Fujairah College

Department of Business Administration

Investment analysis
First Semester / 2014 2015

(worksheet CH 7&ch 8 : portfolio management)

______________________________________________________________________
Student ID. No.

Put ( ) in front of correct answer

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

Q1. Multiple Choice Questions

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.

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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.

Portfolio weights are found by:

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.

Which of the following statements regarding expected return of a portfolio

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
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8.
a.
b.
c.
d.

Which of the following is true regarding the expected return of a portfolio?

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.

Which of the following is true regarding random diversification?

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.

Company specific risk is also known as:

market risk
systematic risk
non-diversifiable risk
idiosyncratic risk

11.
a.
b.
c.
d.

The relevant risk for a well-diversified portfolio is:

interest rate risk
inflation risk
business risk
market risk

12.

Which of the following statements regarding the correlation coefficient is

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

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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.

Portfolio risk is most often measured by professional investors using the:

expected value
portfolio beta
weighted average of individual risk
standard deviation

18.
a.
b.

Markowitz's main contribution to portfolio theory is:

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.

When the covariance is positive, the correlation will be:

positive
negative
zero
impossible to determine

21.

Calculate the risk (standard deviation) of the following two-security portfolio if

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.

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22.
a.
b.
c.
d.

The major problem with the Markowitz model is its:

lack of accuracy
predictability flaws
complexity
inability to handle large number of inputs

Q2. True-False Questions

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.

Investments in commodities such as precious metals may provide additional

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.

Q3. Short-Answer Questions

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.

How is the correlation coefficient important in choosing among securities for a

portfolio?

.
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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.

When constructing a portfolio, standard deviations, expected returns, and

correlation coefficients are typically calculated from historical data. Why may
that be a problem?

6.

A portfolio consisting of two securities with perfect negative correlation in the

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.

The number of covariances in the Markowitz model is ________ ; the number of

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

Essay Questions
1.

Conventional wisdom has long held that diversification of a stock portfolio

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%
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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.

Under the Markowitz model, investors:

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.

An indifference curve shows:

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.

Which of the following statements regarding indifference curves is not

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.

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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.

According to Markowitz, an efficient portfolio is one that has the

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.

The optimal portfolio is the efficient portfolio with the

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

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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?

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