Chapter 2 Flashcards
George Parker’s bonds fell in price on news of higher interest rates. To which of the following risks are George’s bonds most likely to be subject?
a. interest rate
b. default
c. financial
d. reinvestment
A.
Triad Industries has a mean return for the past five years of 12%, with a standard deviation of 9%. Assuming the returns are evenly distributed, what is the probability that Triad will have a return greater than 21%?
a. 3%
b. 12%
c. 16%
d. 24%
c. 16%
The current return of the market is 11%. The current market risk premium is 7%, and the risk free rate is 4%.
If the beta of your stock is 1.1, what is your required return?
a. 7.3
b. 11.7
c. 12.10
d. 16.10
b.
r = 4 + (11-4)1.1
11.7
Jake wants to know the beta coefficient for his portfolio of stocks,
Alto A - $33,000 - 1.1 (beta)
Bolero E - 12,500 - 1.0 (beta)
Cactus C. - $45,000 - .9 (beta)
Dire S. - $29,000 - 1.6 (beta)
What is the beta coefficient for Jake’s portfolio?
a. 1.14
b. 1.19
c. 1.23
d. 1.28
A. 1.14
$33,000 / $119,500 x 1.1 = .3038
$12,500 / $119,5000 x 1.0 = .1046
$45,000 / $119,500 x .90 = .3389
$29,000 / $119,500 x 1.6 - .3883
.3038 + .1046 + .3389 + .3883
= 1.1356 or 1.14 rounded
Which of the following are correct interpretations of the meaning of each of the portfolio performance measurements?
I. the higher the treynor ratio is, the better the relative portfolio performance.
II. Jensen’s alpha measures absolute return relative to the amount of risk taken, as measured by standard deviation.
III. Jensen’s alpha is an absolute, not relative, measure of return.
IV. If a portfolio is not well-diversified, the Sharpe ratio is more representative of the risk-adjusted performance.
a. I and II
b. I and III
c. III and IV
d. I, III, and IV
e. II, III, and IV
d.
Jensen’s alpha is the difference between the return of the portfolio and CAPM, which uses beta, not standard deviation. Jensen is an absolute measure of return.
Jake is considering two mutual funds for purchase. The Circus Fund has a beta of 1.2 and three-year return of 8.5%. the Hindsight Fund has a beta of 0.9 and three year return of 8%. The current market risk premium is 5%, and the risk free rate is 3%.
Which fund should Jake purchase, and why?
a. The circus Fund, because it has a higher alpha
b. The hindsight Fund, because it has a higher alpha
c. Either fund, since each has the same alpha
d. Neither fund, since both have negative alphas.
b.
Alpha is calculated as follows for each of the funds:
CF: 8.5 - (3 + (5)1.2) = -.50
HF: 8 - (3 +(5).9) = .50
Your client has narrowed her choices down to three different mutual funds, and you have compiled the folloiwng data on the funds shown.
Name. Beta. R-2. Treynor. Sharpe
GG. .8. 44. 3.36. 5.52
RR. .5. 19. 2.22. 7.66
ZZ. .6. 35. 1.95. 4.34
Which fund should you select?
a. GG
b. RR
c. ZZ
b. RR
The R-squared is too low (below 70) in order for beta to be considered reliable, so Treynor canot be used. this leaves Sharpe, which uses standard deviation, a measure of total risk. Fund RR has the highest Sharpe ratio.
Use the BATS methodology
Randy Tillson bought a mutual fund 14 years ago for $10,000. Today it is worth $32,000.
What rate of return did Randy earn on his investment?
a. 7.62%
b. 8.18%
c. 8.66%
d. 8.92%
c.
Define risk in terms of investing
The degree of uncertainty associated with the return of an asset.
price volatility
possibility of loss
Explain how systematic risk can affect a client’s investment
systematic risk, also called ‘nondiversifiable’ risk, is the uncertainty of return inherent in the system of which any asset is a part.
Market risk
stems from factors that are independent of any particular security; factors include political events, broad economic and social changes, and the mood of the investing public.
interest rate risk
the risk that the price of a security will fall as a result of risking interest rates
reinvestment risk
the risk that an investor will be reinvesting the payment amount from a fixed income instrument at a time when rates are lower than they had been previously
Bill harrington has a portfolio of stocks with an average weighted beta of 0.9. what is the approximate decrease in this portfolio relative to a market decrease of 20%?
.20 x .90 = .18 or an expected decrease of 18%
What is the capital market line?
A graphical representation of the relationship between risk and return, where risk is measured by standard deviation; the captial market line (CML) includes the concept of a risk-free rate of return.
The risk-free rate is 1.25%, the market rate of return is 9% and the beta of ABC stock is .80. Given this information, and using the capital asset pricing model, what is the required return of ABC stock?
.0125 + ((.09 - .0125).80) = .0745 or 7.45%
Put in order the following investments from lowest risk of principal loss to highest risk of principal loss: high grade common stock; high grade corporate bonds; puts and calls; EE and I bonds; and gold and collectibles.
EE and I bonds
high grade corporate bonds
high grade common stocks
puts and calls
gold and collectibles
Put in order the following investments from highest potential for capital appreciation to lowest potential for capital appreciation: balanced mutual funds; high grade common stock; futures contracts; and high grade municipal bonds
Futures contracts
high grade common stock
balanced mutual funds
high grade municipal bonds
How does correlation relate to risk reduction?
In general, the less two assets are correlated the more risk is reduced. Assets that are negatively correlated provide the most risk reduction.
Define excess return
Excess return = total portfolio return - risk free rate
Describe how Jensen’s alpha can be used.
this model is useful in comparing performance money managers on a risk-adjusted basis and can be used by itself. A number above 0.00 indicates the manager had better performance than would be expected given the risk they took, while the number below 0.00 indicates the manager had worse performance than would be expected given the risk they took.
Stock mutual fund BCD, with a beta of 0.90 had a return of 10% during which time the stock market had a return of 13%. The risk free return is 1.25%. Using Jensen’s alpha, did this fund outperform the market on a risk-adjusted basis?
ap = .10 - (.0125 + (.13-.0125).90
= 1.83
this fund underperformed the market by 1.83%
What is the difference between the Treynor and Sharpe ratios?
While the numerator of both ratios is excess return, the denominator (risk measure) is beta for Treynor and standard deviation for Sharpe.
How are the Treynor and Sharpe ratios best used?
Both are used to compare the risk adjusted returns of different funds. the higher the risk adjusted return, the better. The key difference is that Treynor uses beta as its measure of risk, so Treynor can only be used with fully diversified portfolios. Sharpe, on the other hand, uses standard deviation (total risk) as its measure of risk and therefore can be used with either fully diversified or nondiversified portfolios.
