Review for Exam 2. Instructions: Please read carefully

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1 Review for Exam 2 Instructions: Please read carefully The exam will have 25 multiple choice questions and 5 work problems You are not responsible for any topics that are not covered in the lecture note slides (lecture 5, 6, 7, 8). Questions in the multiple choice section will be either concept or calculation questions. The calculation questions will be similar to those in the homework and review. However, the concept questions will be related to any topic we have covered in the class. The concept questions in the review are only some sample questions. You should NOT study only topics in the review. For the work problems, you need to solve the problems without knowing the possible answers. The questions will be similar to those in the homework and the review except that the possible solutions are not given. You can bring a formula sheet to the exam.

2 Chapter 5&6 1. Of the alternatives available, typically have the highest standard deviation of returns. A) commercial paper B) corporate bonds C) stocks D) treasury bills 2. The holding period return on a stock is equal to. A) the capital gain yield over the period plus the inflation rate B) the capital gain yield over the period plus the dividend yield C) the current yield plus the dividend yield D) the dividend yield plus the risk premium 3..Suppose you pay $9,800 for a Treasury bill maturing in two months. What is the annual percentage rate of return for this investment? Assume par value = $10,000 A) 2% B) 12% C) 12.2% D) 16.4% 4. The market risk premium is defined as. A) the difference between the return on an index fund and the return on Treasury bills B) the difference between the return on a small firm mutual fund and the return on the Standard and Poor's 500 index C) the difference between the return on the risky asset with the lowest returns and the return on Treasury bills D) the difference between the return on the highest yielding asset and the lowest yielding asset. 5. The reward/variability ratio is given by. A) the slope of the capital allocation line B) the second derivative of the capital allocation line C) the point at which the second derivative of the investor's indifference curve reaches zero D) none of the above

3 6. A Treasury bill pays a 6% rate of return. A risk averse investor invest in a risky portfolio that pays 12% with a probability of 40% or 2% with a probability of 60% because. A) might; she is rewarded a risk premium B) would not; because she is not rewarded any risk premium C) would not; because the risk premium is small D) cannot be determined 7. The holding period return on a stock was 30%. Its ending price was $26 and its cash dividend was $1.50. Its beginning price must have been. A) $20.00 B) $21.15 C) $86.67 D) $ You have $500,000 available to invest. The risk-free rate as well as your borrowing rate is 8%. The return on the risky portfolio is 16%. If you wish to earn a 22% return, you should. A) invest $125,000 in the risk-free asset B) invest $375,000 in the risk-free asset C) borrow $125,000 D) borrow $375, The price of a stock is $55 at the beginning of the year and $53 at the end of the year. If the stock paid a $3 dividend what is the holding period return for the year? A) 1.82% B) 3.64% C) 5.45% D) 10.0% 10. Elias is a risk-averse investor. David is a less risk-averse investor than Elias. Therefore, A. for the same risk, David requires a higher rate of return than Elias. B. for the same return, Elias tolerates higher risk than David. C. for the same risk, Elias requires a lower rate of return than David. D. for the same return, David tolerates higher risk than Elias. E. cannot be determined.

4 11. A portfolio has an expected rate of return of 0.15 and a standard deviation of The risk-free rate is 6 percent. An investor has the following utility function: U = E(r) - (A/2)s 2. Which value of A makes this investor indifferent between the risky portfolio and the risk-free asset? A. 5 B. 6 C. 7 D. 8 E. none of the above U = E(r) - (A/2)s 2, where A = Based on the utility function above, which investment would you select? A. 1 B. 2 C. 3 D. 4 E. cannot tell from the information given 13. Which investment would you select if you were risk neutral? A. 1 B. 2 C. 3 D. 4 E. cannot tell from the information given 14. The presence of risk means that A. investors will lose money. B. more than one outcome is possible. C. the standard deviation of the payoff is larger than its expected value. D. final wealth will be greater than initial wealth. E. terminal wealth will be less than initial wealth.

5 15. The Capital Allocation Line can be described as the A. investment opportunity set formed with a risky asset and a risk-free asset. B. investment opportunity set formed with two risky assets. C. line on which lie all portfolios that offer the same utility to a particular investor. D. line on which lie all portfolios with the same expected rate of return and different standard deviations. E. none of the above. 16. An investor invests 30 percent of his wealth in a risky asset with an expected rate of return of 0.15 and a variance of 0.04 and 70 percent in a T-bill that pays 6 percent. His portfolio's expected return and standard deviation are and, respectively. A ; 0.12 B ;0.06 C ; 0.12 D ; 0.12 E. none of the above 17. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.11? A. 53.8% and 46.2% B. 75% and 25% C. 62.5% and 37.5% D. 46.1% and 53.8% E. Cannot be determined. 18. What percentages of your money must be invested in the risk-free asset and the risky asset, respectively, to form a portfolio with a standard deviation of 0.20? A. 30% and 70% B. 50% and 50% C. 60% and 40% D. 40% and 60% E. Cannot be determined.

6 Chapter 7&8 19. Risk that can be eliminated through diversification is called risk. A) unique B) firm-specific C) diversifiable D) all of the above 20. The decision should take precedence over the decision. A) asset allocation, stock selection B) choice of fad, mutual fund selection C) stock selection, asset allocation D) stock selection, mutual fund selection 21. The risk that can be diversified away is. A) beta B) firm specific risk C) market risk D) systematic risk 22. is a true statement regarding the variance of risky portfolios. A) The higher the coefficient of correlation between securities, the greater will be the reduction in the portfolio variance B) There is a direct relationship between the securities coefficient of correlation and the portfolio variance C) The degree to which the portfolio variance is reduced depends on the degree of correlation between securities D) none of the above 23. Expected return-standard deviation combinations corresponding to any individual risky asset. A) will always end up on the efficient frontier B) will always end up on the efficient frontier or within the efficient frontier, but never outside the efficient frontier C) will always end up within the efficient frontier D) may end up anywhere in expected return-standard deviation space 24. The optimal risky portfolio can be identified by finding. A) the minimum variance point on the efficient frontier B) the maximum return point on the efficient frontier C) the tangency point of the capital market line and the efficient frontier D) None of the above answers is correct

7 25. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 25% while stock B has a standard deviation of return of 5%. Stock A comprises 20% of the portfolio while stock B comprises 80% of the portfolio. If the variance of return on the portfolio is.0050, the correlation coefficient between the returns on A and B is. A) B) C).474 D) A measure of the riskiness of an asset held in isolation is. A) beta B) standard deviation C) covariance D) semi-variance 27. As additional securities are added to a portfolio, total risk will generally at a rate. A) rise; decreasing B) rise; increasing C) fall; decreasing D) fall; increasing 28. The security characteristic line is. A) the trend line representing the security's tendency to advance or decline in the market over some period of time B) the "best fit" line representing the regression of the security's excess returns on market excess returns over some period of time C) another term for the capital allocation line representing the set of complete portfolios that can be constructed by combining the security with T-bill holdings D) None of the above answers is correct 29. A security's beta coefficient will be negative if. A) its returns are negatively correlated with market index returns B) its returns are positively correlated with market index returns C) its stock price has historically been very stable D) market demand for the firm's shares is very low

8 30. Which of the following correlations coefficients will produce the least diversification benefit? A) -0.6 B) -1.5 C) 0.0 D) What is the standard deviation of a portfolio of two stocks given the following data? Stock A has a standard deviation of 22%. Stock B has a standard deviation of 16%. The portfolio is equally weighted and the correlation coefficient between the two stocks is.35. A) 15.7% B) 16.0% C) 18.8% D) 22.0% 32. 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? A) 0.0 B) 0.45 C) 0.74 D) The efficient frontier of risky assets is A. the portion of the investment opportunity set that lies above the global minimum variance portfolio. B. the portion of the investment opportunity set that represents the highest standard deviations. C. the portion of the investment opportunity set which includes the portfolios with the lowest standard deviation. D. the set of portfolios that have zero standard deviation. E. both A and B are true.

9 34. The Capital Allocation Line provided by a risk-free security and N risky securities is A. the line that connects the risk-free rate and the global minimum-variance portfolio of the risky securities. B. the line that connects the risk-free rate and the portfolio of the risky securities that has the highest expected return on the efficient frontier. C. the line tangent to the efficient frontier of risky securities drawn from the risk-free rate. D. the horizontal line drawn from the risk-free rate. E. none of the above. 35. Which of the following statement(s) is (are) false regarding the selection of a portfolio from those that lie on the Capital Allocation Line? A. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors. B. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors. C. Investors choose the portfolio that maximizes their expected utility. D. A and B. E. A and C. 36. An investor who wishes to form a portfolio that lies to the right of the optimal risky portfolio on the Capital Allocation Line must: A. lend some of her money at the risk-free rate and invest the remainder in the optimal risky portfolio. B. borrow some money at the risk-free rate and invest in the optimal risky portfolio. C. invest only in risky securities. D. such a portfolio cannot be formed. E. B and C 37. Security X has expected return of 12% and standard deviation of 20%. Security Y has expected return of 15% and standard deviation of 27%. If the two securities have a correlation coefficient of 0.7, what is their covariance? A B C D E

10 38. The line representing all combinations of portfolio expected returns and standard deviations that can be constructed from two available assets is called the A. risk/reward tradeoff line B. Capital Allocation Line C. efficient frontier D. portfolio opportunity set E. Security Market Line 39. Given an optimal risky portfolio with expected return of 14% and standard deviation of 22% and a risk free rate of 6%, what is the slope of the best feasible CAL? A B C D E The standard deviation of a two-asset portfolio is a linear function of the assets' weights when A. the assets have a correlation coefficient less than zero. B. the assets have a correlation coefficient equal to zero. C. the assets have a correlation coefficient greater than zero. D. the assets have a correlation coefficient equal to one. E. the assets have a correlation coefficient less than one. 41. When borrowing and lending at a risk-free rate are allowed, which Capital Allocation Line (CAL) should the investor choose to combine with the efficient frontier? I) with the highest reward-to-variability ratio. II) that will maximize his utility. III) with the steepest slope. IV) with the lowest slope. A. I and III B. I and IV C. II and IV D. I only E. I, II, and III

11 Consider the following probability distribution for stocks A and B: 42. The expected rates of return of stocks A and B are and, respectively. A. 13.2%; 9%. B. 13%; 8.4% C. 13.2%; 7.7% D. 7.7%; 13.2% E. none of the above 43. The standard deviations of stocks A and B are and, respectively. A. 1.56%; 1.99% B. 2.45%; 1.68% C. 3.22%; 2.01% D. 1.54%; 1.11% E. none of the above 44. The coefficient of correlation between A and B is A B C D E. none of the above. 45. If you invest 35% of your money in A and 65% in B, what would be your portfolio's expected rate of return and standard deviation? A. 9.9%; 3% B. 9.9%; 1.1% C. 10%; 1.7% D. 10%; 3% E. none of the above

12 Chapter 9& Consider the CAPM. The risk-free rate is 5% and the expected return on the market is 15%. What is the beta on a stock with an expected return of 12%? A).5 B).7 C) 1.2 D) is a true statement regarding the multi-factor arbitrage pricing theory. A) Only the stock beta affects the stock price B) Only the stock unique risk affects the stock price C) Only the stock variance and beta affect the stock price D) Several systematic factors affect the stock price 48. The market portfolio has a beta of. A) -1.0 B) 0 C) 0.5 D) According to the capital asset pricing model, a well-diversified portfolio's rate of return is a function of. A) market risk B) unsystematic risk C) unique risk D) reinvestment risk 50. According to the capital asset pricing model, the expected rate of return on any security is equal to. A) [(the risk-free rate) + (beta of the security)] x (market risk premium) B) (the risk-free rate) + [(variance of the security's return) x (market risk premium)] C) (the risk-free rate) + [(security's beta) x (market risk premium)] D) (market rate of return) + (the risk-free rate) 51. According to the capital asset pricing model, fairly priced securities have. A) negative betas B) positive alphas C) positive betas D) zero alphas

13 52. The difference between a security's actual return and the return predicted by the characteristic line associated with the security's past returns is. A) alpha B) beta C) gamma D) residual 53. The beta, of a security is equal to. A) A) the covariance between the security and market returns divided by the variance of the market's returns B) the covariance between the security and market returns divided by the standard deviation of the market's returns C) the variance of the security's returns divided by the covariance between the security and market returns D) the variance of the security's returns divided by the variance of the market's returns 54. Security A has an expected rate of return of 12% and a beta of The market expected rate of return is 8% and the risk-free rate is 5%. The alpha of the stock is. A) -1.7% B) 3.7% C) 5.5% D) 8.7% 55. The risk-free rate is 4%. The expected market rate of return is 11%. If you expect stock X with a beta of.8 to offer a rate of return of 12 percent, then you should. A) buy stock X because it is overpriced B) buy stock X because it is underpriced C) sell short stock X because it is overpriced D) sell short stock X because it is underpriced 56. According to capital asset pricing theory, the key determinant of portfolio returns is. A) the degree of diversification B) the systematic risk of the portfolio C) the firm specific risk of the portfolio D) economic factors

14 57. Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%. Portfolio X has an expected return of 14% and a beta of Portfolio Y has an expected return of 9.5% and a beta of In this situation, you would conclude that portfolios X and Y. A) are in equilibrium B) offer an arbitrage opportunity C) are both underpriced D) are both fairly priced 58. You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different common stocks. The portfolio beta is equal to You have decided to sell a lead mining stock (b = 1.0) at $5,000 net and use the proceeds to buy a like amount of a steel company stock (b = 2.0). What is the new beta of the portfolio? a b c d e Your opinion is that CSCO has an expected rate of return of It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is According to the Capital Asset Pricing Model, this security is A. underpriced. B. overpriced. C. fairly priced. D. cannot be determined from data provided. E. none of the above. 60. Your opinion is that CSCO has an expected rate of return of It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is According to the Capital Asset Pricing Model, this security is A. underpriced. B. overpriced. C. fairly priced. D. cannot be determined from data provided. E. none of the above.

15 61. Your opinion is that CSCO has an expected rate of return of It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is According to the Capital Asset Pricing Model, this security is A. underpriced. B. overpriced. C. fairly priced. D. cannot be determined from data provided. E. none of the above. 62. As a financial analyst, you are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company has a beta of 1.4 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be %. A B. 7 C. 15 D. 4 E. 1.4 Chapter The weak form EMH states that must be reflected in the stock price. A) all market trading data B) all publicly available information C) all information including inside information D) none of the above 64. Proponents of the EMH typically advocate. A) a conservative investment strategy B) a liberal investment strategy C) a passive investment strategy D) an aggressive investment strategy 65. A chartist is likely to believe in the value of doing. A) fundamental analysis B) technical analysis C) both a and b D) neither a nor b

16 66. is the return on a stock beyond what would be predicted from market movements alone. A) a normal return B) a subliminal return C) an abnormal return D) none of the above 67. If you believe in the form of the EMH, you believe that stock prices reflect all information that can be derived by examining market trading data such as the history of past stock prices, trading volume or short interest. A) semi-strong B) strong C) weak D) any of the above 68. Which of the following have not been considered market anomalies? A) the small-firm January effect B) the reversal effect C) the book-to-market effect D) All of the above have been considered market anomalies 69. Proponents of the EMH think technical analysts. A) should focus on relative strength B) should focus on resistance levels C) should focus on support levels D) are wasting their time 70. When stock returns exhibit positive serial correlation, this means that returns tend to follow returns. A) positive; positive B) positive ; negative C) negative; positive D) None of the above 71. Basu found that firms with high P/E ratios. A) earned higher average returns than firms with low P/E ratios B) earned the same average returns as firms with low P/E ratios C) earned lower average returns than firms with low P/E ratios D) had higher dividend yields than firms with low P/E ratios

17 72. According to the semi-strong form of the efficient markets hypothesis. A) stock prices do not rapidly adjust to new information B) future changes in stock prices cannot be predicted from any information that is publicly available C) corporate insiders should have no better investment performance than other investors D) arbitrage between futures and cash markets should not produce extraordinary profits 73. The semi-strong form of the efficient market hypothesis contradicts. A) technical analysis, but supports fundamental analysis as valid B) fundamental analysis, but supports technical analysis as valid C) both fundamental analysis and technical analysis D) technical analysis, but is silent on the possibility of successful fundamental analysis 74. focus more on past price movements of a firm's stock than on the underlying determinants of future profitability. A. Credit analysts B. Fundamental analysts C. Systems analysts D. Technical analysts E. All of the above 75. According to proponents of the efficient market hypothesis, the best strategy for a small investor with a portfolio worth $40,000 is probably to A. perform fundamental analysis. B. exploit market anomalies. C. invest in Treasury securities. D. invest in derivative securities. E. invest in mutual funds. 76. Google has a beta of 1.0. The annualized market return yesterday was 11%, and the risk-free rate is currently 5%. You observe that Google had an annualized return yesterday of 14%. Assuming that markets are efficient, this suggests that A. bad news about Google was announced yesterday. B. good news about Google was announced yesterday. C. no news about Google was announced yesterday. D. interest rates rose yesterday. E. interest rates fell yesterday.

18 Answers 1. Answer: C 2. Answer: B 3. Answer: C 4. Answer: A 5. Answer: A 6. Answer: B 7. Answer: B 10, 000 9, 800 HPR = 9, 800 = 2. 04% Thus,the nominal annual return is 2. 04% 6 = 12. 2% P = = Answer: D y = = Borrowing = 500, Answer: A HPR = ( ) / 55 = D ( ) = 375,000 The more risk averse the investor, the less risk that is tolerated, given a rate of return. 11. D 0.06 = A/2(0.15) 2 ; = -A/2(0.0225); = A; A = 8; U = /2(0.15) 2 = 6%; U(R f ) = 6%. 12. C U(c) = /2(0.16) 2 = (highest utility of choices). 13. D

19 If you are risk neutral, your only concern is with return, not risk. 14. B The presence of risk means that more than one outcome is possible. 15. A The CAL has an intercept equal to the risk-free rate. It is a straight line through the point representing the risk-free asset and the risky portfolio, in expected-return/standard deviation space. 16. B E(r P ) = 0.3(15%) + 0.7(6%) = 8.7%; s P = 0.3(0.04) 1/2 = 6%. 17. A 11% = w 1 (17%) + (1 - w 1 )(4%); 11% = 17%w 1 + 4% - 4%w 1 ; 7% = 13%w 1 ; w 1 = 0.538; 1 - w 1 = 0.461; 0.538(17%) (4%) = 11.0%. 18. B 0.20 = x(0.40); x = 50% in risky asset. 19. Answer: D 20. Answer: A 21. Answer: B 22. Answer: C 23. Answer: C 24. Answer: C 25. Answer: D.0050 = (.2) 2 (.25) 2 + (.8) 2 (.05) 2 + 2(.2)(.8)(.25)(.05)Corr Corr = Answer: B 27. Answer: C 28. Answer: B 29. Answer: A 30. Answer: D 31. Answer: A σ = (.50) 2 (.22) 2 + (.50) 2 (.16) 32. Answer: B Reward to variability ratio = ( ) /.12 = (.35)(.22)(.16)(.50)(.50) =.157

20 33. A Portfolios on the efficient frontier are those providing the greatest expected return for a given amount of risk. Only those portfolios above the global minimum variance portfolio meet this criterion. 34. C The Capital Allocation Line represents the most efficient combinations of the risk-free asset and risky securities. Only C meets that definition. 35. A All rational investors select the portfolio that maximizes their expected utility; for investors who are relatively more risk-averse, doing so means investing less in the optimal risky portfolio and more in the risk-free asset. 36. E The only way that an investor can create portfolios to the right of the Capital Allocation Line is to create a borrowing portfolio (buy stocks on margin). In this case, the investor will not hold any of the risk-free security, but will hold only risky securities. 37. A Cov(r X, r Y ) = (.7)(.20)(.27) = D The portfolio opportunity set is the line describing all combinations of expected returns and standard deviations that can be achieved by a portfolio of risky assets. 39. E Slope = (14-6)/22 = D When there is a perfect positive correlation (or a perfect negative correlation), the equation for the portfolio variance simplifies to a perfect square. The result is that the portfolio's standard deviation is linear relative to the assets' weights in the portfolio. 41. E

21 The optimal CAL is the one that is tangent to the efficient frontier. This CAL offers the highest reward-to-variability ratio, which is the slope of the CAL. It will also allow the investor to reach his highest feasible level of utility. 42. B E(RA) = 0.15(8%) + 0.2(13%) (12%) + 0.3(14%) + 0.2(16%) = 13%; E(RB) = 0.15(8%) + 0.2(7%) (6%) + 0.3(9%) + 0.2(11%) = 8.4%. 43. B s A = [0.15(8% - 13%) (13% - 13%) (12% - 13%) (14% - 13%) (16% - 13%) 2 ] 1/2 = 2.449%; s B = [0.15(8% - 8.4%) (7% - 8.4%) (6% - 8.4%) (9% - 8.4%) (11% - 8.4%) 2 ] 1/2 = 1.676%. 44. C cova,b = 0.15(8% - 13%)(8% - 8.4%) + 0.2(13% - 13%)(7% - 8.4%) (12% - 13%)(6% - 8.4%) + 0.3(14% - 13%)(9% - 8.4%) + 0.2(16% - 13%)(11% - 8.4%) = 2.40; ra,b = 2.40/[(2.45)(1.68)] = C E(R P ) = 0.35(13%) (8.4%) = 10.01%; s P = [(0.35) 2 (2.45%) 2 + (0.65) 2 (1.68) 2 + 2(0.35)(0.65)(2.45)(1.68)(0.583)] 1/2 = 1.7%. 46. Answer: B 47. Answer: D 48. Answer: D 49. Answer: A 50. Answer: C 51. Answer: D 52. Answer: D 53. Answer: A 54. Answer: B α =. 12[ (08.05)] = Answer: B 56. Answer: B 57. Answer: A 58.B Before: 1.12 = 0.95(b R ) (1.0); 0.95(b R ) = 1.07; b R = After: b P = 0.95(b R ) (2.0) = = 1.17.

22 59. B 11.5% - 4% + 1.3(11.5% - 4%) = -2.25%; therefore, the security is overpriced. 60. C 13.75% - 4% + 1.3(11.5% - 4%) = 0.0%; therefore, the security is fairly priced. 61. A 15% - 4% + 1.3(11.5% - 4%) = 1.25%; therefore, the security is under priced. 62. A The hurdle rate should be the required return from CAPM or (R = 4% + 1.4(11% - 4%) = 11%. 63. Answer: A 64. Answer: C 65. Answer: B 66. Answer: C 67. Answer: D 68. Answer: D 69. Answer: D 70. Answer: A 71. Answer: C 72. Answer: B 73. Answer: C 74. D Technicians attempt to predict future stock prices based on historical stock prices. 75. E Individual investors tend to have relatively small portfolios and are usually unable to realize economies of size. The best strategy is to pool funds with other small investors and allow professional managers to invest the funds. 76. B AR = 14% - (5% (6%)) = +3.0%. A positive abnormal return suggests that there was firm-specific good news.