as follows: FC: -5%, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent. Calculate the covariance between the returns of FC and MC.(Ignore the correction for the loss of a degree of freedom set out in the text.)

A)60
B)80
C)40
D)100

Question 8

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

A)12 percent
B)10 percent
C)11 percent
D)9 percent

Question 9

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

A)FC: 12 percent; MC: 6 percent
B)FC: 10 percent; MC: 12 percent
C)FC: 20 percent; MC: 32 percent
D)None of the options are correct.

Question 10

Florida Company (FC) and Minnesota Company (MC) are both service companies.Their stock returns for the past three years were as follows: FC: -5 percent, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent. Calculate the variances of returns for FC and MC.(Ignore the correction for the loss of a degree of freedom set out in the text.)

A)FC: 100.00; MC: 256.00
B)FC: 350.00; MC: 96.00
C)FC: 116.67; MC: 32.00
D)FC: 48.00; MC: 175.00

Question 11

Normal and lognormal distributions are completely specified by their

A)mean only.
B)mean and standard deviation.
C)standard deviation only.
D)third moment only.

Question 12

By combining lending and borrowing at the risk-free rate with efficient portfolios, we can

A)extend the range of investment possibilities.
B)extend the range of investment possibilities and change the set of efficient portfolios from being curvilinear to a straight line.
C)extend the range of investment possibilities, change the set of efficient portfolios from being curvilinear to a straight line, and provide a higher expected return for any level of risk, except for the tangential portfolio and the risk-free asset.
D)change the set of efficient portfolios from being curvilinear to a straight line and provide a higher expected return for any level of risk, except for the tangential portfolio and the risk-free asset.

Question 13

The distribution of returns, measured over long intervals, like annual returns, is best approximated by the

A)normal distribution.
B)binomial distribution.
C)lognormal distribution.
D)uniform distribution.

Question 14

Suppose you invest equal amounts in a portfolio with an expected return of 16 percent and a standard deviation of returns of 18 percent and a risk-free asset with an interest rate of 4 percent.Calculate the standard deviation of the returns on the resulting portfolio.

A)8 percent
B)10 percent
C)20 percent
D)9 percent

Question 15

Florida Company (FC) and Minnesota Company (MC) are both service companies.Their stock returns for the past three years were as follows: FC: -5 percent, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent. Calculate the standard deviations of returns for FC and MC.(Ignore the correction for the loss of a degree of freedom set out in the text.)

A)FC: 10.8 percent; MC: 5.7 percent
B)FC: 18.7 percent; MC: 9.8 percent
C)FC: 13.2 percent; MC: 6.9 percent
D)FC: 6.9 percent; MC: 13.2 percent

Question 16

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

A)prefer B to C.
B)prefer C to B.
C)reject both B and C.
D)The answer cannot be determined without knowing investors' risk preferences.

Question 17

An efficient portfolio

A)has only unique risk.
B)provides the highest expected return for a given level of risk and provides the least risk for a given level of expected return.
C)has no risk at all.
D)provides the highest expected return for a given level of risk.

Question 18

Florida Company (FC) and Minnesota Company (MC) are both service companies.Their stock returns for the past three years were as follows: FC: -5 percent, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent.What is the standard deviation of a portfolio with 50 percent of the funds invested in FC and 50 percent in MC? (Ignore the correction for the loss of a degree of freedom set out in the text.)

A)10.6 percent
B)14.4 percent
C)9.3 percent
D)7.6 percent

Question 19

The distribution of returns, measured over a short interval of time, such as daily returns, is best approximated by the

A)normal distribution.
B)lognormal distribution.
C)binomial distribution.
D)uniform distribution.

Question 20

Florida Company (FC) and Minnesota Company (MC) are both service companies.Their stock returns for the past three years were as follows: FC: -5 percent, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent.What is the variance of a portfolio with 50 percent of the funds invested in FC and 50 percent in MC? (Ignore the correction for the loss of a degree of freedom set out in the text.)

A)85.75
B)111.50
C)55.75
D)57.17

Question 21

The presence of a risk-free asset enables the investor to

A)invest in the market portfolio and find an interior portfolio using quadratic programming.
B)invest in the market portfolio and borrow or lend at the risk-free rate.
C)borrow or lend at the risk-free rate and form portfolios having greater Sharpe ratios.
D)form portfolios having greater Sharpe ratios.

Question 22

The correlation coefficient measures the

A)rate of return of individual stocks.
B)direction of movement of the return of individual stocks.
C)degree to which the returns of two stocks move together.
D)degree of s unique risk present in the standard deviations of a pair of stocks.

Question 23

The beta of Treasury bills is

A)+1.0.
B)+0.5.
C)-1.0.
D)0.0.

Question 24

If the market risk premium is 8 percent, then according to the CAPM, the risk premium of a stock with beta value of 1.7 must be

A)less than 12 percent.
B)12 percent.
C)greater than 12 percent.
D)The answer cannot be determined.

Question 25

One would expect a stock with a beta of 1.25 to increase in returns

A)25 percent more than the market in up markets.
B)25 percent more than the market in down markets.
C)125 percent more than the market in up markets.
D)125 percent more than the market in down markets.

Question 26

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)Additional information is needed.

Question 27

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 percent and a standard deviation of returns of 16 percent.The risk-free asset has an interest rate of 4 percent.Calculate the standard deviation of the resulting portfolio.

A)28 percent
B)40 percent
C)32 percent
D)36 percent

Question 28

Suppose the beta of Microsoft is 1.13, the risk-free rate is 3 percent, and the market risk premium is 8 percent.Calculate the expected return for Microsoft.

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

Question 29

A stock return's beta measures

A)the stock's covariance with the risk-free asset.
B)the change in the stock's return for a given change in the market return.
C)the return on the stock.
D)the standard deviation on the stock's return.

Question 30

A common criticism of the CAPM is that it

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

Question 31

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

A)+1.0.
B)-1.0.
C)0.0.
D)Further information is needed.

Question 32

Suppose the beta of Exxon-Mobil is 0.65, the risk-free rate is 4 percent, and the expected market rate of return is 14 percent.Calculate the expected rate of return on Exxon-Mobil.

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

Question 33

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

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

Question 34

One would expect a stock with a beta of zero to have a rate of return equal to

A)zero.
B)the market risk premium.
C)the risk-free rate.
D)the market rate of return.

Question 35

The beta of the market portfolio is

A)0.0.
B)+0.5.
C)-1.0.
D)+1.0.

Question 36

The capital asset pricing model (CAPM) states which of the following?

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 is determined entirely by the risk-free rate and the market rate of return.
D)The expected rate of return on an investment is determined entirely by the risk-free rate.

Question 37

Suppose the beta of Amazon is 2.2, the risk-free rate is 5.5 percent, and the market risk premium is 8 percent.Calculate the expected rate of return for Amazon.

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

Question 38

The Sharpe ratio is defined as

A)(r_P - r_f)/σ_P.
B)(r_P - r_M)/σ_P.
C)(r_P - r_f)/β_P.
D)(r_P - r_M)/β_P.

Question 39

The security market line (SML) is the graph of

A)expected rate of return on investment vs.variance of returns.
B)expected rate of return on investment vs.standard deviation of returns.
C)expected rate of return on investment vs.beta.
D)expected rate of return on investment vs.average returns.

Question 40

The graphical representation of the CAPM (capital asset pricing model) is called the

A)capital market line.
B)characteristic line.
C)security market line. C
D)None of the options are correct.

Question 41

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

Question 42

The distribution of annual returns over long periods for stocks is more closely related to the normal distribution than the lognormal distribution.

Question 43

If a stock were 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 44

Assume the following data for a stock: Beta = 1.5; risk-free rate = 4 percent; market rate of return = 12 percent; and expected rate of return on the stock = 15 percent.Then the stock is

A)overpriced.
B)underpriced.
C)correctly priced.
D)cannot be determined.

Question 45

Investors mainly worry about those risks that can be eliminated through diversification.

Question 46

For a company like the aluminum manufacturer Alcoa, what is the most likely factor when developing an arbitrage pricing model?

A)Commodity price
B)GDP
C)Inflation

Question 47

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

Question 48

Assume the following data for a stock: Beta = 0.9; risk-free rate = 4 percent; market rate of return = 14 percent; and expected rate of return on the stock = 13 percent.Then the stock is

A)overpriced.
B)underpriced.
C)correctly priced.
D)The answer cannot be determined.

Question 49

The distribution of daily returns over short periods for stocks is more closely related to the normal distribution than the lognormal distribution.

Question 50

If a stock were underpriced, 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 51

Which of the following is included in the Fama-French three-factor model?

A)Market factor and liquidity factor.
B)Market factor, liquidity factor, and size factor.
C)Market factor, liquidity factor, and book-to-market factor.
D)Market factor, book-to-market factor, and size factor.

Question 52

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

A)22.3 percent
B)7.8 percent
C)10.6 percent
D)20.9 percent

Question 53

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

Question 54

Assume the following data for a stock: Beta = 0.5; risk-free rate = 4 percent; market rate of return = 12 percent; and expected rate of return on the stock = 10 percent.Then the stock is

A)overpriced.
B)underpriced.
C)correctly priced.
D)The answer cannot be determined.

Question 55

A factor in APT is a variable that

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

Question 56

How can 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 fewer high-return stocks.
D)It cannot be done.

Question 57

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

A)14 percent
B)17 percent
C)10 percent
D)13 percent

Question 58

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

Question 59

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

A)22.3 percent
B)7.8 percent
C)11.5 percent
D)20.9 percent

Question 60

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

Question 61

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

Question 62

All else equal, investors prefer to choose from portfolios having higher Sharpe ratios.

Question 63

Underpriced stocks will plot above the security market line.

Question 64

Briefly explain the term risk-free rate of interest.

Question 65

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

Question 66

Briefly explain the effect of introducing borrowing and lending at the risk-free rate on the efficient portfolios.

Question 67

Overpriced stocks will plot below the security market line.

Question 68

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

Question 69

Risk-free U.S.Treasury bills have a beta greater than zero.

Question 70

Most investors dislike uncertainty.

Question 71

Risk-free U.S.Treasury bills have a beta of zero.

Question 72

In addition to common stocks, the addition of real estate (as an investment alternative) will likely expand the efficient frontier to a better risk-return trade-off.

Question 73

Almost all tests of the CAPM have confirmed that it explains stock returns, especially for high-beta stocks.

Question 74

Explain the term efficient portfolio.

Question 75

On an expected return versus standard deviation diagram (with expected return on the vertical axis), most investors prefer portfolios that appear more towards the top and the left.

Question 76

Overpriced stocks will plot above the security market line.

Question 77

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

Question 78

Both the CAPM and the APT stress that unique risk does not affect expected return.

Question 79

Underpriced stocks will plot below the security market line.

Question 80

The correlation between the return on a risk-free asset and the return on any common stock will equal zero.