Question 1

The father of Modern Portfolio Theory is Warren Buffet.

Accepted Answer

The father of Modern Portfolio Theory is Harry Markowitz, not Warren Buffet. Markowitz introduced the concept in his 1952 paper, "Portfolio Selection."

Question 2

An attainable portfolio is one that lies along the minimum variance frontier.

Accepted Answer

An attainable portfolio is one that can be constructed from available assets and lies on the minimum variance frontier, which represents the set of portfolios with the lowest risk for a given level of return.

Question 3

Rational, risk-averse investors are only interested in holding portfolios that are on the efficient frontier.

Accepted Answer

Rational, risk-averse investors aim to maximize their returns for a given level of risk, and portfolios on the efficient frontier represent the best possible combinations of risk and return, making them the most desirable choices for such investors.

Question 4

The new frontier is the set of portfolios that offers the highest expected return for their given level of risk.

Accepted Answer

The correct term for the set of portfolios that offers the highest expected return for a given level of risk is the "efficient frontier," not the "new frontier."

Question 5

Total Risk = Market Risk + Beta Risk

Accepted Answer

Total Risk = Systematic Risk (Market Risk) + Unsystematic Risk (Specific Risk), not Beta Risk. Beta measures the sensitivity of a stock's returns to market returns.

Question 6

The part of risk that is not eliminated by diversification is market risk.

Accepted Answer

Market risk, also known as systematic risk, affects the entire market and cannot be eliminated through diversification.

Question 7

Diversification in a company requires selecting products or projects whose cash flows are not highly correlated with one another.

Accepted Answer

Diversification aims to spread investment risk by choosing projects or products with cash flows that do not move in tandem, reducing the impact of any single investment's poor performance on the overall portfolio.

Question 8

Diversification can only exist when the assets' returns are negatively correlated.

Accepted Answer

Diversification can also be achieved with assets that have low or no correlation. It does not require negative correlation; the key is that the assets do not move exactly in tandem.

Question 9

Benefits to diversification are constant, meaning adding one more stock to a two stock portfolio has the same effect as adding one more stock to a thousand-stock portfolio.

Accepted Answer

The benefits of diversification diminish as more assets are added to the portfolio. Initially, adding stocks to a portfolio significantly reduces risk, but after a certain point, the marginal benefit of adding more stocks decreases.

Question 10

What is the arithmetic mean return for Generic Company stock given the following information:

Accepted Answer

The answer of What is the arithmetic mean return for...

Question 11

There is much uncertainty regarding projected cash flows for your firm's newest location. Analysts provide you with the following possible scenarios and probabilities:
  What is the expected cash flow of the new location?

Accepted Answer

The answer of There is much uncertainty regarding projected cash...

Question 12

You are evaluating job possibilities. After a good deal of research, you feel there is a 10% chance of landing a job that pays $75,000, a 20% chance of paying $60,000, a 50% chance of paying $55,000, and a 20% chance of paying $40,000. What is your expected salary?

Accepted Answer

The answer of You are evaluating job possibilities. After a...

Question 13

A college student has three assets: $10,000 in a 529 college plan, which is expected to return 8%, $2,000 in savings bonds, which are expected to return 2%, and $500 of baseball cards, which are expected to return 40%. What is the weighted expected return of the college student's assets?

Accepted Answer

The answer of A college student has three assets: $10,000...

Question 14

What is an efficient frontier?

Accepted Answer

The answer of What is an efficient frontier?...

Question 15

Suppose an analyst gathers data to calculate sixty monthly stock returns for a particular stock. These returns are best described as:

Accepted Answer

Ex post returns refer to actual historical returns, which is what the analyst has gathered by calculating sixty monthly stock returns for a particular stock. Ex ante returns, on the other hand, are expected or forecasted returns.

Question 16

Consider a stock that had a price of $40 per share at the beginning of the year, paid $2 of dividends at the end of the year, and traded for $45 at the end of the year. This stock's return for the year is closest to:

Accepted Answer

The stock's return is calculated as (Ending Price - Beginning Price + Dividends) / Beginning Price. Here, it is ($45 - $40 + $2) / $40 = $7 / $40 = 0.175 or 17.5 percent. However, the closest option provided is 15.6 percent.

Question 17

Consider a stock that has a 40 percent chance of a return of 5 percent, and a 60 percent change of a return of 10 percent. The expected return, based on this probability distribution, is closest to:

Accepted Answer

The expected return is calculated by multiplying each possible return by its probability and then summing these products. So, (0.40 * 5%) + (0.60 * 10%) = 2% + 6% = 8%.

Question 18

When we calculate the expected return by weighted possible returns by the likelihood of the return, we are calculating:

Accepted Answer

Ex ante returns refer to the expected returns on an investment, calculated based on the probabilities of various outcomes before they actually happen. This contrasts with ex post returns, which are calculated after the fact based on actual outcomes.

Question 19

Consider a stock that has a 40 percent chance of a return of 5 percent, and a 60 percent change of a return of 10 percent. The standard deviation of this probability distribution is closest to:

Accepted Answer

The expected return (E(R)) is calculated as: $E(R) = (0.4 \times 5\%) + (0.6 \times 10\%) = 2\% + 6\% = 8\%$.The variance ($\sigma^2$) is calculated as: $\sigma^2 = (0.4 \times (5\% - 8\%)^2) + (0.6 \times (10\% - 8\%)^2) = (0.4 \times (-3\%)^2) + (0.6 \times 2\%^2) = (0.4 \times 0.0009) + (0.6 \times 0.0004) = 0.00036 + 0.00024 = 0.0006$.The standard deviation ($\sigma$) is the square root of the variance: $\sigma = \sqrt{0.0006} \approx 0.0245$ or 2.45%, which rounds to approximately 2.5%, making the initial selection incorrect based on the calculation provided. The correct calculation leads to an answer not listed exactly as provided, indicating a need for clarification in the calculation or the options provided. However, based on the standard approach to calculating standard deviation in a probability distribution context, the process involves calculating the expected return, determining the variance by considering the squared differences from the expected return weighted by their probabilities, and then taking the square root of the variance to find the standard deviation.

Question 20

Suppose you have a portfolio consisting of three stocks, and are considering the addition of a fourth stock. The possible stocks are Stock A, which has a correlation of 0.2 with the existing portfolio, and Stock B, which has a correlation of 0.4 with the existing portfolio. Which stock offers the greater diversification potential?

Accepted Answer

Stock A offers greater diversification potential because it has a lower correlation (0.2) with the existing portfolio, meaning its price movements are less closely related to those of the current portfolio, thus providing better diversification benefits.

Quiz 8: Risk, Return, and Portfolio Theory