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Ch8
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Chapter Seven
Portfolio Theory
82
Student Name:
2.
-------------------is concerned with the interrelationships between security returns
as well as the expected returns and variances of those returns.
a.
random diversification.
b.
correlating diversification
c.
Friedman diversification
d.
Markowitz diversification
3.Given the following probability distribution, calculate the expected return of security
XYZ.
Security XYZ's
Potential return
Probability
20%
0.3
30%
0.2
-40%
0.1
50%
0.1
10%
0.3
a.
b.
c.
d.
16 percent
22 percent
25 percent
18 percent
4.
a.
b.
c.
d.
Probability distributions:
are always discrete.
are always continuous.
can be either discrete or continuous.
are inverse to interest rates.
5.
a.
b.
c.
d.
6.
a.
b.
c.
d.
7.
In order to determine the expected return of a portfolio, all of the following must
be known, except:
a.
probabilities of expected returns of individual assets
b.
weight of each individual asset to total portfolio value
c.
expected return of each individual asset
d.
variance of return of each individual asset and correlation of returns between
assets
Chapter Seven
Portfolio Theory
83
8.
a.
b.
c.
d.
9.
a.
b.
c.
d.
10.
a.
b.
c.
d.
11.
a.
b.
c.
d.
12.
a.
b.
c.
d.
13.
Two stocks with perfect negative correlation will have a correlation coefficient of:
a.
+1.0
b.
-2.0
c.
0
d.
1.0
14.
Security A and Security B have a correlation coefficient of 0. If Security As
return is expected to increase by 10 percent,
a.
Security Bs return should also increase by 10 percent
b.
Security Bs return should decrease by 10 percent
c.
Security Bs return should be zero
d.
Security Bs return is impossible to determine from the above information
Chapter Seven
Portfolio Theory
84
15.
Which of the following statements regarding portfolio risk and number of stocks
is generally true?
a.
Adding more stocks increases risk
b.
Adding more stocks decreases risk but does not eliminate it
c.
Adding more stocks has no effect on risk
d.
Adding more stocks increases only systematic risk
16.
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
infinit
17.
a.
b.
c.
d.
18.
a.
b.
c.
d.
19.
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
20.
a.
b.
c.
d.
21.
a.
b.
c.
d.
Chapter Seven
Portfolio Theory
85
22.
a.
b.
c.
d.
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.
7.
8.
9.
10.
11.
12.
Throwing a dart at the WSJ and selecting stocks on this basis would be
considered random diversification.
Portfolio risk can be reduced by reducing portfolio weights for assets with
positive correlations.
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.
In the case of a four-security portfolio, there will be 8 covariances.
The correlation coefficient explains the cause in the relative movement in returns
between two securities.
In a portfolio consisting of two perfectly negatively correlated securities, the
highest attainable expected return will consist of a portfolio containing 100% of
the asset with the highest expected return.
.
Chapter Seven
Portfolio Theory
86
3.
Why was the Markowitz model impractical for commercial use when it was first
introduced in 1952? What has changed by the 1990s?
4.
Provide an example of two industries that might have low correlation with one
another. Give an example that might exhibit high correlation.
5.
6.
Fill-in-the-blank Questions
1.
Markowitz diversification, also called _____________ diversification, removes
_________________ risk from the portfolio.
2.
An efficiently diversified portfolio still has _____________________ risk.
3.
The major problem with Markowitz diversification model is that it requires a full
set of ________________________ between the returns of all securities being
considered in order to calculate portfolio variance.
4.
Essay Questions
1.
. 2.
Why is more difficult to put Markowitz diversification into effect than random
diversification?
Problems
1.
Calculate the expected return and risk (standard deviation) for General Fudge for
200X, given the following information:
Probabilities
0.20 0.15 0.50 0.15
Possible Outcomes 20% 15% 11% -5%
Chapter Seven
Portfolio Theory
87
Ch.08
Multiple Choice Questions
1.
According to Markowitz, rational investors will seek efficient portfolios
because these portfolios are optimal based on:
a.
b.
c.
d.
expected return.
risk.
expected return and risk.
transactions costs.
2.
a.
b.
c.
d.
3.
a.
b.
c.
d.
4.
a.
b.
c.
d.
When the Markowitz model assumes that most investors are considered to be
risk averse, this really means that they:
will not take a fair gamble
will take a fair gamble
will take a fair gamble fifty percent of the time
will never assume investment risk
5.
a.
b.
c.
d.
6.
a.
b.
c.
d.
7.
a.
b.
Chapter Seven
Portfolio Theory
88
c.
d.
8.
a.
b.
c.
d.
occurs at the point of tangency between the highest indifference curve and the
efficient set of portfolios
occurs at the point of tangency between the highest expected return and lowest
risk efficient portfolios
Indifference curves reflect -------------- while the efficient set of portfolios
represent ---------------.
portfolio possibilities; investor preferences.
investor preferences; portfolio possibilities.
portfolio return; investor risk.
investor preferences; portfolio return.
9.
a.
b.
c.
d.
10.
a.
b.
c.
d.
11.
a.
b.
c.
d.
Portfolios lying on the upper right portion of the efficient frontier are likely to be
chosen by
aggressive investors
conservative investors
risk-averse investors
defensive investors
A portfolio which lies below the efficient frontier is described as
optimal
unattainable
dominant
dominated
12.
a.
b.
c.
d.
13.
a.
b.
c.
d.
14.
a.
b.
c.
d.
As a measure of market risk, the beta for the S&P 500 is generally considered to be:
-1.0
1.0
0
impossible to determine
Systematic risk is also called:
diversifiable risk
market risk
random risk
company-specific risk
Chapter Seven
Portfolio Theory
89
True/False Questions
1. Because of its complexity, the Markowitz model is no longer used by institutional
investors.
2. When using the Markowitz model, aggressive investors would select portfolios on the
left end of the efficient frontier.
3. Markowitz derived the efficient frontier as an upward-sloping straight line.
4. A major assumption of the Markowitz model is that investors base their decisions
strictly on expected return and risk factors.
5.
Under the Markowitz model, the risk of a portfolio is measured by the standard
deviation of the portfolio return.
6.
The single index model requires (3n+2) total pieces of data to implement.
7.
The Sharpe model was found to outperform the Markowitz model in longer time
periods.
8.
Asset allocation accounts for less than 50 percent of the variance in quarterly
returns for a typical pension fund.
9.
A well diversified portfolio will typically consist of a mix of small, mid and large
cap stocks, both U.S. and foreign, as well as corporate and U.S. Treasury bonds,
real estate and commodities.
10.
Real estate has never been shown to be positively correlated with the performance
of stocks.
Short-Answer Questions
1.
Explain what is efficient about the efficient frontier.
2.
What variable is manipulated to determine efficient portfolios, and why are the
other variables not changed at will?
3.
Discuss the importance of the asset allocation decision for portfolio performance.
4.
Distinguish between systematic and nonsystematic risk. What are two other
names for each? Give examples of each.
5.
Suppose you interview two different portfolio managers about their efficient sets
of portfolios. Is it possible, or even probable, that they would have two different
efficient sets? Why?
Problems
1.
Given the following information, calculate the expected return of Portfolio ABC.
Expected return of stock A = 10%, Expected return of stock B = 15%, Expected
return of stock C = 6%. 40 percent of the portfolio is invested in A, 40 percent is
invested in B and 20 percent is invested in C.
2.
Assume ABC are all positively correlated. A fourth stock is being considered for
addition to the portfolio, either stock D or stock E. Both D and E have expected
returns of 12%. If stock D is positively correlated with ABC and E is negatively
correlated with ABC, which stock should be added to the portfolio? Why?
Chapter Seven
Portfolio Theory
90