Deck 7: Portfolio Theory

Question 1

Company specific risk is also known as:

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

Answer 1

D

Question 2

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

A)+1.0
B)-2.0
C)0.0
D)-1.0

Answer 2

D

Question 3

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.

Answer 3

A

Question 4

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 5

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 6

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

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

Question 7

Which of the following is true regarding random diversification?

A)Investment characteristics are considered important in random diversification.
B)The net benefit of random diversification eventually disappears 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 8

Which of the following statements about the correlation coefficient of the returns for two securities is not true?

A)It is a statistical measure.
B)It measures the relationship between the two securities' returns.
C)It determines the cause of the relationship between the two securities' returns.
D)Its value falls between -1 and +1.

Question 9

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

A)be higher than the weighted average expected return of the individual assets.
B)be lower than the weighted average return of the individual assets.
C)never differ from the weighted average expected return of the individual assets.
D)not be calculated.

Question 10

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

A)the probabilities of expected returns of the individual assets.
B)the weight of each individual asset in the portfolio.
C)the expected return of each individual asset.
D)the variance of return of each individual asset and correlation of returns between assets.

Question 11

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 12

Each individual asset's weight in the portfolio is found by:

A)dividing the asset's standard deviation by its expected value.
B)calculating the percentage of the asset's value to the total portfolio value.
C)calculating the return of the asset as a percent of total portfolio return.
D)dividing the asset's expected value by its standard deviation.

Question 13

The relevant risk for a well-diversified portfolio is:

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

Question 14

Given the following probability distribution,calculate the expected return of security XYZ.
Security XYZ's
Potential returnProbability
20%0.3
30%0.2
-40%0.1
50%0.1
10%0.3

A)16 percent
B)22 percent
C)25 percent
D)18 percent

Question 15

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 16

Which of the following statements regarding portfolio risk and number ofstocks 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 decreases only systematic risk.

Question 17

Which of the following involves the interrelationship 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 18

Probability distributions:

A)are always discrete.
B)are always continuous.
C)can be either discrete or continuous.
D)are always symmetric.

Question 19

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

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

Question 20

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

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

Question 21

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

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

Question 22

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 23

Owning two securities instead of one will not improve a portfolio's risk-return tradeoff 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 24

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

Question 25

When the covariance is positive,the correlation will be:

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

Question 26

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 27

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

Question 28

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

A)17.0 percent
B)5.4 percent
C)2.0 percent
D)3.7 percent
$\begin{aligned}\sigma_{\mathrm{p}} & =\left[\mathrm{wl}^{2} \sigma_{1}^{2}+\mathrm{w}_{2}^{2} \sigma_{2}^{2}+2\left(\mathrm{w}_{1}\right)\left(\mathrm{w}_{2}\right)\left(\rho_{1,2}\right) \sigma_{1} \sigma_{2}\right]^{1 / 2} \\& =\left[(0.3)^{2}(10)+(0.7)^{2}(20)+\right. \\& \left.=2(0.3)(0.7)(0.5)(10)^{1 / 2}(20)^{1 / 2}\right]^{1 / 2}=3.7 \%\end{aligned}$

Question 29

Markowitz's main contribution to portfolio theory is that risk is:

A)the same for each type of financial asset.
B)a function of credit,liquidity,and market factors.
C)not quantifiable.
D)influenced more by covariance than variance when portfolios are large.

Question 30

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

Question 31

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

Question 32

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 33

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

Question 34

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

A)expected value.
B)portfolio's beta.
C)weighted average of the individual asset's risk.
D)portfolio's standard deviation.

Question 35

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

Question 36

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 37

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 38

The correlation coefficient identifies what causes the relative movement in returns between two securities.

Question 39

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

Question 40

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

Question 41

An efficiently diversified portfolio still has _____________________ risk.

Question 42

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 43

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

Question 44

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

Question 45

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 46

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

Question 47

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

Question 48

The major problem with the Markowitz model is that it requires a full set of ___________ between the asset returns in order to calculate portfolio variance.

Question 49

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

Question 50

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

Question 51

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

Question 52

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 53

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