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Investment analysis

First Semester / 2014 2015

______________________________________________________________________

Student ID. No.

QUES A

B

C

D

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

QUES A

19

20

21

22

23

Ch8

1

2

3

4

5

6

7

8

9

10

11

1

13

1.

The expected value is the:

a.

inverse of the standard deviation

b.

correlation between a securitys risk and return.

c.

weighted average of all possible outcomes.

d.

same as the discrete probability distribution.

Chapter Seven

Portfolio Theory

82

Student Name:

2.

-------------------is concerned with the interrelationships between security returns

as well as the expected returns and variances of those returns.

a.

random diversification.

b.

correlating diversification

c.

Friedman diversification

d.

Markowitz diversification

3.Given the following probability distribution, calculate the expected return of security

XYZ.

Security XYZ's

Potential return

Probability

20%

0.3

30%

0.2

-40%

0.1

50%

0.1

10%

0.3

a.

b.

c.

d.

16 percent

22 percent

25 percent

18 percent

4.

a.

b.

c.

d.

Probability distributions:

are always discrete.

are always continuous.

can be either discrete or continuous.

are inverse to interest rates.

5.

a.

b.

c.

d.

dividing standard deviation by expected value

calculating the percentage each assets value to the total portfolio value

calculating the return of each asset to total portfolio return

dividing expected value by the standard deviation

6.

is true?

It can be higher than the weighted average expected return of individual assets

It can be lower than the weighted average return of the individual assets

It can never be higher or lower than the weighted average expected return of

individual assets

Expected return of a portfolio is impossible to calculate

a.

b.

c.

d.

7.

In order to determine the expected return of a portfolio, all of the following must

be known, except:

a.

probabilities of expected returns of individual assets

b.

weight of each individual asset to total portfolio value

c.

expected return of each individual asset

d.

variance of return of each individual asset and correlation of returns between

assets

Chapter Seven

Portfolio Theory

83

8.

a.

b.

c.

d.

It is a weighted average only for stock portfolios

It can only be positive

It can never be above the highest individual asset return

It is always below the highest individual asset return

9.

a.

b.

Investment characteristics are considered important in random diversification

The benefits of random diversification eventually no longer continue as more

securities are added

Random diversification, if done correctly, can eliminate all risk in a portfolio

Random diversification eventually removes all company specific risk from a

portfolio

c.

d.

10.

a.

b.

c.

d.

market risk

systematic risk

non-diversifiable risk

idiosyncratic risk

11.

a.

b.

c.

d.

interest rate risk

inflation risk

business risk

market risk

12.

not true?

It is a statistical measure

It measure the relationship between two securities returns

It determines the causes of the relationship between two securities returns

It is greater than or equal to -1 and less than or equal to +1

a.

b.

c.

d.

13.

Two stocks with perfect negative correlation will have a correlation coefficient of:

a.

+1.0

b.

-2.0

c.

0

d.

1.0

14.

Security A and Security B have a correlation coefficient of 0. If Security As

return is expected to increase by 10 percent,

a.

Security Bs return should also increase by 10 percent

b.

Security Bs return should decrease by 10 percent

c.

Security Bs return should be zero

d.

Security Bs return is impossible to determine from the above information

Chapter Seven

Portfolio Theory

84

15.

Which of the following statements regarding portfolio risk and number of stocks

is generally true?

a.

Adding more stocks increases risk

b.

Adding more stocks decreases risk but does not eliminate it

c.

Adding more stocks has no effect on risk

d.

Adding more stocks increases only systematic risk

16.

a.

b.

c.

d.

When returns are perfectly positively correlated, the risk of the portfolio is:

zero

the weighted average of the individual securities risk

equal to the correlation coefficient between the securities

infinit

17.

a.

b.

c.

d.

expected value

portfolio beta

weighted average of individual risk

standard deviation

18.

a.

b.

that risk is the same for each type of financial asset

that risk is a function of credit, liquidity and market

factors

risk is not quantifiable

insight about the relative importance of variance and covariance in determining

portfolio risk

c.

d.

19.

a.

b.

c.

d.

Owning two securities instead of one will not reduce the risk taken by an investor

if the two securities are

perfectly positively correlated with each other

perfectly independent of each other

perfectly negatively correlated with each other

of the same category, e.g. blue chips

20.

a.

b.

c.

d.

positive

negative

zero

impossible to determine

21.

the correlation coefficient between the two securities is equal to 0.5.

Variance

Weight (in the portfolio)

Security A

10

0.3

Security B

20

0.7

17.0 percent

5.4 percent

2.0 percent

3.7 percent

a.

b.

c.

d.

Chapter Seven

Portfolio Theory

85

22.

a.

b.

c.

d.

lack of accuracy

predictability flaws

complexity

inability to handle large number of inputs

1.Standard deviations for well-diversified portfolios are reasonably steady over time.

2.

A probability distribution shows the likely outcomes that may occur and the

probabilities associated with these likely outcomes.

3.

Portfolio risk is a weighted average of the individual security risks.

4.

A negative correlation coefficient indicates that the returns of two

securities have a tendency to move in opposite directions.

5.

diversification opportunities for portfolios consisting primarily of stocks and

bonds.

6.

According to the Law of Large Numbers, the larger the sample size, the more

likely it is that the sample mean will be close to the population expected value.

7.

8.

9.

10.

11.

12.

Throwing a dart at the WSJ and selecting stocks on this basis would be

considered random diversification.

Portfolio risk can be reduced by reducing portfolio weights for assets with

positive correlations.

If an analyst uses ex post data to calculate the correlation coefficient and

covariance and uses them in the Markowitz model, the assumption is that

past relationships will continue in the future.

In the case of a four-security portfolio, there will be 8 covariances.

The correlation coefficient explains the cause in the relative movement in returns

between two securities.

In a portfolio consisting of two perfectly negatively correlated securities, the

highest attainable expected return will consist of a portfolio containing 100% of

the asset with the highest expected return.

1.

Are the expected returns and standard deviation of a portfolio both weighted

averages of the individual securities expected returns and standard deviations? If

not, what other factors are required?

2.

portfolio?

.

Chapter Seven

Portfolio Theory

86

3.

Why was the Markowitz model impractical for commercial use when it was first

introduced in 1952? What has changed by the 1990s?

4.

Provide an example of two industries that might have low correlation with one

another. Give an example that might exhibit high correlation.

5.

correlation coefficients are typically calculated from historical data. Why may

that be a problem?

6.

proper proportions can be shown to have a standard deviation of zero. What

makes this riskless portfolio impossible to achieve in the real world?

Fill-in-the-blank Questions

1.

Markowitz diversification, also called _____________ diversification, removes

_________________ risk from the portfolio.

2.

An efficiently diversified portfolio still has _____________________ risk.

3.

The major problem with Markowitz diversification model is that it requires a full

set of ________________________ between the returns of all securities being

considered in order to calculate portfolio variance.

4.

unique covariances is [n (n-1)]/2.

Essay Questions

1.

should be across industries. Does the correlation coefficient indirectly

recommend the same thing?

. 2.

Why is more difficult to put Markowitz diversification into effect than random

diversification?

Problems

1.

Calculate the expected return and risk (standard deviation) for General Fudge for

200X, given the following information:

Probabilities

0.20 0.15 0.50 0.15

Possible Outcomes 20% 15% 11% -5%

Chapter Seven

Portfolio Theory

87

Ch.08

Multiple Choice Questions

1.

According to Markowitz, rational investors will seek efficient portfolios

because these portfolios are optimal based on:

a.

b.

c.

d.

expected return.

risk.

expected return and risk.

transactions costs.

2.

a.

b.

c.

d.

3.

a.

b.

c.

d.

are assumed to be risk-seekers

are not allowed to use leverage

are assumed to be institutional investors

are always better off if they select portfolios consisting of multiple securities

Which of the following is not one of the assumptions of portfolio theory?

Liquidity of positions

Investor preferences are based only on expected return and risk

Low transactions costs

A single investment period

4.

a.

b.

c.

d.

When the Markowitz model assumes that most investors are considered to be

risk averse, this really means that they:

will not take a fair gamble

will take a fair gamble

will take a fair gamble fifty percent of the time

will never assume investment risk

5.

a.

b.

c.

d.

the one most desirable portfolio for a particular investor

all combinations of portfolios that are equally desirable to a particular investor

all combinations of portfolios that are equally desirable to all investors

the one most desirable portfolio for all investors

6.

true?

Investors have a finite number of indifference curves

The greater the slope of the indifference curve, the greater the risk aversion of

investors

The indifference curves for all risk-averse investors will be upward sloping

Indifference curves cannot intersect

The optimal portfolio for a risk-averse investor:

cannot be determined

occurs at the point of tangency between the highest indifference curve and the

highest expected return

a.

b.

c.

d.

7.

a.

b.

Chapter Seven

Portfolio Theory

88

c.

d.

8.

a.

b.

c.

d.

occurs at the point of tangency between the highest indifference curve and the

efficient set of portfolios

occurs at the point of tangency between the highest expected return and lowest

risk efficient portfolios

Indifference curves reflect -------------- while the efficient set of portfolios

represent ---------------.

portfolio possibilities; investor preferences.

investor preferences; portfolio possibilities.

portfolio return; investor risk.

investor preferences; portfolio return.

9.

a.

b.

c.

d.

largest expected return for the smallest level of risk

largest expected return and zero risk

largest expected return for a given level of risk

smallest level of risk

10.

a.

b.

c.

d.

11.

a.

b.

c.

d.

Portfolios lying on the upper right portion of the efficient frontier are likely to be

chosen by

aggressive investors

conservative investors

risk-averse investors

defensive investors

A portfolio which lies below the efficient frontier is described as

optimal

unattainable

dominant

dominated

12.

a.

b.

c.

d.

lowest risk

highest risk

highest utility

least investment

13.

a.

b.

c.

d.

14.

a.

b.

c.

d.

As a measure of market risk, the beta for the S&P 500 is generally considered to be:

-1.0

1.0

0

impossible to determine

Systematic risk is also called:

diversifiable risk

market risk

random risk

company-specific risk

Chapter Seven

Portfolio Theory

89

True/False Questions

1. Because of its complexity, the Markowitz model is no longer used by institutional

investors.

2. When using the Markowitz model, aggressive investors would select portfolios on the

left end of the efficient frontier.

3. Markowitz derived the efficient frontier as an upward-sloping straight line.

4. A major assumption of the Markowitz model is that investors base their decisions

strictly on expected return and risk factors.

5.

Under the Markowitz model, the risk of a portfolio is measured by the standard

deviation of the portfolio return.

6.

The single index model requires (3n+2) total pieces of data to implement.

7.

The Sharpe model was found to outperform the Markowitz model in longer time

periods.

8.

Asset allocation accounts for less than 50 percent of the variance in quarterly

returns for a typical pension fund.

9.

A well diversified portfolio will typically consist of a mix of small, mid and large

cap stocks, both U.S. and foreign, as well as corporate and U.S. Treasury bonds,

real estate and commodities.

10.

Real estate has never been shown to be positively correlated with the performance

of stocks.

Short-Answer Questions

1.

Explain what is efficient about the efficient frontier.

2.

What variable is manipulated to determine efficient portfolios, and why are the

other variables not changed at will?

3.

Discuss the importance of the asset allocation decision for portfolio performance.

4.

Distinguish between systematic and nonsystematic risk. What are two other

names for each? Give examples of each.

5.

Suppose you interview two different portfolio managers about their efficient sets

of portfolios. Is it possible, or even probable, that they would have two different

efficient sets? Why?

Problems

1.

Given the following information, calculate the expected return of Portfolio ABC.

Expected return of stock A = 10%, Expected return of stock B = 15%, Expected

return of stock C = 6%. 40 percent of the portfolio is invested in A, 40 percent is

invested in B and 20 percent is invested in C.

2.

Assume ABC are all positively correlated. A fourth stock is being considered for

addition to the portfolio, either stock D or stock E. Both D and E have expected

returns of 12%. If stock D is positively correlated with ABC and E is negatively

correlated with ABC, which stock should be added to the portfolio? Why?

Chapter Seven

Portfolio Theory

90

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