File: ch08

Type: Multiple Choice

1. Which of the following is the single most important concept in portfolio management? a) Expected return b) Risk as measured by standard deviation c) Risk as measured by variance d) Risk reduction through diversification Ans: D EASY Response: Diversification is key to optimal risk management. Section: Portfolio Selection and Asset Allocation

2. Using the Markowitz model, which of the following inputs is NOT necessary to choosing the most efficient portfolio(s)? a) b) c) d) the expected return of each asset the standard deviation of each asset the correlation between each pair of assets the risk preference of the investor

Ans: D EASY Response: The expected returns, the standard deviations and the correlations are necessary to find the efficient frontier. The investor then chooses from among those portfolios on the efficient frontier. See page 8-2. Section: Building a Portfolio Using Markowitz Principles.

3. Which of the following is NOT an assumption underlying Markowitzs portfolio theory? a) All returns are measured in dollars. b) The investor has a time horizon of one period. c) The investor may buy or sell with no transaction costs. d) The investors preference is based only on expected return and risk, as measured by standard deviation Ans: A

EASY Response: The theory works just as well in any currency. Section: Building a Portfolio Using Markowitz Principles.

4. What is meant by an efficient portfolio? a) The portfolio consists of the fewest possible securities. b) The portfolio has the highest return for a given level of risk. c) The portfolio has the highest return for a given level of return. d) The portfolio includes all appropriate securities. Ans: B EASY Response: An efficient portfolio is also defined as the one with the smallest portfolio risk for a given level of return. Section: Building a Portfolio Using Markowitz Principles.

5. What is the difference between an efficient portfolio and an obtainable portfolio? a) Obtainable portfolios are any that an ordinary investor can purchase; efficient are those that the investor can purchase with reasonable commissions. b) Efficient portfolio refers to all possible combination of the underlying securities; obtainable portfolio refers to those that can actually be found in existing mutual funds. c) Obtainable portfolios are all possible combinations of the underlying assets; the efficient portfolios are a subset, with minimum risk for a given level of return. d) Obtainable and efficient mean the same thing in this context. Ans: C MEDIUM Response: Not all obtainable portfolios are considered efficient. Section: Building a Portfolio Using Markowitz Principles.

6. Refer to Figure 8-1. Why is segment AB considered the efficient set? a) Any point on segment AB has a higher return, but the same risk, as any point directly below. b) The portfolios on segment AB are appropriate only for sophisticated investors. c) Any point on segment AB has lower return, but the same risk, as possible portfolios directly above. d) Any point on segment AC has lower return, but the same risk, as possible portfolios directly above.

Ans: A MEDIUM Response: Section: Building a Portfolio Using Markowitz Principles.

7. Refer to Figure 8-2. If segment AB is the efficient set, how does the investor choose from among all the points on this segment? a) Pick the point with the lowest risk (point A). b) Pick the point with the highest return (point B). c) Pick the point which is tangent to the indifference curve that is tangent to segment AB (point O). d) Pick any point on the highest indifference curve (any point on curve U1). Ans: C MEDIUM Response: Section: Building a Portfolio Using Markowitz Principles.

8. The textbook suggests that the correlation between the economies of various countries is increasing, thus reducing the diversification effect of international investing. Which of the following continues to be a good argument for international investing? a) The economies and corporate profits in some foreign countriesare increasing faster than in the U.S. b) Some European countries have better investor protection laws than the U.S. c) The correlation-based argument is simplistic and passe. d) The economy of Japan has been basically flat for the last 14 years. Ans: A EASY Response A: Emerging markets, for example, are thought to have growth prospects well in excess of those of the U.S. market. Section: The Global Perspective International Diversification.

9. Which of the following is NOT an important point about the Markowitz portfolio selection model? a) The Markowitz model assumes that investors make decisions based on their preferences of risk and return, but no other parameters. b) The Markowitz model generates a set of many efficient portfolios. c) The Markowitz model allows investors to borrow or lend the risk-free asset, or any other asset.

d) The Markowitz model is cumbersome to work with, even using computers, because of the large variance-covariance matrix. Ans: C EASY Response: The Markowitz model does not allow borrowing or lending. Section: Section: Some Important Conclusions About the Markowitz Model.

10. Which of the following is a disadvantage of the single index approach to portfolio selection? a) The single index approach eliminates the need to calculate thousands of correlations. b) The single index approach is easier for the less-informed investor to comprehend. c) The single index approach requires the choice of index and calculation of s d) The single index approach splits the returns into a company-specific part and a market-related part. Ans: C MEDIUM Response: The selection of the specific index to be used is arbitrary different analysts may choose different indexes. The calculation of past s can be made, but it is not clear whether future s will be the same. Section: Some Important Conclusions About the Markowitz Model.

11. Which of the following terms is NOT included in the Single Index Model? a) The returns that are caused by events affecting only the specific company. b) The returns that are caused by events affecting the companys industry. c) The returns that are caused by the market as a whole. d) An error term, representing that portion of the return not explained by the model. Ans: B EASY Response: Formula 8-1 explains the factors in the Single Index Model. Section: Alternative Methods of Obtaining the Efficient Frontier.

12. Which of the following is probably a market-related event, affecting all stocks? a) The discovery of new oil reserves in a filed owed by BP. b) The indictment of a corporate officer for fraud and insider trading. c) The increase in interest rates announced by the Federal Reserve Chairman. d) The FDA approval of a new treatment for cancer.

Ans: C EASY Response: Interest rate moves will tend to affect entire markets, and often will impact stock markets in other countries also. Section: Selecting Optimal Asset Classes The Asset Allocation Decision.

13. Which of the following portfolio selection models is better, and why? a) The Markowitz variance-covariance model. b) The Sharpe Single Index Model c) The Multi-index model using market and industry factors d) All produce about the same results. Ans: B EASY Response: Surprisingly, the single index model more closely replicated the variance-covariance model, and is easier to set up and understand. Section: Alternative Methods of Obtaining the Efficient Frontier.

14. Which of the following factors could NOT reasonably be considered to be used as another factor in the multi-index model? a) Industry effects b) Effects on asset classes c) Effects of interest rates d) Effects on all stocks Ans: D EASY Response: The market effect is used in the single index model. An analyst could possibly use the other three in addition to the market effect. Section: Alternative Methods of Obtaining the Efficient Frontier.

15. Which of the following asset classes has shown the highest historical price volatility? a) Treasury bonds b) Money market instruments c) High yield corporate bonds d) Common stocks

Ans: D EASY Response: While most asset classes experience some degree of price volatility, common stocks have been far more volatile throughout history, particularly in the last 10 years. . Section: Asset Allocation and the Individual Investor.

16. Which of the following asset classes is most highly correlated with the S&P 500? a) large-cap European stocks b) U.S. Real Estate Investment Trusts c) TIPS d) Investment-grade corporate bonds in the U.S. Ans: A EASY Response A: Section: Selecting Optimal Asset Classes The Asset Allocation Decision.

17. Diversification across traditional asset classes, even equally weighted, can often outperform the S&P 500 index. Which of the following is NOT considered a traditional asset class? a) Blue chip stocks b) Small cap stocks c) International equities d) Real estate funds such as REITS Ans: D EASY Response: The non-traditional asset classes are simply more newly developed investment vehicles. Section: Selecting Optimal Asset Classes The Asset Allocation Decision.

18. Adding more and more assets to a portfolio reduces the standard deviation of the portfolio. Which of the following describes a risk that cannot be eliminated? a) Nonsystematic risk b) Market risk c) Unique risk d) Business risk Ans: B EASY

Response: Market risk is also known as systematic risk, which cannot be eliminated. Section: The Impact of Diversification on Risk.

19. According to a recent study, asset allocation accounted for what percent of the variance in the quarterly returns of pension funds? a) 50% b) 65% c) 80% d) 90% Ans: D MEDIUM Response: Many knowledgeable market observers agree that the asset allocation decision is the most important decision made by an investor. Section: Asset Allocation and the Individual Investor.

20. Why do portfolios recently require more securities to become well diversified, as compared to 25 or more years ago? a) Government regulations have changed. b) The volatility of individual stocks has increased. c) The volatility of the overall stock market has increased. d) Investors are more risk averse. Ans: B EASY Response: Increased market volatility requires greater effort to achieve the benefits of portfolio diversification. Section: The Impact of Diversification on Risk.

Type: True - False

1. All investors are risk averse, that is, the investors prefer less risk for a given level of expected return. Ans: False Response: Most investors are risk averse, but some are risk neutral or risk seeking. Section: Building a Portfolio Using Markowitz Principles.

2. If two investors have different risk preferences, their utility functions will have different slopes, and they will find different points of tangency on the efficient frontier. In other words, the investors will choose different efficient portfolios. Ans: True Response: Section: Building a Portfolio Using Markowitz Principles.

3. By adding securities issued in other countries, or adding securities of companies doing significant business in other countries, the shape and location of the efficient frontier changes. Ans: True Response: See page 8-8. Section: The Global Perspective International Diversification.

4. The Single Index Model states that the returns of a specific stock are caused only by specific events affecting only that company. Ans: False Response: The Single Index Model states that the returns of a specific stock are caused by specific events affecting only that company, and those events affecting the economy as a whole. Section: Alternative Methods of Obtaining the Efficient Frontier.

5. The Single Index Model assumes that returns of any two securities are related only as far as each is related to the market index. Ans: True Response: This assumption unrealistically eliminates the effect of industries. . Section: Alternative Methods of Obtaining the Efficient Frontier.

6. Many analysts believe that the market, the industry, and the specific company can affect the returns for a specific company. These analysts can rely on the Single Index Model. Ans: False Response: These beliefs can be more accurately modeled using a two-index model, using an industry factor as the second factor. Section: Alternative Methods of Obtaining the Efficient

Frontier.

7. The multi-index model typically is better than the single index model at identifying relationships among underlying securities. Ans: False Response: In theory it should work, but some indicate that the single index model is better at matching the variance-covariance model. . Section: Alternative Methods of Obtaining the Efficient Frontier.

8. The Markowitz approach and the Single Index Model can be used to combine individual securities into efficient portfolios. These methods can also be used to combine mutual funds to form efficient portfolios. Ans: True Response: Table 8-1and Figure 8-5show the effects of adding additional classes of investments. Section: Selecting Optimal Asset Classes The Asset Allocation Decision.

9. Recent research suggests that investing in stocks has become safer and more predictable in recent years. Ans: False Response: Chapter 8 discusses two recent articles documenting that the volatility of individual stocks is increasing. Section: The Impact of Diversification on Risk.

10. Simon is considering buying a stock with considerable idiosyncratic risk. Simon should expect to be compensated for this risk by receiving a higher return. Ans: False Response: The discussion in Chapters 7 and 8 describes how idiosyncratic risk can be reduced by holding this stock in a well diversified portfolio. Informed investors will therefore diversify, so Simon cannot expect to be compensated for a risk he can avoid. Section: The Impact of Diversification on Risk.