Deck 5: Risk and Return: Past and Prologue

Question 1

Which one of the following statements regarding hedging is true?

A) Hedging is adding securities to an existing portfolio to increase the overall return.
B) Hedging is a strategy used by investors to increase both the risk and return of a portfolio.
C) Hedging is a strategy used by investors to reduce the risk of a portfolio.
D) Hedging is a strategy used to increase portfolio volatility.
E) None of these is true.

Answer 1

C

Question 2

Consider a risky portfolio,A,with an expected rate of return of 0.15 and a standard deviation of 0.15,that lies on a given indifference curve.Which one of the following portfolios might lie on the same indifference curve?

A) E(r)= 0.15;Standard deviation = 0.20
B) E(r)= 0.15;Standard deviation = 0.10
C) E(r)= 0.10;Standard deviation = 0.10
D) E(r)= 0.20;Standard deviation = 0.15
E) E(r)= 0.10;Standard deviation = 0.20

Answer 2

C

Question 3

Which of the following statements regarding risk-averse investors is true?

A) They only care about the rate of return.
B) They accept investments that are fair games.
C) They only accept risky investments that offer risk premiums over the risk-free rate.
D) They are willing to accept lower returns and high risk.
E) a and b.

Answer 3

C

Question 4

In the mean-standard deviation graph an indifference curve has a ________ slope.

A) negative
B) zero
C) positive
D) northeast
E) cannot be determined

Question 5

In the mean-standard deviation graph,which one of the following statements is true regarding the indifference curve of a risk-averse investor?

A) It is the locus of portfolios that have the same expected rates of return and different standard deviations.
B) It is the locus of portfolios that have the same standard deviations and different rates of return.
C) It is the locus of portfolios that offer the same utility according to returns and standard deviations.
D) It connects portfolios that offer increasing utilities according to returns and standard deviations.
E) none of these.

Question 6

When an investment advisor attempts to determine an investor's risk tolerance,which factor would they be least likely to assess?

A) the investor's prior investing experience
B) the investor's degree of financial security
C) the investor's tendency to make risky or conservative choices
D) the level of return the investor prefers
E) the investor's feeling about loss

Question 7

Consider the following two investment alternatives.First,a risky portfolio that pays a 15 percent rate of return with a probability of 60% or a 5 percent return with a probability of 40%,and second,a T-bill that pays 6 percent.The risk premium on the risky investment is

A) 11 percent.
B) 1 percent.
C) 9 percent.
D) 5 percent.
E) none of these.

Question 8

According to the mean-variance criterion,which one of the following investments dominates all others?

A) E(r)= 0.15;Variance = 0.20
B) E(r)= 0.10;Variance = 0.20
C) E(r)= 0.10;Variance = 0.25
D) E(r)= 0.15;Variance = 0.25
E) none of these is dominates the other alternatives.

Question 9

Which of the following statements is(are)false?
I)Risk-averse investors reject investments that are fair games.
II)Risk-neutral investors judge risky investments only by the expected returns.
III)Risk-averse investors judge investments only by their riskiness.
IV)Risk-loving investors will not engage in fair games.

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

Question 10

In a return-standard deviation space,which of the following statements is(are)true for risk-averse investors? (The vertical and horizontal lines are referred to as the expected return-axis and the standard deviation-axis,respectively. )
I)An investor's own indifference curves might intersect.
II)Indifference curves have negative slopes.
III)In a set of indifference curves,the highest offers the greatest utility.
IV)Indifference curves of two investors might intersect.

A) I and II only
B) II and III only
C) I and IV only
D) III and IV only
E) none of these

Question 11

Assume an investor with the following utility function: U = E(r)- 3/2(s²).To maximize her expected utility,she would choose the asset with an expected rate of return of _______ and a standard deviation of ________,respectively

A) 12%;20%
B) 10%;15%
C) 10%;10%
D) 8%;10%
E) none of these

Question 12

Which of the following statements is(are)true?
I)Risk-averse investors reject investments that are fair games.
II)Risk-neutral investors judge risky investments only by the expected returns.
III)Risk-averse investors judge investments only by their riskiness.
IV)Risk-loving investors will not engage in fair games.

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

Question 13

A portfolio has an expected rate of return of 0.15 and a standard deviation of 0.15.The risk-free rate is 6 percent.An investor has the following utility function: U = E(r)- (A/2)s².Which value of A makes this investor indifferent between the risky portfolio and the risk-free asset?

A) 5
B) 6
C) 7
D) 8
E) none of these

Question 14

Elias is a risk-averse investor.David is a less risk-averse investor than Elias.Therefore,

A) for the same risk,David requires a higher rate of return than Elias.
B) for the same return,Elias tolerates higher risk than David.
C) for the same risk,Elias requires a lower rate of return than David.
D) for the same return,David tolerates higher risk than Elias.
E) cannot be determined.

Question 15

If a T-bill pays 5 percent,which of the following investments would not be chosen by a risk-averse investor?

A) An asset that pays 10 percent with a probability of 0.60 or 2 percent with a probability of 0.40.
B) An asset that pays 10 percent with a probability of 0.40 or 2 percent with a probability of 0.60.
C) An asset that pays 10 percent with a probability of 0.20 or 3.75 percent with a probability of 0.80.
D) An asset that pays 10 percent with a probability of 0.30 or 3.75 percent with a probability of 0.70.
E) neither a nor b would be chosen.

Question 16

Assume an investor with the following utility function: U = E(r)- 3/2(s²).To maximize her expected utility,which one of the following investment alternatives would she choose?

A) A portfolio that pays 10 percent with a 60 percent probability or 5 percent with 40 percent probability.
B) A portfolio that pays 10 percent with 40 percent probability or 5 percent with a 60 percent probability.
C) A portfolio that pays 12 percent with 60 percent probability or 5 percent with 40 percent probability.
D) A portfolio that pays 12 percent with 40 percent probability or 5 percent with 60 percent probability.
E) none of these.

Question 17

Consider the following two investment alternatives.First,a risky portfolio that pays a 15 percent rate of return with a probability of 60% or a 5 percent return with a probability of 40%,and second,a T-bill that pays 6 percent.If you invest $50,000 in the risky portfolio,your expected profit would be __________.

A) $5,500
B) $7,500
C) $25,000
D) $3,000
E) none of these

Question 18

The exact indifference curves of different investors

A) cannot be known with perfect certainty.
B) can be calculated precisely with the use of advanced calculus.
C) although not known with perfect certainty,do allow the advisor to create more suitable portfolios for the client.
D) a and c.
E) none of these.

Question 19

The riskiness of individual assets

A) should be considered for the asset in isolation.
B) should be considered in the context of the effect on overall portfolio volatility.
C) combined with the riskiness of other individual assets (in the proportions these assets constitute of the entire portfolio)should be the relevant risk measure.
D) b and c.
E) none of these.

Question 20

A T-bill pays 6 percent rate of return.Would risk-averse investors invest in a risky portfolio that pays 12 percent with a probability of 40 percent or 2 percent with a probability of 60 percent?

A) Yes,because they are rewarded with a risk premium.
B) No,because they are not rewarded with a risk premium.
C) No,because the risk premium is small.
D) Cannot be determined.
E) None of these.

Question 21

The standard deviation of a portfolio of assets

A) increases as the number of assets in the portfolio increases.
B) increases as the weight in any particular asset increases.
C) increases as the standard deviations of the assets change through time.
D) increases as the assets' expected returns increase.
E) increases as the assets' covariances increase.

Question 22

The standard deviation of a portfolio that has 40% of its value invested in a risk-free asset and 60% of its value invested in a risky asset with a standard deviation of 30% is

A) 18%.
B) 14%.
C) 21%.
D) 24%.
E) 20%.

Question 23

The utility score an investor assigns to a particular portfolio,other things equal,

A) will decrease as the rate of return increases.
B) will decrease as the standard deviation increases.
C) will decrease as the variance increases.
D) will increase as the variance increases.
E) will increase as the rate of return increases.

Question 24

Which of the following statements regarding the Capital Allocation Line (CAL)is false?

A) The CAL shows risk-return combinations.
B) The slope of the CAL equals the increase in the expected return of a risky portfolio per unit of additional standard deviation.
C) The slope of the CAL is also called the reward-to-variability ratio.
D) The CAL is also called the efficient frontier of risky assets in the absence of a risk-free asset.
E) both a and d are true.

Question 25

Adding a home insurance policy to your portfolio of assets is an example of

A) speculating
B) asset dominance
C) hedging
D) neurosis
E) risk neutrality

Question 26

You are a risk-averse investor.Portfolio A has E(r)= 12% and σ= 18%.Portfolio B has σ = 21%,and has end-of-year cash flows of either $84,000 or $144,000 with equal probability.At what price for portfolio B would you be indifferent between A and B?

A) $100,000
B) $101,786
C) $84,000
D) $121,000
E) None of these

Question 27

A fair game

A) Will not be undertaken by a risk-averse investor.
B) Is a risky investment with a zero risk premium.
C) Is a riskless investment.
D) Both a and b are true.
E) Both a and c are true.

Question 28

An investor invests 30 percent of his wealth in a risky asset with an expected rate of return of 0.13 and a variance of 0.03 and 70 percent in a T-bill that pays 6 percent.His portfolio's expected return and standard deviation are __________ and __________,respectively.

A) 0.114;0.128
B) 0.087;0.063
C) 0.295;0.125
D) 0.081;0.052
E) 0.795;0.14

Question 29

You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05.A portfolio that has an expected outcome of $115 is formed by

A) investing $100 in the risky asset.
B) investing $80 in the risky asset and $20 in the risk-free asset.
C) borrowing $43 at the risk-free rate and investing the total amount ($143)in the risky asset.
D) investing $43 in the risky asset and $57 in the riskless asset.
E) Such a portfolio cannot be formed.

Question 30

An investor invests 30 percent of his wealth in a risky asset with an expected rate of return of 0.15 and a variance of 0.04 and 70 percent in a T-bill that pays 6 percent.His portfolio's expected return and standard deviation are _________ and __________,respectively.

A) 0.114;0.12
B) 0.087;0.06
C) 0.295;0.12
D) 0.087;0.12
E) none of these

Question 31

An investor can choose to invest in T-bills paying 5% or a risky portfolio with end-of-year cash flow of $132,000.If the investor requires a risk premium of 5%,what would she be willing to pay for the risky portfolio?

A) $100,000
B) $108,000
C) $120,000
D) $145,000
E) $147,000

Question 32

You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05.What percentages of your money must be invested in the risky asset and the risk-free asset,respectively,to form a portfolio with an expected return of 0.09?

A) 85% and 15%
B) 75% and 25%
C) 67% and 33%
D) 57% and 43%
E) cannot be determined

Question 33

The Capital Allocation Line can be described as the

A) investment opportunity set formed with a risky asset and a risk-free asset.
B) investment opportunity set formed with two risky assets.
C) line on which lie all portfolios that offer the same utility to a particular investor.
D) line on which lie all portfolios with the same expected rate of return and different standard deviations.
E) none of these.

Question 34

An investor invests 60 percent of his wealth in a risky asset with an expected rate of return of 0.14 and a variance of 0.32 and 40 percent in a T-bill that pays 3 percent.His portfolio's expected return and standard deviation are __________ and __________,respectively.

A) 0.096;0.339
B) 0.087;0.267
C) 0.295;0.123
D) 0.087;0.182
E) none of these

Question 35

Steve is more risk-averse than Edie.On a graph that shows Steve's and Edie's indifference curves,which of the following is true? Assume that the graph shows expected return on the vertical axis and standard deviation on the horizontal axis.
I)Steve and Edie's indifference curves might intersect.
II)Steve's indifference curves will have flatter slopes than Edie's.
III)Steve's indifference curves will have steeper slopes than Edie's.
IV)Steve and Edie's indifference curves will not intersect.
V)Steve's indifference curves will be downward sloping and Edie's will be upward sloping.

A) I and V
B) I and III
C) III and IV
D) I and II
E) II and IV

Question 36

Given the capital allocation line,an investor's optimal portfolio is the portfolio that

A) maximizes her expected profit.
B) maximizes her risk.
C) minimizes both her risk and return.
D) maximizes her expected utility.
E) none of these.

Question 37

The presence of risk means that

A) Investors will lose money.
B) More than one outcome is possible.
C) the standard deviation of the payoff is larger than its expected value.
D) Final wealth will be greater than initial wealth.
E) Terminal wealth will be less than initial wealth.

Question 38

You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05.What percentages of your money must be invested in the risk-free asset and the risky asset,respectively,to form a portfolio with a standard deviation of 0.06?

A) 30% and 70%
B) 50% and 50%
C) 60% and 40%
D) 40% and 60%
E) cannot be determined

Question 39

The certainty equivalent rate of a portfolio is

A) the rate that a risk-free investment would need to offer with certainty to be considered equally attractive as the risky portfolio.
B) the rate that the investor must earn for certain to give up the use of his money.
C) the minimum rate guaranteed by institutions such as banks.
D) the rate that equates "A" in the utility function with the average risk aversion coefficient for all risk-averse investors.
E) represented by the scaling factor "-.005" in the utility function.

Question 40

Which of the following sayings illustrates the concept of diversification?

A) Don't throw the baby out with the bathwater.
B) A stitch in time saves nine.
C) Neither a borrower nor a lender be.
D) Don't put all your eggs in one basket.
E) Out of sight,out of mind.

Question 41

Discuss the differences between investors who are risk averse,risk neutral,and risk loving.

Question 42

The change from a straight to a kinked capital allocation line is a result of:

A) reward-to-volatility ratio increasing.
B) borrowing rate exceeding lending rate.
C) an investor's risk tolerance decreasing.
D) increase in the portfolio proportion of the risk-free asset.
E) none of these.

Question 43

Based on their relative degrees of risk tolerance

A) investors will hold varying amounts of the risky asset in their portfolios.
B) all investors will have the same portfolio asset allocations.
C) investors will hold varying amounts of the risk-free asset in their portfolios.
D) a and c.
E) none of these.

Question 44

Treasury bills are commonly viewed as risk-free assets because

A) their short-term nature makes their values insensitive to interest rate fluctuations.
B) the inflation uncertainty over their time to maturity is negligible.
C) their term to maturity is identical to most investors' desired holding periods.
D) both a and b are true.
E) both b and c are true.

Question 45

The first major step in asset allocation is:

A) assessing risk tolerance.
B) analyzing financial statements.
C) estimating security betas.
D) identifying market anomalies.
E) none of these.

Question 46

In the utility function: U = E(r)-0.005As²,what is the significance of "A"?

Question 47

Discuss the differences between the asset allocation decision and the security selection decision.

Question 48

If you want to form a portfolio with an expected rate of return of 0.10,what percentages of your money must you invest in the T-bill,X,and Y,respectively if you keep X and Y in the same proportions to each other as in portfolio P?

A) 0.25;0.45;0.30
B) 0.19;0.49;0.32
C) 0.32;0.41;0.27
D) 0.50;0.30;0.20
E) cannot be determined

Question 49

In the mean-standard deviation graph,the line that connects the risk-free rate and the optimal risky portfolio,P,is called ______________

A) the Security Market Line
B) the Capital Allocation Line
C) the Indifference Curve
D) the investor's utility line
E) none of these

Question 50

Passive investing

A) may be accomplished by investing in index mutual funds.
B) involves considerable security selection.
C) involves considerable transaction costs.
D) a and c.
E) b and c.

Question 51

Draw graphs that represent indifference curves for the following investors: Harry,who is a risk-averse investor;Eddie,who is a risk-neutral investor;and Ozzie,who is a risk-loving investor.Discuss the nature of each curve and the reasons for its shape.

Question 52

A reward-to-volatility ratio is useful in:

A) measuring the standard deviation of returns.
B) understanding how returns increase relative to risk increases.
C) analyzing returns on variable rate bonds.
D) assessing the effects of inflation.
E) none of these.

Question 53

When a portfolio consists of only a risky asset and a riskless asset,increasing the fraction of the overall portfolio invested in the risky asset will

A) increase the expected return on the portfolio.
B) increase the standard deviation of the portfolio.
C) not change the risk-reward ratio.
D) neither a,b nor c are true.
E) a,b and c are all true.

Question 54

What would be the dollar value of your positions in X,Y,and the T-bills,respectively,if you decide to hold a portfolio that has an expected outcome of $1,120?

A) Cannot be determined
B) $568;$378;$54
C) $568;$54;$378
D) $378;$54;$568
E) $108;$514;$378

Question 55

Asset allocation

A) may involve the decision as to the allocation between a risk-free asset and a risky asset.
B) may involve the decision as to the allocation among different risky assets.
C) may involve considerable security analysis.
D) a and b.
E) a and c.

Question 56

Describe how an investor may combine a risk-free asset and one risky asset in order to obtain the optimal portfolio for that investor.

Question 57

The Capital Market Line
I)is a special case of the Capital Allocation Line
II)represents the opportunity set of a passive investment strategy
III)has the one-month T-Bill rate as its intercept
IV)uses a broad index of common stocks as its risky portfolio

A) I,III,and IV
B) II,III,and IV
C) III and IV
D) I,II,and III
E) I,II,III,and IV

Question 58

What would be the dollar values of your positions in X and Y,respectively,if you decide to hold 40% percent of your money in the risky portfolio and 60% in T-bills?

A) $240;$360
B) $360;$240
C) $100;$240
D) $240;$160
E) Cannot be determined

Question 59

What is a fair game? Explain how the term relates to a risk-averse investor's attitude toward speculation and risk and how the utility function reflects this attitude.

Question 60

Toby and Hannah are two risk-averse investors.Toby is more risk-averse than Hannah.Draw one indifference curve for Toby and one indifference curve for Hannah on the same graph.Show how these curves illustrate their relative levels of risk aversion.