Deck 7: Risk and Return

Question 1

Variance is best defined as:

A)difference of opinion in expected returns.
B)the mean of the squared deviations from the expected value.
C)the median difference between the most probable outcome and least probable outcome.
D)the difference between the expected return and the actual return.

Answer 1

the mean of the squared deviations from the expected value.

Question 2

Assume two securities A and B.The correlation coefficient between these two securities can be written as:

A)
B)
C)
D)

Answer 2

Question 3

Portfolio theory was initially developed by:

A)Fama (1970).
B)Markowitz (1952).
C)Modigliani and Miller (1958).
D)Sharpe (1950).

Answer 3

Markowitz (1952).

Question 4

Which investor attaches decreasing utility to each increment in wealth?

A)A risk-seeking investor.
B)A risk-neutral investor.
C)A risk-averse investor.
D)All of the given options.

Question 5

Which investor attaches equal utility to each increment in wealth?

A)A risk-seeking investor.
B)A risk-averse investor.
C)A well diversified investor.
D)A risk-neutral investor.

Question 6

It is often assumed that an investment's distribution of returns follows a normal distribution because:

A)investment distributions are not usually bell shaped.
B)the expected value is the weighted average expected return from an investment.
C)the expected value gives a measurement of risk.
D)it enables an investment to be described by its expected value and standard deviation.

Question 7

An investor's preferences regarding expected return and risk can be illustrated using:

A)yield curves.
B)a normal distribution.
C)indifference curves.
D)an efficient portfolio.

Question 8

Examine the following probability distribution:
The expected value from this is:

A)$3500
B)$4000
C)$3000
D)$2500

Question 9

Examine the following probability distribution:
The range and standard deviation of the distribution are:

A)$4000 and $1095.45,respectively.
B)$1095.45 and $4000,respectively.
C)$5000 and $1095.45,respectively.
D)$4000 and $2000,respectively.

Question 10

Which type of risk is unique to a firm and may be eliminated by diversification?

A)Macro risk.
B)Unsystematic risk.
C)Systematic risk.
D)Total risk.

Question 11

Which statement best describes the market portfolio?

A)Portfolio of all traded assets in the universe.
B)Portfolio of all assets weighted according to their market capitalisation.
C)Portfolio of all risky assets weighted according to their value.
D)Portfolio of all risky assets weighted according to their market capitalisation.

Question 12

What would be the shape of the probability distribution for completely uncertain returns?

A)Horizontal line above the x axis.
B)Vertical line.
C)Horizontal line along the x axis.
D)Bell-shaped but very flat.

Question 13

Which distribution is a list of the possible dollar returns from the investment together with the probability of each return?

A)Normal distribution.
B)Probability distribution.
C)Both Normal distribution and Probability distribution.
D)utility function.

Question 14

Examine the following probability distribution:
The mean,range and standard deviation are:

A)0.06,0.10 and 0.0693,respectively.
B)0.06,0.08 and 0.0693,respectively.
C)0.06,0.08 and 0.022,respectively.
D)0.07,0.10 and 0.022,respectively.

Question 15

A security market line:

A)explains the co-variance between the returns on the risky asset and the market portfolio.
B)explains the co-variance between the returns on the risky asset and a riskless asset.
C)is a graphical representation of the CAPM.
D)is a graphical representation of the CML.

Question 16

Which distribution can be fully described by its expected value and standard deviation?

A)Normal distribution.
B)Probability distribution.
C)Both Normal distribution and Probability distribution.
D)None of the given options.

Question 17

What would be the shape of the probability distribution for completely certain returns?

A)A vertical line.
B)Bell shaped but with a high peak.
C)A horizontal line.
D)Two or more vertical lines.

Question 18

Which investor has a positive attitude towards expected return and a negative attitude towards risk?

A)A risk-averse investor.
B)A risk-neutral investor.
C)A risk-seeking investor.
D)A well-diversified investor.

Question 19

Which statement best describes the attitude of investors towards risk?

A)Investors may behave as though they are risk seekers for small investments.
B)Investors behave as though they are risk averse for investments of significant size.
C)For a risk-averse investor,the standard deviation of the return distribution is a relevant measure of risk.
D)All of the given answers.

Question 20

The capital market line:

A)describes the equilibrium risk-return relationship for efficient portfolios.
B)describes the equilibrium risk-return relationship for all portfolios.
C)describes the equilibrium risk-return relationship for riskless portfolios.
D)describes the equilibrium risk-return relationship for risky portfolios.

Question 21

Increasing the amount of wealth in Asset A whilst maintaining the entire wealth invested in a portfolio consisting of two assets only,A and B (assume that the expected return and standard deviation of both assets are A: 0.10 and 0.03,and B: 0.15 and 0.05,respectively):

A)will increase the expected return of the portfolio.
B)may reduce the variance of the portfolio regardless of the correlation coefficient between Assets A and B
C)will decrease the expected return of the portfolio,but the expected return will be closer to 15% than before.
D)will decrease the expected return of the portfolio,but the expected return will still be greater than if the portfolio consisted of Asset A only.

Question 22

Suppose that the returns on an investment are normally distributed with an expected return of 8% and standard deviation of 4%.What is the likelihood of making a negative return? (Hint: the area under a curve for 1 std dev is 34.13%,2 std dev is 47.73% and 3 std dev is 49.87%).

A)47.73%
B)34.13%
C)15.87%
D)2.27%

Question 23

Which of the following investments does a rational investor prefer?

A)Investment A: E(R)= 10%,
= 3%
B)Investment B: E(R)= 10%,
= 5%
C)Investment C: E(R)= 11%,
= 3%
D)None of the given options,as a rational investor would require more information from which to make a decision.

Question 24

A risk-averse investor attaches:

A)increasing utility to each increment in wealth.
B)decreasing utility to each increment in wealth.
C)increasing utility to each increment in risk.
D)no utility to each increment in risk.

Question 25

Two important assumptions of portfolio theory are:

A)returns from investments are normally distributed and investors seek to minimise transaction costs.
B)returns from investments are normally distributed and investors are risk averse.
C)returns on a portfolio are normally distributed and investors are risk averse.
D)the standard deviation of returns on a portfolio is normally distributed and investors are risk averse.

Question 26

Which of the following two investments would a risk seeker choose: Investment A with an expected outcome of $1000 and standard deviation of $500,or Investment B with an expected outcome of $1000 and standard deviation of $200?

A)Investment A because if Investment B is chosen the expected utility from the increase in spread of expected returns below $1000 outweighs the expected utility from the increase in spread of expected returns above $1000.
B)Investment A because it offers the chance of more wealth.
C)Investment A because the downside risk is greater.
D)Investment B because the downside risk is less.

Question 27

Suppose that the returns on an investment are normally distributed with an expected return of 10% and standard deviation of 5%.What is the likelihood of making a positive return? (Hint: the area under a curve for 1 std dev is 34.13%,2 std dev is 47.73% and 3 std dev is 49.87%. )

A)84.13%
B)2.27%
C)97.73%
D)15.87%

Question 28

An 'efficient' portfolio is one that:

A)combines assets whose returns are not perfectly correlated.
B)offers the highest expected return for a given level of risk.
C)holds a proportion of all possible assets.
D)combines many diverse assets.

Question 29

The efficient frontier:

A)includes those portfolios that offer the maximum expected return for a given level of risk.
B)combines those assets in a portfolio that offer the highest expected return for a given level of risk.
C)includes the portfolio of all possible assets.
D)combines portfolios that offer the maximum level of expected return for a given amount of wealth invested.

Question 30

The benefit of diversification to an investor is the reduction of:

A)brokerage costs.
B)brokerage costs and risk.
C)risk.
D)research time.

Question 31

Which of the following statements is true?

A)Two assets that are perfectly negatively correlated can produce a portfolio with zero variance.
B)Adding an asset to a portfolio by random selection will reduce the risk of a portfolio.
C)Adding a riskless security to a portfolio will increase its overall risk.
D)The amount of risk reduction that can be achieved by adding a new security to an existing portfolio increases as the correlation between the expected returns of the new security and the expected returns on the existing portfolio increases.

Question 32

Suppose you have the choice between two investments - one that pays fixed interest of 4% p.a. ,and another whose returns are normally distributed with an expected return of 10% and standard deviation of 3%.What is the likelihood of receiving a return on the second investment that is equal to or greater than that which can be received from the first investment? (Hint: the area under a curve for 1 std dev is 34.13%,2 std dev is 47.73% and 3 std dev is 49.87%. )

A)97.73%
B)84.13%
C)65.87%
D)52.27%

Question 33

According to portfolio theory,which of the following assumptions is not essential to the equilibrium pricing of risky assets?

A)All investors have the same estimate of expected returns and variance of expected returns on each asset.
B)All investors have a common single-period time horizon for investment decisions.
C)All assets are traded in perfect markets.
D)All investors can sell short assets (sell an asset first and then purchase later).

Question 34

Risk aversion implies that:

A)an investor will prefer a higher expected return than a lower expected return.
B)an investor will refuse to bear any risk at all.
C)an investor will tolerate extra risk if it is expected that the return will compensate them for bearing it.
D)an investor will be indifferent to the level of risk providing that the expected return is identical.

Question 35

A risk-neutral investor attaches:

A)increasing utility to each increment in wealth.
B)decreasing utility to each increment in wealth.
C)decreasing utility to each increment in risk.
D)equal utility to each increment in wealth.

Question 36

Calculate the expected return from a portfolio consisting of three securities with the following expected returns and weights:

A)0.114%
B)12%
C)11.4%
D)36%

Question 37

The variance of a portfolio does not depend on:

A)the proportion of the current market value of the portfolio constituted by each security.
B)the variance of the possible returns of each security.
C)the total market value of the portfolio.
D)the correlation between possible returns on the securities held in the portfolio.

Question 38

A risk-seeking investor attaches:

A)increasing utility to each increment in wealth.
B)increasing utility to each decrement in risk.
C)decreasing utility to each increment in risk.
D)decreasing utility to each increment in wealth.

Question 39

Suppose that the returns on an investment are normally distributed with an expected return of 16% and standard deviation of 3%.What is the likelihood of receiving a return that is equal to or less than 19%? (Hint: the area under a curve for 1 std dev is 34.13%,2 std dev is 47.73% and 3 std dev is 49.87%. )

A)97.73%
B)84.13%
C)15.87%
D)2.27%

Question 40

Systematic risk represents:

A)diversifiable risk.
B)risk that is unavoidable.
C)risk that is diversifiable.
D)none of the options given.

Question 41

Which of the following is NOT a portfolio performance measure?

A)Jensen's beta.
B)The Sharpe ratio.
C)The Treynor Ratio.
D)Jenson's alpha.

Question 42

The Fama-French three-factor model of expected returns includes the following three factors:

A)the market risk premium,the size of firms and the risk free rate.
B)the risk free rate,the market risk premium and price earnings ratios.
C)the market risk premium,the size of firms and book-to-market ratios.
D)the market risk premium,the risk free rate and book-to-market ratios.

Question 43

After adjusting for risk,the returns to a portfolio can differ from the benchmark portfolio as a result of:

A)asset allocation.
B)market timing.
C)random events.
D)all of the given answers.

Question 44

The relationship between the required rate of return for a security and market risk is:

A)non-linear.
B)linear.
C)denoted by the capital market line.
D)concave.

Question 45

The straight line passing through the risk-free rate of return on the vertical axis and the expected return-standard deviation point for the market portfolio is known as the:

A)security market line.
B)capital market line.
C)characteristic line.
D)efficient frontier.

Question 46

What is the expected return on an asset with a beta of 2.0,if the risk-free rate of interest is 5% and the expected return on the market portfolio is 10%?

A)12.5%
B)20%
C)10%
D)15%

Question 47

Which of the following is typically used in empirical studies as a proxy for the market portfolio?

A)Consumer price index.
B)All Ordinaries Accumulation Index.
C)Treasury notes.
D)GDP.

Question 48

The _____________________ plots the relationship between the expected return and beta of a security.

Question 49

Fama and French (2002)use the dividend growth model and conclude that the market risk premium is now of the order of:

A)2% p.a.
B)1% p.a.
C)3% p.a.
D)5.5% p.a.

Question 50

Which of the following is not an example of unsystematic risk?

A)Changes in the level of interest rates.
B)The chief executive officer resigns.
C)A legal suit against a company for environmental pollution.
D)The development of a new product line.

Question 51

An investor would like to evaluate the performance of her portfolio using the Sharpe ratio.The past year realised return and standard deviation of returns of the portfolio,the benchmark portfolio,given by the S&P/ASX share price index,and government bonds are:
Has the portfolio:

A)underperformed relative to the benchmark.
B)outperformed the market benchmark on a risk-adjusted basis.
C)underperformed the market benchmark on a risk-adjusted basis.
D)outperformed the Government Bonds.

Question 52

A popular measure of risk in corporate finance called the value at risk (VaR),which is defined as:

A)the best return from a high risk investment.
B)the worst loss that is possible under normal market conditions.
C)the worst possible loss under any market conditions.
D)the worst return from a low risk investment.

Question 53

Beta is a measure of the extent to which:

A)the returns on the stock market as a whole change over time.
B)a security's risk can be eliminated by proper diversification.
C)the returns on a given stock move with the stock market.
D)a security's risk can be eliminated by random diversification.

Question 54

An investor would like to evaluate the performance of her portfolio using the Treynor ratio.The past year realised return and systematic risk of the portfolio,the benchmark portfolio,given by the S&P/ASX share price index,and government bonds are:
Has the portfolio:

A)underperformed relative to the benchmark.
B)outperformed the market benchmark on a risk-adjusted basis.
C)underperformed the market benchmark on a risk-adjusted basis.
D)outperformed the Government Bonds.

Question 55

Mehra and Prescott (1985)showed that a long-term risk premium such as that found in the US,Canada,the UK and Australia:

A)exceeds 3% p.a.
B)does not exceed 3% p.a.
C)can be explained by standard models of risk and return.
D)cannot be explained by standard models of risk and return.

Question 56

The _______________ is a curve that includes all portfolios with the highest return for a given level of risk.

Question 57

From the following information,calculate the expected return and standard deviation of a portfolio that consists of 60% of Security A (expected return of 0.10 and standard deviation of 0.03)and 40% of Security B (expected return of 0.20 and standard deviation of 0.05),assuming the co-variance between A and B is -0.0012.

A)E(R)= 0.152,σ = 0.161
B)E(R)= 0.138,σ = 0.012
C)E(R)= 0.14,σ = 0.085
D)E(R)= 0.14,σ = 0.012

Question 58

A risk __________ investor will make their investment decision purely on the return generated by a project.

Question 59

Claus and Thomas (2001)use forecasts by security analysts and conclude that the market risk premium is approximately:

A)2% p.a.
B)3% p.a.
C)4% p.a.
D)1% p.a.

Question 60

Standard deviation is measured as the _______________ of variance.

Question 61

A well-diversified portfolio should have a beta significantly less than one.

Question 62

Portfolio theory,as initially developed by Markowitz (1952),assumes that the returns from investments are normally distributed.

Question 63

If an asset has a beta of 0.8,this indicates that the expected return of the asset should be greater than the market portfolio.

Question 64

Where two securities are perfectly positively correlated,there is no reduction in unsystematic risk through diversification.

Question 65

A simple performance benchmark is to compare the return of a well diversified portfolio of domestic shares to the S&P/ASX200 Index.

Question 66

In order to benchmark the performance of a portfolio it is important to compare it to a portfolio of ___________________.

Question 67

Explain the difference between systematic and unsystematic risk.

Question 68

Explain the key differences between the Capital Market Line and the Security Market Line.

Question 69

The typical utility-to-wealth function for a risk-seeking investor is upward sloping.

Question 70

Beta is calculated by finding the co-variance between the return on the asset and the return on the market and dividing it by the variance of the return on the market.

Question 71

The Fama-French three-factor model of expected returns indicates a linear relationship according to the size of the firm and book-to-market ratios.

Question 72

You are considering investing in ZIN mining corp.Research into the company suggests that the company will achieve one of three possible returns over the next 12 months.The possible returns along with the probability of each are listed in the following table.
a.What is the expected return of ZIN?
b.What is the standard deviation of returns of ZIN?
You also consider the stock WMC,which has an expected return of 15% and a standard deviation of 4%.If you create a portfolio with 60% weight on ZIN and 40% WMC and the correlation coefficient is 0.8,then:
c.What is the expected return of this portfolio?
d.What is the risk of the portfolio?

Question 73

The Fama-French three-factor model of asset pricing attempted to improve the CAPM by integrating variables that measured a firm's size and its ___________________.

Question 74

What are the two components of expected return in the CAPM?

Question 75

The Capital Asset Pricing Model (CAPM)assumes that all securities are priced according to their unsystematic risk.

Question 76

An investor would like to evaluate the performance of her portfolio using the Treynor ratio.The past year realised return and systematic risk of the portfolio,the benchmark portfolio,given by the S&P/ASX share price index,and government bonds are: Has the portfolio: