Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

Chapter 06 Risk Aversion and Capital Allocation to Risky Assets

Multiple Choice Questions 1. Which of the followin state!ents re ardin risk-averse investors is true" A. #hey only care a$out the rate of return. %. #hey accept invest!ents that are fair a!es. C. #hey only accept risky invest!ents that offer risk pre!iu!s over the risk-free rate. &. #hey are willin to accept lower returns and hi h risk. '. A and %. Risk-averse investors only accept risky invest!ents that offer risk pre!iu!s over the risk-free rate.
Difficulty: Moderate

(. Which of the followin state!ents is )are* true" +* Risk-averse investors re,ect invest!ents that are fair a!es. ++* Risk-neutral investors ,ud e risky invest!ents only $y the e-pected returns. +++* Risk-averse investors ,ud e invest!ents only $y their riskiness. +.* Risk-lovin investors will not en a e in fair a!es. A. + only %. ++ only C. + and ++ only &. ++ and +++ only '. ++/ +++/ and +. only Risk-averse investors consider a risky invest!ent only if the invest!ent offers a risk pre!iu!. Risk-neutral investors look only at e-pected returns when !akin an invest!ent decision.
Difficulty: Moderate

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

0. +n the !ean-standard deviation raph/ which one of the followin state!ents is true re ardin the indifference curve of a risk-averse investor" A. +t is the locus of portfolios that have the sa!e e-pected rates of return and different standard deviations. %. +t is the locus of portfolios that have the sa!e standard deviations and different rates of return. C. +t is the locus of portfolios that offer the sa!e utility accordin to returns and standard deviations. &. +t connects portfolios that offer increasin utilities accordin to returns and standard deviations. '. none of the a$ove. +ndifference curves plot trade-off alternatives that provide e1ual utility to the individual )in this case/ the trade-offs are the risk-return characteristics of the portfolios*.
Difficulty: Moderate

6. +n a return-standard deviation space/ which of the followin state!ents is )are* true for riskaverse investors" )#he vertical and hori2ontal lines are referred to as the e-pected return-a-is and the standard deviation-a-is/ respectively.* +* An investor3s own indifference curves !i ht intersect. ++* +ndifference curves have ne ative slopes. +++* +n a set of indifference curves/ the hi hest offers the reatest utility. +.* +ndifference curves of two investors !i ht intersect. A. + and ++ only %. ++ and +++ only C. + and +. only &. +++ and +. only '. none of the a$ove An investor3s indifference curves are parallel/ and thus cannot intersect and have positive slopes. #he hi hest indifference curve )the one in the !ost northwestern position* offers the reatest utility. +ndifference curves of investors with si!ilar risk-return trade-offs !i ht intersect.
Difficulty: Moderate

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

4. When an invest!ent advisor atte!pts to deter!ine an investor3s risk tolerance/ which factor would they $e least likely to assess" A. the investor3s prior investin e-perience %. the investor3s de ree of financial security C. the investor3s tendency to !ake risky or conservative choices &. the level of return the investor prefers '. the investor3s feelin a$out loss +nvest!ent advisors would $e least likely to assess the level of return the investor prefers. #he investors investin e-perience/ financial security/ feelin s a$out loss/ and disposition toward risky or conservative choices will i!pact risk tolerance.
Difficulty: Moderate

Assu!e an investor with the followin utility function5 6 7 ')r* - 89()s(*. 10. #o !a-i!i2e her e-pected utility/ which one of the followin invest!ent alternatives would she choose" A. A portfolio that pays 10 percent with a 60 percent pro$a$ility or 0 percent with :0 percent pro$a$ility. %. A portfolio that pays 10 percent with :0 percent pro$a$ility or 0 percent with a 60 percent pro$a$ility. C. A portfolio that pays 1( percent with 60 percent pro$a$ility or 0 percent with :0 percent pro$a$ility. &. A portfolio that pays 1( percent with :0 percent pro$a$ility or 0 percent with 60 percent pro$a$ility. '. none of the a$ove. 6)c* 7 ;.0(<= hi hest utility of possi$ilities.
Difficulty: Difficult

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

11. A portfolio has an e-pected rate of return of 0.10 and a standard deviation of 0.10. #he risk-free rate is 6 percent. An investor has the followin utility function5 6 7 ')r* - )A9(*s(. Which value of A !akes this investor indifferent $etween the risky portfolio and the risk-free asset" A. 0 %. 6 C. > &. 4 '. none of the a$ove 0.06 7 0.10 - A9()0.10*(= 0.06 - 0.10 7 -A9()0.0((0*= -0.0; 7 -0.011(0A= A 7 4= ?o 6 7 0.10 - 49()0.10*( 7 6<= sa!e as 6)Rf* 7 6<.
Difficulty: Difficult

18. Consider a risky portfolio/ A/ with an e-pected rate of return of 0.10 and a standard deviation of 0.10/ that lies on a iven indifference curve. Which one of the followin portfolios !i ht lie on the sa!e indifference curve" A. ')r* 7 0.10= ?tandard deviation 7 0.(0 %. ')r* 7 0.10= ?tandard deviation 7 0.10 C. ')r* 7 0.10= ?tandard deviation 7 0.10 &. ')r* 7 0.(0= ?tandard deviation 7 0.10 '. ')r* 7 0.10= ?tandard deviation 7 0.(0 @ortfolio A has a reward-to-risk ratio of 1.0= portfolio C is the only choice with the sa!e riskreturn tradeoff.
Difficulty: Difficult

6 7 ')r* - )A9(*s(/ where A 7 :.0. 1:. %ased on the utility function a$ove/ which invest!ent would you select" A. 1 %. ( C. 8 &. : '. cannot tell fro! the infor!ation iven

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

6)c* 7 0.(1 - :9()0.16*( 7 10.44 )hi hest utility of choices*.

Difficulty: Difficult

14. #he riskiness of individual assets A. should $e considered for the asset in isolation. %. should $e considered in the conte-t of the effect on overall portfolio volatility. C. co!$ined with the riskiness of other individual assets )in the proportions these assets constitute of the entire portfolio* should $e the relevant risk !easure. &. % and C. '. none of the a$ove. #he relevant risk is portfolio risk= thus/ the riskiness of an individual security should $e considered in the conte-t of the portfolio as a whole.
Difficulty: Easy

1;. A fair a!e A. will not $e undertaken $y a risk-averse investor. %. is a risky invest!ent with a 2ero risk pre!iu!. C. is a riskless invest!ent. &. %oth A and % are true. '. %oth A and C are true. A fair a!e is a risky invest!ent with a payoff e-actly e1ual to its e-pected value. ?ince it offers no risk pre!iu!/ it will not $e accepta$le to a risk-averse investor.
Difficulty: Moderate

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

((. #he certainty e1uivalent rate of a portfolio is A. the rate that a risk-free invest!ent would need to offer with certainty to $e considered e1ually attractive as the risky portfolio. %. the rate that the investor !ust earn for certain to ive up the use of his !oney. C. the !ini!u! rate uaranteed $y institutions such as $anks. &. the rate that e1uates AAA in the utility function with the avera e risk aversion coefficient for all risk-averse investors. '. represented $y the scalin factor A-.000A in the utility function. #he certainty e1uivalent rate of a portfolio is the rate that a risk-free invest!ent would need to offer with certainty to $e considered e1ually attractive as the risky portfolio.
Difficulty: Moderate

(8. Accordin to the !ean-variance criterion/ which of the state!ents $elow is correct"

A. +nvest!ent % do!inates +nvest!ent A. %. +nvest!ent % do!inates +nvest!ent C. C. +nvest!ent & do!inates all of the other invest!ents. &. +nvest!ent & do!inates only +nvest!ent %. '. +nvest!ent C do!inates invest!ent A. #his 1uestion tests the student3s understandin of how to apply the !ean-variance criterion.
Difficulty: Moderate

(0. #he Capital Allocation Bine can $e descri$ed as the A. invest!ent opportunity set for!ed with a risky asset and a risk-free asset. %. invest!ent opportunity set for!ed with two risky assets. C. line on which lie all portfolios that offer the sa!e utility to a particular investor. &. line on which lie all portfolios with the sa!e e-pected rate of return and different standard deviations. '. none of the a$ove. #he CAB has an intercept e1ual to the risk-free rate. +t is a strai ht line throu h the point representin the risk-free asset and the risky portfolio/ in e-pected-return9standard deviation space.

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

Difficulty: Moderate

(6. Which of the followin state!ents re ardin the Capital Allocation Bine )CAB* is false" A. #he CAB shows risk-return co!$inations. %. #he slope of the CAB e1uals the increase in the e-pected return of a risky portfolio per unit of additional standard deviation. C. #he slope of the CAB is also called the reward-to-volatility ratio. &. #he CAB is also called the efficient frontier of risky assets in the a$sence of a risk-free asset. '. %oth A and & are true. #he CAB consists of co!$inations of a risky asset and a risk-free asset whose slope is the reward-to-volatility ratio= thus/ all state!ents e-cept d are true.
Difficulty: Moderate

(4. An investor invests 80 percent of his wealth in a risky asset with an e-pected rate of return of 0.10 and a variance of 0.0: and >0 percent in a #-$ill that pays 6 percent. Cis portfolio3s e-pected return and standard deviation are DDDDDDDDDD and DDDDDDDDDD/ respectively. A. 0.11:= 0.1( %. 0.04>= 0.06 C. 0.(;0= 0.1( &. 0.04>= 0.1( '. none of the a$ove ')r@* 7 0.8)10<* E 0.>)6<* 7 4.><= s@ 7 0.8)0.0:*19( 7 6<.

Difficulty: Moderate

Fou invest G100 in a risky asset with an e-pected rate of return of 0.1( and a standard deviation of 0.10 and a #-$ill with a rate of return of 0.00. 8(. What percenta es of your !oney !ust $e invested in the risky asset and the risk-free asset/ respectively/ to for! a portfolio with an e-pected return of 0.0;" A. 40< and 10< %. >0< and (0< C. 6>< and 88< &. 0>< and :8< '. cannot $e deter!ined

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

;< 7 w1)1(<* E )1 - w1*)0<*= ;< 7 1(<w1 E 0< - 0<w1= :< 7 ><w1= w1 7 0.0>= 1 - w1 7 0.:8= ?o/ 0.0>)1(<* E 0.:8)0<* 7 4.;;<.
Difficulty: Moderate

8:. A portfolio that has an e-pected outco!e of G110 is for!ed $y A. investin G100 in the risky asset. %. investin G40 in the risky asset and G(0 in the risk-free asset. C. $orrowin G:8 at the risk-free rate and investin the total a!ount )G1:8* in the risky asset. &. investin G:8 in the risky asset and G0> in the riskless asset. '. ?uch a portfolio cannot $e for!ed. Hor G100/ )110 - 100*9100 7 10<= .10 7 w1).1(* E )1 - w1*).00*= .10 7 .1(w1 E .00 - .00w1= 0.10 7 0.0>w1= w1 7 1.:8)G100* 7 G1:8= )1 - w1*G100 7 -G:8.
Difficulty: Difficult

86. Consider a #-$ill with a rate of return of 0 percent and the followin risky securities5 ?ecurity A5 ')r* 7 0.10= .ariance 7 0.0: ?ecurity %5 ')r* 7 0.10= .ariance 7 0.0((0 ?ecurity C5 ')r* 7 0.1(= .ariance 7 0.01 ?ecurity &5 ')r* 7 0.18= .ariance 7 0.06(0 Hro! which set of portfolios/ for!ed with the #-$ill and any one of the : risky securities/ would a risk-averse investor always choose his portfolio" A. #he set of portfolios for!ed with the #-$ill and security A. %. #he set of portfolios for!ed with the #-$ill and security %. C. #he set of portfolios for!ed with the #-$ill and security C. &. #he set of portfolios for!ed with the #-$ill and security &. '. Cannot $e deter!ined. ?ecurity C has the hi hest reward-to-volatility ratio.

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

Difficulty: Difficult

Fou are considerin investin G1/000 in a #-$ill that pays 0.00 and a risky portfolio/ @/ constructed with ( risky securities/ I and F. #he wei hts of I and F in @ are 0.60 and 0.:0/ respectively. I has an e-pected rate of return of 0.1: and variance of 0.01/ and F has an e-pected rate of return of 0.10 and a variance of 0.0041. 8>. +f you want to for! a portfolio with an e-pected rate of return of 0.11/ what percenta es of your !oney !ust you invest in the #-$ill and @/ respectively" A. 0.(0= 0.>0 %. 0.1;= 0.41 C. 0.60= 0.80 &. 0.00= 0.00 '. cannot $e deter!ined ')rp* 7 0.6)1:<* E 0.:)10<* 7 1(.:<= 11< 7 0- E 1(.:)1 - -*= - 7 0.14; )#-$ills* and )1--* 70.411 )risky asset*.
Difficulty: Moderate

84. +f you want to for! a portfolio with an e-pected rate of return of 0.10/ what percenta es of your !oney !ust you invest in the #-$ill/ I/ and F/ respectively if you keep I and F in the sa!e proportions to each other as in portfolio @" A. 0.(0= 0.:0= 0.80 %. 0.1;= 0.:;= 0.8( C. 0.8(= 0.:1= 0.(> &. 0.00= 0.80= 0.(0 '. cannot $e deter!ined ')rp* 7 .10 7 0w E 1(.:)1 - w*= - 7 0.8( )wei ht of #-$ills*= As co!position of I and F are .6 and .: of @/ respectively/ then for 0.64 wei ht in @/ the respective wei hts !ust $e 0.:1 and 0.(>= .6).64* 7 :1<= .:).64* 7 (><

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

Difficulty: Difficult

:0. What would $e the dollar value of your positions in I/ F/ and the #-$ills/ respectively/ if you decide to hold a portfolio that has an e-pected outco!e of G1/(00" A. Cannot $e deter!ined %. G0:= G064= G8>4 C. G064= G0:= G8>4 &. G8>4= G0:= G064 '. G104= G01:= G8>4 )G1/(00 - G1/000*9G1/000 7 1(<= )0.6*1:< E )0.:*10< 7 1(.:<= 1(< 7 w0< E 1(.:<)1 - w*= w 7 .00:= 1 - w 7 .;:6= w 7 0.00:)G1/000* 7 G0: )#-$ills*= 1 - w 7 1 - 0.00: 7 0.;:6)G1/000* 7 G;:6 )in P* G;:6 - 0.6 7 G064 in I= G;:6 - 0.: 7 G8>4 in F.
Difficulty: Difficult

:(. #he chan e fro! a strai ht to a kinked capital allocation line is a result of5 A. reward-to-volatility ratio increasin . %. $orrowin rate e-ceedin lendin rate. C. an investor3s risk tolerance decreasin . &. increase in the portfolio proportion of the risk-free asset. '. none of the a$ove. #he linear capital allocation line assu!es that the investor !ay $orrow and lend at the sa!e rate )the risk-free rate*/ which o$viously is not true. Rela-in this assu!ption and incorporatin the hi her $orrowin rates into the !odel results in the kinked capital allocation line.
Difficulty: Difficult

:8. #he first !a,or step in asset allocation is5 A. assessin risk tolerance. %. analy2in financial state!ents. C. esti!atin security $etas. &. identifyin !arket ano!alies. '. none of the a$ove. A should $e the first consideration in asset allocation. %/ C/ and & refer to security selection.

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

Difficulty: Moderate

::. %ased on their relative de rees of risk tolerance A. investors will hold varyin a!ounts of the risky asset in their portfolios. %. all investors will have the sa!e portfolio asset allocations. C. investors will hold varyin a!ounts of the risk-free asset in their portfolios. &. A and C. '. none of the a$ove. %y deter!inin levels of risk tolerance/ investors can select the opti!u! portfolio for their own needs= these asset allocations will vary $etween a!ounts of risk-free and risky assets $ased on risk tolerance.
Difficulty: Easy Difficulty: Moderate

Four client/ %o Re ard/ holds a co!plete portfolio that consists of a portfolio of risky assets )@* and #-%ills. #he infor!ation $elow refers to these assets.

:4. What is the e-pected return on %o3s co!plete portfolio" A. 10.8(< %. 0.(4< C. ;.6(< &. 4.::< '. >.04<

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

')rC* 7 .4 J 1(.00< E .( J 8.6< 7 10.8(<

Difficulty: Easy

:;. What is the standard deviation of %o3s co!plete portfolio" A. >.(0< %. 0.:0< C. 6.;(< &. :.;4< '. 0.>6< ?td. &ev. of C 7 .4 J >.(0< 7 0.>6<
Difficulty: Easy

00. What is the e1uation of %o3s Capital Allocation Bine" A. ')rC* 7 >.( E 8.6 J ?tandard &eviation of C %. ')rC* 7 8.6 E 1.16> J ?tandard &eviation of C C. ')rC* 7 8.6 E 1(.0 J ?tandard &eviation of C &. ')rC* 7 0.( E 1.16> J ?tandard &eviation of C '. ')rC* 7 8.6 E 0.40> J ?tandard &eviation of C #he intercept is the risk-free rate )8.60<* and the slope is )1(.00<-8.60<*9>.(0< 7 1.16>.

Difficulty: Moderate

01. What are the proportions of ?tocks A/ %/ and C/ respectively in %o3s co!plete portfolio" A. :0</ (0</ 80< %. 4</ 0</ >< C. 8(</ (0</ (4< &. 16</ 10</ 1:< '. (0</ 1(.0</ 1>.0<

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

@roportion in A 7 .4 J :0< 7 8(<= proportion in % 7 .4 J (0< 7 (0<= proportion in C 7 .4 J 80< 7 (4<.

Difficulty: Moderate

08. #he Capital Market Bine +* is a special case of the Capital Allocation Bine. ++* represents the opportunity set of a passive invest!ent strate y. +++* has the one-!onth #-%ill rate as its intercept. +.* uses a $road inde- of co!!on stocks as its risky portfolio. A. +/ +++/ and +. %. ++/ +++/ and +. C. +++ and +. &. +/ ++/ and +++ '. +/ ++/ +++/ and +. K#he Capital Market Bine is the Capital Allocation Bine $ased on the one-!onth #-%ill rate and a $road inde- of co!!on stocks. +t applies to an investor pursuin a passive !ana e!ent strate y.
Difficulty: Moderate

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