Chapter 7 PORTFOLIO THEORY Multiple Choice Questions

Dealing With Uncertainty 1. a. b. c. d. With a continuous probability distribution,: a probability is assigned to each possible outcome. possible outcomes are constantly changing. an infinite number of possible outcomes exist. there is no variance.

(c, moderate) 2. a. b. c. d. The expected value is the: inverse of the standard deviation correlation between a securitys risk and return. weighted average of all possible outcomes. same as the discrete probability distribution.

(c, easy) 3. a. b. c. d. -------------------is concerned with the interrelationships between security returns. random diversification. correlating diversification Friedman diversification Markowitz diversification

(d, moderate) 4. a. b. c. d. The one-period rate of return from a stock or bond which may or may not be realized can be described by using the term: holding-period return. yield. random variable market return.

(c, easy)

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5.

Given the following probability distribution, calculate the expected return of security XYZ. Probability 0.3 0.2 0.1 0.1 0.3 Solution: E(R) = Ripri = (20)(0.3) + (30)(0.2) + (- 40)(0.1) + (50)(0.1) + = (10)(0.3) = 22 percent

Security XYZ's Potential return 20% 30% -40% 50% 10% a. b. c. d. 16 percent 22 percent 25 percent 18 percent

(b, moderate) 6. a. b. c. d. Probability distributions: are always discrete. are always continuous. can be either discrete or continuous. are inverse to interest rates.

(c, easy) 7. a. b. c. d. The most familiar distribution is the normal distribution which is: upward sloping. downward sloping. linear. bell-shaped.

(d, easy) Portfolio Return and Risk 8. a. b. c. d. Portfolio weights are found by: dividing standard deviation by expected value. calculating the percentage each asset is to the total portfolio value. calculating the return of each asset to total portfolio return. dividing expected value by the standard deviation.

(b, moderate)

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9. a. b. c. d.

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.

(c, moderate) 10. a. b. c. d. In order to determine the expected return of a portfolio, all of the following must be known except: probabilities of expected returns of individual assets. weight of each individual asset to total portfolio value. expected return of each individual asset. All of the above must be known in order to determine the expected return of a portfolio.

(a, difficult) 11. 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 return. All of the above are true.

(c, moderate) Analyzing Portfolio Risk 12. a. b. c. d. Which of the following is true regarding random diversification? Investment characteristics are considered important in random diversification. The benefits of random diversification do not continue as more securities are added. Random diversification, if done correctly, can eliminate all risk in a portfolio. All of the above are true.

(b, difficult) 13.

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Company specific risk is also known as:

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a. b. c. d.

market risk. systematic risk. non-diversifiable risk. idiosyncratic risk.

(d, moderate) 14. a. b. c. d. The relevant risk for a well-diversified portfolio is: interest rate risk. inflation risk. business risk. market risk.

(d, easy)

The Components of Portfolio Risk 15. a. b. c. d. 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. All of the above are true.

(c, difficult) 16. a. b. c. d. The range of the correlation coefficient is from: 0 to +1.0 0 to +2.0 1.0 to 0 1.0 to +1.0

(d, easy)

17.

Security A and Security B have a correlation coefficient of 0. If Security As return is expected to increase by 10 percent,
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a. b. c. d.

Security Bs return should also increase by 10 percent. Security Bs return should decrease by 10 percent. Security Bs return should be zero. Security Bs return is impossible to determine from the above information.

(d, moderate) 18. a. b. c. d. Which of the following portfolios has the least reduction of risk? A portfolio with securities all having positive correlation with each other. A portfolio with securities all having zero correlation with each other. A portfolio with securities all having negative correlation with each other. A portfolio with securities all having skewed correlation with each other.

(a, moderate) 19. a. b. c. d. The major difference between the correlation coefficient and the covariance is that: the correlation coefficient can be positive, negative or zero while the covariance is always positive. the correlation coefficient measures relationship between securities and the covariance measures relationships between a security and the market. the correlation coefficient is a relative measure showing association between security returns and the covariance is an absolute measure showing association between security returns. the correlation coefficient is a geometric measure and the covariance is a statistical measure.

(c, difficult) 20. a. b. c. d. Which of the following statements regarding portfolio risk and number of stocks is generally true? Adding more stocks increases risk. Adding more stocks decreases risk but does not eliminate it. Adding more stocks has no effect on risk. Adding more stocks increases only systematic risk.

(b, moderate)

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21. 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. infinite.

(b, moderate) 22. a. b. c. d. Portfolio risk is best measured by the: expected value.. portfolio beta. weighted average of individual risk. standard deviation.

(d, easy) 23. a. b. c. d. A change in the correlation coefficient of the returns of two securities in a portfolio causes a change in both the expected return and the risk of the portfolio. only the expected return of the portfolio. only the risk level of the portfolio. neither the expected return nor the risk level of the portfolio.

(c, moderate) 24. a. b. c. d. 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 variances and covariances in determining portfolio risk.

(d, moderate)

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25. 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.

(a, easy) 26. a. b. c. d. When the covariance is positive, the correlation will be: positive. negative. zero. impossible to determine.

(a, easy) Calculating Portfolio Risk 27. Calculate the risk (standard deviation) of the following two-security portfolio if the correlation coefficient between the two securities is equal to 0.5. 10 0.7 Solution: p = = = [w1212 + w2222 + 2(w1)(w2)(1,2)12]1/2 [(0.3)2(10) + (0.7)2(20) + 2(0.3)(0.7)(0.5)(10)1/2(20)1/2]1/2 = 3.7 percent Weight (in the portfolio) 0.3

Variance Security A Security B 20 a. b. c. d. 17.0 percent 5.4 percent 2.0 percent 3.7 percent

(d, difficult) Obtaining the Data 28. 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.

(c, difficult)

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True-False Questions
Dealing With Uncertainty 1. Standard deviations for well-diversified portfolios are reasonably steady over time.

(T, moderate) 2. A probability distribution shows the likely outcomes that may occur and the probabilities associated with these likely outcomes.

(T, easy) Portfolio Return and Risk 3. Portfolio risk is a weighted average of the individual security risks.

(F, moderate) The Components of Portfolio Risk 4. A negative correlation coefficient indicates that the returns of two securities have a tendency to move in opposite directions.

(T, easy) Analyzing Portfolio Risk 5. Gold offers additional diversification since gold's performance typically moves independent of other investments and even major economic indicators.

(T, moderate) 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.

(T, moderate) 7. Throwing a dart at the WSJ and selecting stocks on this basis would be considered random diversification.

(T, easy)

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Calculating Portfolio Risk 8. Portfolio risk is affected by both the correlation between assets and by the percentage of funds invested in each asset.

(T, moderate) Obtaining the Data 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. (T, difficult) 10. In the case of a four-security portfolio, there will be 8 covariances. 9.

(F, moderate)

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? The expected return is a weighted average. The portfolio standard deviation is not a weighted average but also requires correlation coefficients among the securities.

Answer:

(moderate) 2. How is the correlation coefficient important in choosing among securities for a portfolio? If security returns are highly correlated (high positive correlation) diversification does little to reduce risk of returns. The lower the correlation coefficients among the securities, the more advantage is gained from diversification.

Answer:

(moderate) 3. Why was the Markowitz model impractical for commercial use when it was first introduced in 1952? What has changed by the 1990s?

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Answer:

The volume of calculations required for a large portfolio was physically impractical in the 1950s. By the 1990s, the proliferation of computers has made the volume of calculations practical.

(moderate) 4. Give an example of two industries that might exhibit low correlation of returns. Give an example that might exhibit high correlation. Low correlation might be found between large appliances and retail food markets in that retail food is somewhat steady through economic ups and downs, while appliances tend to fall off during economic slow downs. High correlation might be found between auto manufacturers and steel manufacturers.

Answer:

(moderate) When constructing a portfolio, standard deviations are typically calculated from historical data. Why may that be a problem?
5.

Answer:

The problem is that historical patterns may not be repeated in the future. We are planning a portfolio for the future and would like to have future (ex ante) data but have only historical (ex post) data.

(moderate) 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? Perfect negative correlation is not achievable in most cases since most securities have positive correlation or low correlation. Even if it were observed for a period of time, it could not be counted on to hold for long in the future.

Answer:

(difficult)

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Critical Thinking/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? Correlation coefficients between securities in different industries represent the extent to which their fortunes depend on mutual factors. The correlation coefficients, then, simply give investors a way to measure conventional wisdom.

Answer:

(difficult) 2. Why is more difficult to put Markowitz diversification into effect than random diversification? It requires more quantitative analysis and generally the use of a computer software program. In addition, it is harder to find securities with either negative correlation or low correlation than it is to simply select securities in different industries and sectors as is done in random diversification.

Answer:

(moderate)

Problems
1. Calculate the expected return and risk (standard deviation) for General Fudge for 200X, given the following information: 20% 0.20 15% 0.15 11% 0.50 -5% 0.15

Probabilities Possible Outcomes Solution:

E(Ri) = = =

.20(.20) + .15(.15) + .50(.11) + .15(-.05) .04 + .0225 + .055 + (-.0075) .11

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 =[R i E ( R i )] 2 p i ]1 / 2 [ r
i= 1

(1) Possible Outcome ER .20 .15 .11 -.05

(2) R-ER .11 .11 .11 .11

(3) (PR-ER)2 .09 .04 .00 -.16

(4) Prob. .0081 .0016 .0000 .0256

(5) (4) x (5) .20 .15 .50 .15

(6) .00162 .00024 .00000 .00384 .00570

= (.00570)1/2 = 7.55 percent (difficult)

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