FIN4504 Chapter 6

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Risk that can be eliminated through diversification is called ______ risk.

A. unique
B. firm-specific
C. diversifiable
D. all of the above

The _______ decision should take precedence over the _____ decision.

asset allocation, stock selection

Many current and retired Enron Corp. employees had their 401k retirement accounts wiped out when Enron collapsed because ___.

their 401k accounts were not well diversified

Based on the outcomes in the table below choose which of the statements is/are correct:

I. The covariance of Security A and Security B is zero
II. The correlation coefficient between Security A and C is negative
III. The correlation coefficient between Security B and C is positive

I and II only

Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would prefer a portfolio using the risk-free asset and ______.

asset A

Adding additional risky assets to the investment opportunity set will generally move the efficient frontier _____ and to the ______.

up, left

An investor's degree of risk aversion will determine his or her ______.

optimal mix of the risk-free asset and risky asset

The ________ is equal to the square root of the systematic variance divided by the total variance.

correlation coefficient

Which of the following statistics cannot be negative?

Variance

Asset A has an expected return of 20% and a standard deviation of 25%. The risk free rate is 10%. What is the reward-to-variability ratio?

20-10 / 25 = .40 = 40%

The correlation coefficient between two assets equals to _________.

their covariance divided by the product of their standard deviations

Diversification is most effective when security returns are _________.

negatively correlated

The expected rate of return of a portfolio of risky securities is _________.

the weighted sum of the securities' expected returns

Beta is a measure of security responsiveness to _________.

market risk

The risk that can be diversified away is __________.

firm specific risk

To eliminate the bias in calculating the variance and covariance of returns from historical data the average squared deviation must be multiplied by _________.

n/(n - 1)

Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum variance portfolio has a standard deviation that is always _________.

equal to 0

Market risk is also called __________ and _________.

systematic risk, nondiversifiable risk

Firm specific risk is also called __________ and __________.

unique risk, diversifiable risk

Which one of the following stock return statistics fluctuates the most over time?

Average return

Harry Markowitz is best known for his Nobel prize winning work on _____________.

techniques used to identify efficient portfolios of risky assets

Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means that ______.

the returns on the stock and bond portfolio tend to vary independently of each other

You put half of your money in a stock portfolio that has an expected return of 14% and a standard deviation of 24%. You put the rest of you money in a risky bond portfolio that has an expected return of 6% and a standard deviation of 12%. The stock and bond portfolio have a correlation 0.55. The standard deviation of the resulting portfolio will be ________________.

more than 12% but less than 18%

On a standard expected return vs. standard deviation graph investors will prefer portfolios that lie to the _____________ of the current investment opportunity set.

left and above

The term "complete portfolio" refers to a portfolio consisting of _________________.

the risk-free asset combined with at least one risky asset

Rational risk-averse investors will always prefer portfolios _____________.

located on the capital market line to those located on the efficient frontier

The optimal risky portfolio can be identified by finding ____________.
I. the minimum variance point on the efficient frontier
II. the maximum return point on the efficient frontier the minimum variance point on the efficient frontier
III. the tangency point of the capital market line and the efficient frontier
IV. the line with the steepest slope that connects the risk free rate to the efficient frontier

III and IV only

Reward-to-variability ratios are ________ on the ________ capital market line

lower; steeper

A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 24% while stock B has a standard deviation of return of 18%. Stock A comprises 60% of the portfolio while stock B comprises 40% of the portfolio. If the variance of return on the portfolio is .0380, the correlation coefficient between the returns on A and B is _________.

A. 0.583

0.0380 = (.62)(.242) + (.42)(.182) + 2(.6)(.4)(.24)(.18) ;  = 0.583

The standard deviation of return on investment A is .10 while the standard deviation of return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation coefficient between the returns on A and B is _________.

correlation = .0030 / .10(.05) = .60

A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 35% while stock B has a standard deviation of return of 15%. The correlation coefficient between the returns on A and B is 0.45. Stock A comprises 40% of the portfolio while stock B comprises 60% of the portfolio. The standard deviation of the return on this portfolio is _________.

19.76%

2p = (.402)(.352) + (.602)(.15)2 + (2)(.4)(.6)(.35)(.15)(.45)
2p = .039046
p = 19.76%

The standard deviation of return on investment A is .10 while the standard deviation of return on investment B is .04. If the correlation coefficient between the returns on A and B is -.50, the covariance of returns on A and B is _________.

Covariance = -.50(.10)(.04)= -.0020

Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of return of 16% and a standard deviation of return of 20%. B has an expected rate of return of 10% and a standard deviation of return of 30%. The weight of security B in the minimum variance portfolio is _________.

40%

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is 0.50. The risk-free rate of return is 10%.

The proportion of the optimal risky portfolio that should be invested in stock A is _________.

0%

The expected return on the optimal risky portfolio is _________.

14.0%

E(rp) = 1.00(.14)=.14

The standard deviation of return on the optimal risky portfolio is _________.

5%

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is 0.4. The risk-free rate of return is 5%.

The proportion of the optimal risky portfolio that should be invested in stock B is approximately _________.

71%

The expected return on the optimal risky portfolio is _________.

16%

The standard deviation of the returns on the optimal risky portfolio is _________.

21.4%

2rp = (.292)(.392) + (.712)(.202) + 2(.29)(.71)(.39)(.20).4
2rp = .045804
rp = 21.4%

An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 24% while the standard deviation on stock B is 14%. The correlation coefficient between the return on A and B is 0.35. The expected return on stock A is 25% while on stock B it is 11%. The proportion of the minimum variance portfolio that would be invested in stock B is approximately _________.

85%

An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20% while the standard deviation on stock B is 15%. The expected return on stock A is 20% while on stock B it is 10%. The correlation coefficient between the return on A and B is 0%. The expected return on the minimum variance portfolio is approximately _________.

13.60%

An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20% while the standard deviation on stock B is 15%. The correlation coefficient between the return on A and B is 0%. The standard deviation of return on the minimum variance portfolio is _________.

12%

A measure of the riskiness of an asset held in isolation is ____________.

standard deviation

Semitool Corp has an expected excess return of 6% for next year. However for every unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it turns out the economy and the stock market do better than expected by 1.5% and Semitool's products experience more rapid growth than anticipated, pushing up the stock price by another 1%. Based on this information what was Semitool's actual excess return?

8.80%

6% + (1.5%)(1.2) + 1% = 8.8%

The part of a stock's return that is systematic is a function of which of the following variables?
I. Volatility in excess returns of the stock market
II. The sensitivity of the stock's returns to changes in the stock market
III. The variance in the stock's returns that is unrelated to the overall stock market

I and II only

Stock A has a beta of 1.2 and Stock B has a beta of 1. The returns of Stock A are ______ sensitive to changes in the market as the returns of Stock B.

20% more

Which risk can be diversified away as additional securities are added to a portfolio?
I. Total risk
II. Systematic risk
III. Firm specific risk

I and III

According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of __________ and __________.

identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion

You are constructing a scatter plot of excess returns for Stock A versus the market index. If the correlation coefficient between Stock A and the index is -1 you will find that the points of the scatter diagram ______________________ and the line of best fit has a ______________.

all fall on the line of best fit; negative slope

The term excess-return refers to ______________.

the difference between the rate of return earned and the risk-free rate

You are recalculating the risk of ACE stock in relation to the market index and you find the ratio of the systematic variance to the total variance has risen. You must also find that the ____________.

correlation coefficient between ACE and the market has risen

A stock has a correlation with the market of 0.45. The standard deviation of the market is 21% and the standard deviation of the stock is 35%. What is the stock's beta?

0.75

The values of beta coefficients of securities are __________.

usually positive, but are not restricted in any particular way

A security's beta coefficient will be negative if ____________.

its returns are negatively correlated with market index returns

The market value weighted average beta of firms included in the market index will always be _____________.

1

Diversification can reduce or eliminate __________ risk.

non-systematic

In order to construct a riskless portfolio using two risky stocks, one would need to find two stocks with a correlation coefficient of ________.

-1.0

Some diversification benefits can be achieved by combining securities in a portfolio as long as the correlation between the securities is _____________.

less than 1

If an investor does not diversify their portfolio and instead puts all of their money in one stock, the appropriate measure of security risk for that investor is the ________.

stock's standard deviation

Which of the following provides the best example of a systematic risk event?

The Federal Reserve increases interest rates 50 basis points.

Which of the following statements is true regarding time diversification?
I. The standard deviation of the average annual rate of return over several
years will be smaller than the one-year standard deviation.
II. For a longer time horizon, uncertainty compounds over a greater number
of years.
III. Time diversification does not reduce risk.

I, II and III

You find that the annual standard deviation of a stock's returns is equal to 25%. For a 3 year holding period the standard deviation of your total return would equal _______.

43%

The beta of this stock is ____.

1.32
Beta equals slope coefficient = 1.32

This stock has greater systematic risk than a stock with a beta of ___.

0.50

0.50 < 1.32

The characteristic line for this stock is Rstock = ___ + ___ Rmarket.

4.05, 1.32
Intercept equals 4.05 and slope equals 1.32.

____ percent of the variance is explained by this regression.

12
R2 = 12 means 12% of the variance is explained by the regression.

The stock is ______ riskier than the typical stock.

32%
Beta of 1.32 means that this stock is 32% riskier than the market.

Decreasing the number of stocks in a portfolio from 50 to 10 would likely _________________________.

increase the unsystematic risk of the portfolio

If you want to know the portfolio standard deviation for a three stock portfolio you will have to

calculate three covariances

Which of the following correlations coefficients will produce the least diversification benefit?

0.8

Which of the following correlation coefficients will produce the most diversification benefits?

-0.9

What is the most likely correlation coefficient between a stock index mutual fund and the S&P 500?

1.0

Investing in two assets with a correlation coefficient of -0.5 will reduce what kind of risk?

Unique risk

Investing in two assets with a correlation coefficient of 1.0 will reduce which kind of risk?

With a correlation of 1.0, no risk will be reduced

A portfolio of stocks fluctuates when the treasury yields change. Since this risk can not be eliminated through diversification, it is called __________.

systematic risk

As you lengthen the time horizon of your investment period and decide to invest for multiple years you will find that ________.
I. the average risk per year may be smaller over longer investment horizons
II. the overall risk of your investment will compound over time
III. your overall risk on the investment will fall

I and II only

You are considering adding a new security to your portfolio. In order to decide whether you should add the security you need to know the security's _______.
I. expected return
II. standard deviation
III. correlation with your portfolio

I, II and III

Which of the following is a correct expression concerning the formula for the standard deviation of returns of a two asset portfolio where the correlation coefficient is positive?

2rp < (W1212 + W2222)

What is the standard deviation of a portfolio of two stocks given the following data? Stock A has a standard deviation of 18%. Stock B has a standard deviation of 14%. The portfolio contains 40% of stock A and the correlation coefficient between the two stocks is -.23.

9.7%

What is the standard deviation of a portfolio of two stocks given the following data? Stock A has a standard deviation of 30%. Stock B has a standard deviation of 18%. The portfolio contains 60% of stock A and the correlation coefficient between the two stocks is -1.0.

10.8%

The expected return of portfolio is 8.9% and the risk free rate is 3.5%. If the portfolio standard deviation is 12.0%, what is the reward to variability ratio of the portfolio?

0.45
Reward to variability ratio = (.089 - .035)/.12 = 0.45

A project has a 60% chance of doubling your investment in one year and a 40% chance of losing half your money. What is the standard deviation of this investment?

73%

A project has a 50% chance of doubling your investment in one year and a 50% chance of losing half your money. What is the expected return on this investment project?

25%
E[rp] = (.5)(100) + (.5)(-50) = 25%

Which stock is likely to further reduce risk for an investor currently holding his portfolio in a well diversified portfolio of common stock?

Stock B

Which stock is riskier to a non-diversified investor who puts all his money in only one of these stocks?

Stock A is riskier

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