Chapter 3 - Self test Q's

Question 1

An investor plans to build a portfolio on the principles of CAPM. What key factor needs to be considered?

A. Alpha.
B. Beta.
C. Covariance.
D. Standard deviation.

Answer 1

B - Beta

Question 2

Adam is a high rate taxpayer and has a medium attitude to risk. He is considering what assets he should choose and has asked you to explain the efficient frontier. You explain that the efficient frontier shows the optimum balance between:

A. Risk and return.
B. Taxation and risk.
C. Return and diversification.
D. Correlation and inflation.

Answer 2

A - Risk and Return

Question 3

Amanda and Claire have shares in companies that operate in the same sector. Amanda’s shares have a beta of 1.4 whilst Claire’s have proved to be 30% more volatile than the market. This confirms that…

A. Claire’s shares have under-performed those of Amanda’s.
B. Claire’s shares have over-performed those of Amanda’s.
C. Claire’s shares are more volatile than Amanda’s.
D. Claire’s shares are less volatile than Amanda’s.

Answer 3

D - If Claire’s are 30% more volatile it means they have a beta of 1.3

Question 4

When reviewing a customer’s collective investments, you notice that they have negatively correlated assets within them. This should ensure that…

A. they outperform positively correlated assets.
B. they are offering a good amount of diversification.
C. the beta of the fund is kept high.
D. they have a high standard deviation.

Answer 4

B

There are 3 types of correlation, negative (which provides the widest diversification model), positive and no correlation.
High beta and standard deviation are high risk and you cannot say that they would outperform
positively correlated.

Question 5

Ben asks you to explain the principles behind the efficient market hypothesis (EMH). You can tell him that…

A. The availability of information in a large-cap developed market means that it is likely that active managers will outperform the market over the long term.
B. It is possible to outperform over the long term by selecting undervalued equities in smaller companies.
C. In a semi-strong market the prices of securities reflects all known information, including private.
D. Weak form EMH is due to the effect of irrational human behaviour on the market.

Answer 5

B -

Smaller companies tend to have fewer analysts researching them and as there is less information available the market is less efficient than that of larger companies. This means that it may be possible to identify undervalued securities and outperform over the long term.

Developed markets in large companies are efficient making it unlikely that active managers will
outperform Private information being reflected in security prices would define strong form EMH, not semi-strong. EMH is based on the principle that investors act rationally.

Question 6

What is the expected return for Smith Consultancy if it has a beta of 1.4, a standard deviation of 6%, the expected return (ER) on the market portfolio is 14% and the expected return on a Treasury Bill is 5%?

A. 24.60%.
B. 21.00%.
C. 26.60%.
D. 17.60%.

Answer 6

D - Standard deviation is irrelevant as we are calculating the expected return.

Subtract the risk free from the ER, (14-5=9) multiply the amount by the beta and add back on the risk free amount (9 x 1.4) +5 = 17.60%

CAPM is (risky x beta) + risk free

Question 7

Standard deviation

1. Calculate the range of returns expected over 3 standard deviations for a fund that has a mean of 9% and a standard deviation of 5%.
2. Identify the range of results that an investor could expect 95% of the time.

Answer 7

One standard deviation is between 4% and 14% (9-5 and 9+5)
* Two standard deviations is between -1% and 19% (9-5-5 and 9+5+5)
* Three standard deviations is between -6% and 24% (9-5-5-S and 9+5+5+S)
An investor can expect that 95% of the time his returns would be within two standard deviations so in the case of thISund, will fluctuate between a 1% loss and 19% gain

Question 8

CAPM

Angela is considering an investment into a company’s shares and has narrowed her search to two stocks. Which of the two companies listed below should she select based on CAPM?
* Company A has a beta of 1.6, an expected market return of 11% and the risk-free returns are 3%
* Company B has a beta of 1.7 and expected market return of 11% and the risk-free returns are 4%

Answer 8

• Company A - Risky element is 8% (11% - 3%) so (8 x 1.6) + 3 = 15.8%
• Company B - Risky element is 7% (11% - 4%) so (7 x 1.7) + 4 = 15.9%

They both have the same expected market return (11%) but Company B has the slightly higher risk adjusted return and Angela should invest in this company’s shares.