Review for Exam 2

Instructions: Please read carefully The exam will have 21 multiple choice questions and 5 work problems. 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. However, you should not write definitions/concepts on the sheet.

Chapter 5 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? 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

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) $91.67

8. 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 $375,000

9. 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%

Chapter 6
10. Risk that can be eliminated through diversification is called ______ risk. A) unique B) firm-specific C) diversifiable D) all of the above

11. 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 12. The risk that can be diversified away is ___________. A) beta B) firm specific risk C) market risk D) systematic risk

13. __________ 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

14. 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

15. 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

16. 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) -.225 B) -.474 C) .474 D) .225

17. A measure of the riskiness of an asset held in isolation is _____________. A) beta B) standard deviation C) covariance D) semi-variance

18. 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 19. 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 20. 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

21. Which of the following correlations coefficients will produce the least diversification benefit? A) -0.6 B) -1.5 C) 0.0 D) 0.8

22. 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%

23. 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) 1.35

Chapter 7
24. 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) 1.4 25. __________ 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

26. The market portfolio has a beta of __________. A) -1.0 B) 0 C) 0.5 D) 1.0

27. 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 28. 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) 29. According to the capital asset pricing model, fairly priced securities have __________. A) negative betas B) positive alphas C) positive betas D) zero alphas 30. 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 31. 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

32. Security A has an expected rate of return of 12% and a beta of 1.10. 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% 33. 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

34. 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

35. 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 1.00. Portfolio Y has an expected return of 9.5% and a beta of 0.25. 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 36. You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different common stocks. The portfolio beta is equal to 1.12. 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. 1.12 1.17 1.22 1.10 1.02

Chapter 8

37.

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

38.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 39. 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

40.__________ 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

41. 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 42. 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

43. 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 44. 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 45. 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

46.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 47. 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

Answers
1. Answer: C 2. Answer: B 3. Answer: C
HPR = 10 ,000 9 ,800 = 2.04% 9 ,800

Thus, the nominal annual return is 2.04% 6 = 12.2%

4. Answer: A 5. Answer: A 6. Answer: B 7. Answer: B

P=
8. Answer: D

26.00 + 1.50 = 21.15 1 + .30

y=

.22 .08 = 1.75 .16 .08

Borrowing = 500,000(1.75 - 1) = 375,000 9. Answer: A HPR = (53 55 +3) / 55 = .0182

10. Answer: D 11. Answer: A 12. Answer: B 13. Answer: C 14. Answer: C 15. Answer: C 16. Answer: D

.0050 = (.2) 2 (.25) 2 + (.8) 2 (.05) 2 + 2(.2)(.8)(.25)(.05)Corr

Corr = .225

17. Answer: B 18. Answer: C 19. Answer: B 20. Answer: A 21. Answer: D 22. Answer: A

 = (.50) 2 (.22) 2 + (.50) 2 (.16) 2 + 2(.35)(.22)(.16)(.50)(.50) = .157

23. Answer: B
Reward to variability ratio = (.089 - .035) / .12 = 0.45

24. Answer: B 25. Answer: D 26. Answer: D 27. Answer: A 28. Answer: C 29. Answer: D 30. Answer: D 31. Answer: A 32. Answer: B

= .12[.05 + 1.1(08 .05)] = .037

33. Answer: B 34. Answer: B 35. Answer: A 36.B
Before: 1.12 = 0.95(bR) + 0.05(1.0); 0.95(bR) = 1.07; bR = 1.13. After: bP = 0.95(bR) + 0.05(2.0) = 1.07 + 0.10 = 1.17.

37. Answer: A 38. Answer: C 39. Answer: B 40. Answer: C 41. Answer: D 42. Answer: D 43. Answer: D 44. Answer: A 45. Answer: C 46. Answer: B 47. Answer: C