Ch 2 Practice Test Flashcards
Which one of the following is NOT an example of systematic risk?
a. interest rate risk
b. business risk
c. purchasing power risk
d. reinvestment risk
B.
Also known as nondiversifiable risk, systematic risk reflects the uncertainty of returns associated with an investment in any type of asset.
If international stocks were added to a portfolio of U.S. stocks, which one of the following risks would specifically be added to the portfolio?
a. exchange rate risk
b. interest rate risk
c. default risk
d. purchasing power risk
A.
International stocks specifically add exchange rate risk to a portfolio since their value is affected by changes in the values of foreign currencies relative to that of the U.S. dollar.
George has an investment portfolio with an actual rate of return of 6.5%, a standard deviation of 3% , and a beta of .85. If the market’s actual return is 7% and the risk-free rate of return is 3%, calculate the Sharpe ratio for this portfolio.
a. 2.25
b. 0.17
c. 0.06
d. 1.17
D. 1.17
Sharpe ratio for this portfolio is 1.17 calculated as follows:
(0.065 - 0.03) / 0.03.
Recall, the Sharpe ratio uses standard deviation in the denominator.
A measure of a security’s systematic risk is
a. Jensen’s alpha
b. the Sharpe ratio
c. beta coefficient
d. standard deviation
C. beta coefficient
Beta, or beta coefficient, measures the degree to which a security moves with the market or systematic risk.
Assume a growth stock mutual fund has a beta of 1.3. If the stock market increases by 9%, you would expect this mutual fund to
a. increase by 11.7%
b. decrease by 9%
c. decrease by 11.7%
d. increase by 9%
A. increase by 11.7%
(1.3 x 9) = 11.7
Given the following information, calculate the expected return of XYZ stock using the captial asset pricing model (CAPM).
- Risk-free rate = 1.25%
- Market rate of return = 8%
- Standard deviation of XYZ stock = 20%
- Beta of XYZ stock = 1.10
a. 12.2%
b. 8.68%
c. 7.7%
d. 12.1%
CAPM is the risk-free rate plus beta times excess return or Rs = 1.25% + (8% - 1.25%) 1.1 = 8.68%
b. 8.68%
CAPM is the risk-free rate plus beta times excess return or Rs = 1.25% + (8% - 1.25%) 1.1 = 8.68%
Bill and Jane are considering adding additional assets to their investment portfolio. They consider themselves moderate-to-high-risk investors. Based on safety of principal, which of the following investments would offer the couple the least amount of protection?
a. money market accounts
b. futures
c. balanced mutual funds
d. high-grade muni bonds
b. futures
During his next meeting with his FA, Zachary would like to compare the performance of his international investments against a benchmark. Which of these would be the appropriate benchmark to use for the commparison?
a. MSCI EAFE Index
b. Dow Jones industrial average
c. Wilshire 5000 index
d. S&P 500 index
a. MSCI EAFE Index
Ophelia is considering the quest mutual fund with these characteristics:
- Beta = 1.2
- Standard Deviation = 15%
- Average return = 11%
If the current risk free rate is 4% and the market risk premium is 7%, should Ophelia purchase the fund?
a. no, because the fund’s Sharpe ratio
b. Yes, because the fund has 11% return
c. no because the fund has a negative alpha
d. Yes, because of the fund’s Treynor ratio
c. no because the fund has a negative alpha
This question can be answered with or without a calculation. We have nothing to compare the Quest Mutual Fund to, and both Share and Treynor are comparative measures. The calculation would be as follows:
a = Rp - (Rf + (Rm - Rf) Bp
a = 11 - (4 + 7)1.2
a = .11 - (.124)
a = -1.40
The fund has a negative alpha of 1.40, meaning the fund manager has not obtained the return he or she should for the amount of risk taken.
Assume each of the asset classes below has the following correlation to long-term gov bonds.
- T bills: .67
- Corp bonds: .81
- Large Stocks: .37
- Small stocks: .12
Which one of the following correctly states the impact of diversification on a portfolio of long-term gov bonds?
a. corp bonds provide more diversification than large stocks
b. there is no diversification effect because all of the correlations are positive
c. treasure bills provide more diversification than small stocks
d. small stocks provide more diversification than large stocks.
d. small stocks provide more diversification than large stocks.
Because the correlations of small stocks to long term government bonds are less than that of large stocks (even though both are positive), small stocks provide more diversification than large stocks.
Gary Stevens has the following investment portfolio:
Stock. Shares. Beta. FMV.
ACE. 100. 1.1. $5,000
BDF. 400. 0.7. $8,000
GIK. 200. 1.5. $10,000
What is the overall weighted beta coefficient for Gary’s portfolio?
a. 1.13
b. 1.01
c. 1.05
d. 1.10
a. 1.13
$5k + $8k + $10k = $23k
($5k / $23 k)1.1 = .2391
($8k / $23 k)0.7 = .2434
($10k / $23 k)1.5 = .6521
.2391 + .2434 + .6521 = 1.13
The higher the standard deviation of an investment in relation to its rate of return,
a. the lower the level of risk for a given level of return
b. the greater the expected rate of return and the lower the level of risk
c. the greater the level of risk for a given rate of return
d. the lower the expected rate of return and the lower the level of risk.
c. the greater the level of risk for a given rate of return
The greater the dispersion of returns around an average rate of return, the greater will be the standard deviation and, consequently, the higher the level of risk for a given rate of return.
During the past year, the portfolio of your largest client had a return of 10% and a beta of 1.1. During the same year, the average T-bill rate was 1.25%. What is the Treynor ratio for the performance of this portfolio?
a. .0796
b. .0993
c. .550
d. .1527
a. .0796
The Treynor ratio divides the excess return (return - risk free rate) by the beta. In this case, (.10 - .0125) / 1.1 = .0796
The risk adjusted measurement that can be used by itself (without comparison to something else) is the
a. jensen’s alpha
b. treynor ratio
c. information ratio
d. sharpe ratio
a. jensen’s alpha
Alpha compares a portfolio’s actual return with the return that could be expected based on the risk incurred in managing that portfolio, and therefore can be used alone.
Portfolio X had a Sharpe ratio of 1.10, while portfolio Y had a sharpe ratio of .55. Based on this information, which one of the following statement is correct?
a. portfolio x had better performance than portfolio y on a risk adjusted basis.
b. portfolio x had worse performance than portfolio y
c. portfolio x had twice the return of portfolio y
d. portfolio x had better performance than portfolio y
a. portfolio x had better performance than portfolio y on a risk adjusted basis.
A higher sharpe ratio does indicate better performance based on the risk taken, as measured by standard deviation.
which one of these is a type of systematic risk?
a. financial risk
b. liquidity risk
c. default risk
d. reinvestment risk
d. reinvestment risk
Reinvestment risk is a type of systematic risk. The other choices are examples of unsystematic risks.
Remember PRIME
Which of these types of risk can be reduced through diversification?
a. interest rate risk
b. reinvestment risk
c. unsystematic risk
d. systematic risk
c. unsystematic risk
Unsystematic risk depends on factors unique to a particular asset, so diversification reduces unsystematic risk.
Unsystematic risk (diversifiable): Business, financial, political
The act of acquiring assets that have different risk characteristics is
a. differentiation
b. determination
c. diversification
d. correlation
c. diversification
Which one of these betas indicate a stock that is more volatile than the market?
a. 0.75
b. 1.25
c. 1.00
d. 0.98
b. 1.25
Beta is a relative measure of volatility, so anything greater than 1.0 indicates more volatility than the market.
Several individual investments each have high standard deviations. Which of these are true about the standard deviation for a portfolio of these same investments?
l. has to be high since the standard deviations are high
ll. has to be low since the standard deviations are high
lll. can be low if there is a low correlation of returns between the investments
lV. can be high if there is a high correlation of returns between the investments
a. lll and lV
b. l and lV
c. l and lll
d. ll and lV
a. lll and lV
If the investments have a low correlation coefficient between them, they will reduce investment risk, which can result in a portfolio with a low standard deviation. If the investments have a high correlation of returns between them, then they will not reduce investment risk, and the portfolio will continue to have high systematic risk, hence a high standard deviation for the portfolio
Which one of the following has a direct bearing on which investments are appropriate for achieving a goal?
a. the investment’s alpha
b. the investors time horizon
c. the investments beta
d. the investors net worth
b. the investors time horizon
The time horizon has a direct bearing; net worth does not, and beta and alpha are measures of volatility and performance, respectively.
If an investor were looking to add another investment to his portfolio, which of the following correlations coefficients would provide the greatest risk reduction?
a. a large cap stock fund with a correlation of 0.9
b. a natural resource fund with a correlation of 0.0
c. A managed futures fund with a correlation of -0.25
d. a small cap fund with a correlation of 0.5
c. A managed futures fund with a correlation of -0.25
The scale of correlation coefficients gos from -1.0 (perfectly negatively correlated) to 1.0 (perfectly positively correlated). The further to the left you go on the scale, the lower the correlation and the greater the risk reduction.
With respect to the investment pyramid, which one of the following would provide the least potential for capital appreciation?
a. large cap stocks
b. small cap stocks
c. series EE bonds
d. Gold and collectibles
c. series EE bonds
Stock ABC has an average return of 9.0% with a standard deviation of 7.0%. what is the range of expected returns for ABC 68% of the time?
a. -12% to +23%
b. +2% to +16%
c. +2.% to +23%
d. -5% to +16%
b. +2% to +16%
68% of the time the returns will fall with one standard deviation of the average return. One standard deviation below the mean is 9% -7% = 2% while one standard deviation above the mean is 9% + 7% = 16%
