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Essentials of investment Chapter 6

investment essentials
STUDY
PLAY
1. Risk that can be eliminated through diversification is called ______ risk.
Unique , Firm-specific , Diversifiable
2. The _______ decision should take precedence over the _____ decision.
Asset allocation, stock selection
3. 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
4. Based on the outcomes in the table below choose which of the statements is/are correct:
The covariance of Security A and Security B is zero
The correlation coefficient between Security A and C is negative
5. 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
6. Adding additional risky assets to the investment opportunity set will generally move the efficient frontier _____ and to the _______.
Up, left
7. An investor's degree of risk aversion will determine his or her _______.
Optimal mix of the risk-free asset and optimal risky asset
8. The ________ is equal to the square root of the systematic variance divided by the total variance.
Correlation coefficient
9. Which of the following statistics cannot be negative?
Variance
10. 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?
.40
11. Diversification is most effective when security returns are __________.
Negatively correlated
12. The variance of a portfolio of risky securities is __________.
The weighted sum of the securities' covariances
13. Beta is a measure of __________.
Market risk
14. The risk that can be diversified away is ___________.
Firm specific risk
15. 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)
16. 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
17. Market risk is also called __________ and __________.
Systematic risk, nondiversifiable risk
18. Firm specific risk is also called __________ and ___________.
Unique risk, diversifiable risk
19. Which one of the following stock return statistics is usually the least stable over time?
Average return
20. Harry Markowitz is best known for his Nobel prize winning work on ______________.
Techniques used to identify efficient portfolios of risky assets
21. 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
22. 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 _________________.
Less than 18%
23. On a standard expected return vs standard deviation graph investors will prefer portfolios that lie to the
Northeast
24. The term "complete portfolio" refers to a portfolio consisting of __________________.
The risk-free asset combined with at least one risky asset
25. Rational risk-averse investors will always prefer portfolios ______________.
Located on the capital market line to those located on the efficient frontier
26. The optimal risky portfolio can be identified by finding _____________.
the tangency point of the capital market line and the efficient frontier
the line with the steepest slope that connects the risk free rate to the efficient frontier
27. Reward-to-variability ratios are ________ on the capital market line than (as) on the efficient frontier.
Lower
28. 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 __________.
0.583
.0380= (.24)^2 (.60)^2 + (.18)^2 (.40)^2 + 2 (.6) (.4) (.24) (.18) Corr
.0380= .020736+.005184+.020736corr
.0380= .02592+.020736corr
.01208= .020736corr
.01208/.020736=corr=.583
29. 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 __________.
.60
30. 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%
St Dev= SQR(.4)^2 (.35)^2 + (.6)^2 (.15)^2 + 2(.45)(.15)(.35)(.4)(.6)
St Dev= SQR (.0296+.0081 + 01134
= SQR .03904 = .19758 = 19.76%
31. 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 __________.
-.0020
32. 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 10% and a standard deviation of return of 30%. The weight of security B in the global minimum variance 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%.

33. The proportion of the optimal risky portfolio that should be invested in stock A is __________.
0%
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%.

34. The expected return on the optimal risky portfolio is __________.
14.0%
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 risk-free rate of return is 10%. 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 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 B is approximately __________.
71%
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 expected return on the optimal risky portfolio is __________.
16%
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 standard deviation of the returns on the optimal risky portfolio is __________.
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 __________.
85%
40. 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%
41. 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%
42. A measure of the riskiness of an asset held in isolation is _____________.
Standard deviation
43. Semitool Corp has an expected excess return of 5% for next year. However for every unexpected 1% change in the market, Semitool's return responds by a factor of 1.3. 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?
7.95%
44. The part of a stock's return that is systematic is a function of which of the following variables?
Volatility in excess returns of the stock market
The sensitivity of the stock's returns to changes in the stock market
45. The measure of risk used in the Capital Asset Pricing Model is ____________.
Beta
46. 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
47. As additional securities are added to a portfolio, total risk will generally ________ at a _________ rate.
Fall; increasing
48. 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
49. 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
50. The term excess-return refers to _______________.
The difference between the rate of return earned and the risk-free rate
51. 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
52. 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
53. The values of beta coefficients of securities are ___________.
Usually positive, but are not restricted in any particular way
54. A security's beta coefficient will be negative if _____________.
Its returns are negatively correlated with market index returns
55. The market value weighted average beta of firms included in the market index will always be ______________.
1
56. Diversification can reduce or eliminate __________ risk.
Non-systematic
57. According to Markowitz and other proponents of modern portfolio theory which of the following activities would not be expected to produce any benefits?
Engaging in active portfolio management to enhance returns
58. 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
59. Some diversification benefits can be achieved by combining securities in a portfolio as long as the correlation between the securities is ______________.
Less than 1
60. 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
61. Which of the following provides the best example of a systematic risk event?
The Federal Reserve increases interest rates 50 basis points
62. Which of the following statements is true regarding time diversification?
The standard deviation of the average annual rate of return over several
years will be smaller than the one-year standard deviation.
For a longer time horizon, uncertainty compounds over a greater number
of years.
Time diversification does not reduce risk.
63. 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%
64. The beta of this stock is _____.
1.32
65. This stock has greater systematic risk than a stock with a beta of ____.
0.50
66. The characteristic line for this stock is Rstock = ___ + ___ Rmarket.
4.05, 1.32
67. ____ percent of the variance is explained by this regression
12
68. The stock is ______ riskier than the typical stock.
32%
69. Decreasing the number of stocks in a portfolio from 50 to 10 would likely __________________________.
Increase the unsystematic risk of the portfolio
70. If you want to know the portfolio standard deviation for a three stock portfolio you will have to
Calculate three covariances
71. Which of the following correlations coefficients will produce the least diversification benefit?
0.0
72. Which of the following correlation coefficients will produce the most diversification benefits?
-0.9
73. What is the most likely correlation coefficient between a stock index mutual fund and the S&P 500?
1.0
74. Investing in two assets with a correlation coefficient of -0.5 will reduce what kind of risk?
Unique risk
75. 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
76. 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
the average risk per year may be smaller over longer investment horizons
the variance of the total rate of return on your investment will be larger
78. 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
expected return
standard deviation
correlation with your portfolio
79. 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 between +1 and -1?
A. 2rp < (W1212 + W1212)
80. 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%
81. 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%
82. 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
83. 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%
84. Which of the following is the most likely reward to variability ratio for a capital allocation line that is optimal, assuming all ratios are generated from the same set of potential assets?
0.69
85. Which stock is riskier for an investor currently holding his portfolio in a well diversified portfolio of common stock?
Stock B is riskier
86. Which stock is riskier to a non-diversified investor who puts all his money in only one of these stocks?
Stock A is riskier
set of all attainable combination of risk and return offered by portfolios formed using the available assets in differing proportions
investment opportunity set
set of available portfolio risk-return combination
investment opportunity set
the best combination of risky assets to be mixed with safe assets to form the complete portfolio
optimal risky portfolio
graph representing a set of portfolios that maximizes expected return at each level of portfolio risk
efficient frontier
introduced by james tobin. implies that portfolio choice can be separated into 2 independent tasks. determination of the risky portfolio (technical) and personal choice of best mix of risky portfolio and risky asset
separation property
statistical model to estimate the 2 components of risk (broad market index and firm risk influence) for a security on portfolio
index model
rate of return in excess of the risk free rate
excess return
response of a particular stock excess return to changes in the market excess return
beta
expected return on the stock beyond any return induced by movements in the market index
alpha
firm specific risk
residual risk
plot of security excess return as a function of the excess return on the market
security characteristic line
ratio of alpha to standard deviation of residual return
information ratio
portfolio formed optimally combining analyzed stocks with perceived nonzero alpha values
active portfolio