Efficient Diversification
Chapter 06
Efficient Diversification
Multiple Choice Questions
A. / unique
B. / firm-specific
C. / diversifiable
D. / all of these options
2. / The ______decision should take precedence over the _____ decision.
A. / asset allocation; stock selection
B. / bond selection; mutual fund selection
C. / stock selection; asset allocation
D. / stock selection; mutual fund selection
3. / Many current and retired Enron Corp. employees had their 401k retirement accounts wiped out when Enron collapsed because ______.
A. / they had to pay huge fines for obstruction of justice
B. / their 401k accounts were held outside the company
C. / their 401k accounts were not well diversified
D. / none of these options
4. / Based on the outcomes in the following table, choose which of the statements below is (are) correct?
I. The covariance of security A and security B is zero.
II. The correlation coefficient between securities A and C is negative.
III. The correlation coefficient between securities B and C is positive.
A. / I only
B. / I and II only
C. / II and III only
D. / I, II, and III
5. / Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would prefer a portfolio using the risk-free asset and ______.
A. / asset A
B. / asset B
C. / no risky asset
D. / The answer cannot be determined from the data given.
6. / Adding additional risky assets to the investment opportunity set will generally move the efficient frontier _____ and to the ______.
A. / up; right
B. / up; left
C. / down; right
D. / down; left
7. / An investor's degree of risk aversion will determine his or her ______.
A. / optimal risky portfolio
B. / risk-free rate
C. / optimal mix of the risk-free asset and risky asset
D. / capital allocation line
8. / The ______is equal to the square root of the systematic variance divided by the total variance.
A. / covariance
B. / correlation coefficient
C. / standard deviation
D. / reward-to-variability ratio
9. / Which of the following statistics cannot be negative?
A. / Covariance
B. / Variance
C. / E(r)
D. / Correlation coefficient
10. / Asset A has an expected return of 20% and a standard deviation of 25%. The risk-free rate is 10%. What is the reward-to-variability ratio?
A. / .40
B. / .50
C. / .75
D. / .80
11. / The correlation coefficient between two assets equals ______.
A. / their covariance divided by the product of their variances
B. / the product of their variances divided by their covariance
C. / the sum of their expected returns divided by their covariance
D. / their covariance divided by the product of their standard deviations
12. / Diversification is most effective when security returns are ______.
A. / high
B. / negatively correlated
C. / positively correlated
D. / uncorrelated
13. / The expected rate of return of a portfolio of risky securities is ______.
A. / the sum of the securities' covariances
B. / the sum of the securities' variances
C. / the weighted sum of the securities' expected returns
D. / the weighted sum of the securities' variances
14. / Beta is a measure of security responsiveness to ______.
A. / firm-specific risk
B. / diversifiable risk
C. / market risk
D. / unique risk
15. / The risk that can be diversified away is ______.
A. / beta
B. / firm-specific risk
C. / market risk
D. / systematic risk
16. / Approximately how many securities does it take to diversify almost all of the unique risk from a portfolio?
A. / 2
B. / 6
C. / 8
D. / 20
17. / Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum-variance portfolio has a standard deviation that is always ______.
A. / equal to the sum of the securities' standard deviations
B. / equal to -1
C. / equal to 0
D. / greater than 0
18. / Market risk is also called ______and ______.
A. / systematic risk; diversifiable risk
B. / systematic risk;nondiversifiable risk
C. / unique risk;nondiversifiable risk
D. / unique risk; diversifiable risk
19. / Firm-specific risk is also called ______and ______.
A. / systematic risk; diversifiable risk
B. / systematic risk;nondiversifiable risk
C. / unique risk;nondiversifiable risk
D. / unique risk; diversifiable risk
20. / Which one of the following stock return statistics fluctuates the most over time?
A. / Covariance of returns
B. / Variance of returns
C. / Average return
D. / Correlation coefficient
21. / Harry Markowitz is best known for his Nobel Prize-winning work on ______.
A. / strategies for active securities trading
B. / techniques used to identify efficient portfolios of risky assets
C. / techniques used to measure the systematic risk of securities
D. / techniques used in valuing securities options
22. / Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means that ______.
A. / the returns on the stock and bond portfolios tend to move inversely
B. / the returns on the stock and bond portfolios tend to vary independently of each other
C. / the returns on the stock and bond portfolios tend to move together
D. / the covariance of the stock and bond portfolios will be positive
24. / On a standard expected return versus standard deviation graph, investors will prefer portfolios that lie to the ______of the current investment opportunity set.
A. / left and above
B. / left and below
C. / right and above
D. / right and below
25. / The term complete portfolio refers to a portfolio consisting of ______.
A. / the risk-free asset combined with at least one risky asset
B. / the market portfolio combined with the minimum-variance portfolio
C. / securities from domestic markets combined with securities from foreign markets
D. / common stocks combined with bonds
26. / Rational risk-averse investors will always prefer portfolios ______.
A. / located on the efficient frontier to those located on the capital market line
B. / located on the capital market line to those located on the efficient frontier
C. / at or near the minimum-variance point on the efficient frontier
D. / that are risk-free to all other asset choices
27. / The optimal risky portfolio can be identified by finding:
I. The minimum-variance point on the efficient frontier
II. The maximum-return point on the efficient frontier and the minimum-variance point on the efficient frontier
III. The tangency point of the capital market line and the efficient frontier
IV. The line with the steepest slope that connects the risk-free rate to the efficient frontier
A. / I and II only
B. / II and III only
C. / III and IV only
D. / I and IV only
28. / The ______reward-to-variability ratio is found on the ______capital market line.
A. / lowest; steepest
B. / highest; flattest
C. / highest; steepest
D. / lowest; flattest
43. / A measure of the riskiness of an asset held in isolation is ______.
A. / beta
B. / standard deviation
C. / covariance
D. / alpha
45. / The part of a stock's return that is systematic is a function of which of the following variables?
I. Volatility in excess returns of the stock market
II. The sensitivity of the stock's returns to changes in the stock market
III. The variance in the stock's returns that is unrelated to the overall stock market
A. / I only
B. / I and II only
C. / II and III only
D. / I, II, and III
47. / Which risk can be partially or fully diversified away as additional securities are added to a portfolio?
I. Total risk
II. Systematic risk
III. Firm-specific risk
A. / I only
B. / I and II only
C. / I, II, and III
D. / I and III
48. / According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of ______and ______.
A. / identifying all investor imposed constraints; identifying the set of securities that conform to the investor's constraints and offer the best risk-return trade-offs
B. / identifying the investor's degree of risk aversion; choosing securities from industry groups that are consistent with the investor's risk profile
C. / identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion
D. / choosing which risky assets an investor prefers according to the investor's risk-aversion level; minimizing the CAL by lending at the risk-free rate
49. / You are constructing a scatter plot of excess returns for stock A versus the market index. If the correlation coefficient between stock A and the index is -1, you will find that the points of the scatter diagram ______and the line of best fit has a ______.
A. / all fall on the line of best fit; positive slope
B. / all fall on the line of best fit; negative slope
C. / are widely scattered around the line; positive slope
D. / are widely scattered around the line; negative slope
50. / The term excess return refers to ______.
A. / returns earned illegally by means of insider trading
B. / the difference between the rate of return earned and the risk-free rate
C. / the difference between the rate of return earned on a particular security and the rate of return earned on other securities of equivalent risk
D. / the portion of the return on a security that represents tax liability and therefore cannot be reinvested
51. / You are recalculating the risk of ACE stock in relation to the market index, and you find that the ratio of the systematic variance to the total variance has risen. You must also find that the ______.
A. / covariance between ACE and the market has fallen
B. / correlation coefficient between ACE and the market has fallen
C. / correlation coefficient between ACE and the market has risen
D. / unsystematic risk of ACE has risen
53. / The values of beta coefficients of securities are ______.
A. / always positive
B. / always negative
C. / always between positive 1 and negative 1
D. / usually positive but are not restricted in any particular way
54. / 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
56. / Diversification can reduce or eliminate ______risk.
A. / all
B. / systematic
C. / nonsystematic
D. / only an insignificant
57. / To construct a riskless portfolio using two risky stocks, one would need to find two stocks with a correlation coefficient of ______.
A. / 1
B. / .5
C. / 0
D. / -1
58. / Some diversification benefits can be achieved by combining securities in a portfolio as long as the correlation between the securities is ______.
A. / 1
B. / less than 1
C. / between 0 and 1
D. / less than or equal to 0
59. / If an investor does not diversify his portfolio and instead puts all of his money in one stock, the appropriate measure of security risk for that investor is the ______.
A. / stock's standard deviation
B. / variance of the market
C. / stock's beta
D. / covariance with the market index
60. / Which of the following provides the best example of a systematic-risk event?
A. / A strike by union workers hurts a firm's quarterly earnings.
B. / Mad Cow disease in Montana hurts local ranchers and buyers of beef.
C. / The Federal Reserve increases interest rates 50 basis points.
D. / A senior executive at a firm embezzles $10 million and escapes to South America.
61. / Which of the following statements is (are) true regarding time diversification?
I. The standard deviation of the average annual rate of return over several years will be smaller than the 1-year standard deviation.
II. For a longer time horizon, uncertainty compounds over a greater number of years.
III. Time diversification does not reduce risk.
A. / I only
B. / II only
C. / II and III only
D. / I, II, and III
62. / You find that the annual Sharpe ratio for stock A returns is equal to 1.8. For a 3-year holding period, the Sharpe ratio would equal ______.
A. / 1.8
B. / 2.48
C. / 3.12
D. / 5.49
68. / Decreasing the number of stocks in a portfolio from 50 to 10 would likely ______.
A. / increase the systematic risk of the portfolio
B. / increase the unsystematic risk of the portfolio
C. / increase the return of the portfolio
D. / decrease the variation in returns the investor faces in any one year
69. / If you want to know the portfolio standard deviation for a three-stock portfolio, you will have to ______.
A. / calculate two covariances and one trivariance
B. / calculate only two covariances
C. / calculate three covariances
D. / average the variances of the individual stocks
70. / Which of the following correlation coefficients will produce the least diversification benefit?
A. / -.6
B. / -.3
C. / 0
D. / .8
71. / Which of the following correlation coefficients will produce the most diversification benefits?
A. / -.6
B. / -.9
C. / 0
D. / .4
72. / What is the most likely correlation coefficient between a stock-index mutual fund and the S&P 500?
A. / -1
B. / 0
C. / 1
D. / .5
73. / Investing in two assets with a correlation coefficient of -.5 will reduce what kind of risk?
A. / Market risk
B. / Nondiversifiable risk
C. / Systematic risk
D. / Unique risk
74. / Investing in two assets with a correlation coefficient of 1 will reduce which kind of risk?
A. / Market risk
B. / Unique risk
C. / Unsystematic risk
D. / None of these options (With a correlation of 1, no risk will be reduced.)
75. / A portfolio of stocks fluctuates when the Treasury yields change. Since this risk cannot be eliminated through diversification, it is called ______.
A. / firm-specific risk
B. / systematic risk
C. / unique risk
D. / none of the options
76. / As you lengthen the time horizon of your investment period and decide to invest for multiple years, you will find that:
I. The average risk per year may be smaller over longer investment horizons.
II. The overall risk of your investment will compound over time.
III. Your overall risk on the investment will fall.
A. / I only
B. / I and II only
C. / III only
D. / I, II, and III
77. / You are considering adding a new security to your portfolio. To decide whether you should add the security, you need to know the security's:
I. Expected return
II. Standard deviation
III. Correlation with your portfolio
A. / I only
B. / I and II only
C. / I and III only
D. / I, II, and III
78. / Which of the following is a correct expression concerning the formula for the standard deviation of returns of a two-asset portfolio where the correlation coefficient is positive?
A. / σ2rp < (W12σ12 + W22σ22)
B. / σ2rp = (W12σ12 + W22σ22)
C. / σ2rp = (W12σ12 - W22σ22)
D. / σ2rp > (W12σ12 + W22σ22)