Chapter 4 - Investment Theory

Question 1

The standard deviation of a security is 5%. If the mean return is 15%, then future returns will be expected to be within what range 95% of the time?

Select one:

a. 10% and 20%.
b. 7.5% and 22.5%.
c. 5% and 25%.
d. 14% and 16%.

Answer 1

c. 5% and 25%.

chapter reference 4A1

Question 2

Deborah, an adviser, bases all of her portfolio recommendations on the theory of the efficient frontier. When dealing with her clients, the main differentiating factor for her eventual recommendation will be the maximum:

Select one:

a. time horizon her clients want to invest for.
b. costs her clients are willing to pay.
c. level of constraints imposed by her clients.
d. level of risk that her clients are prepared to take.

Answer 2

d. level of risk that her clients are prepared to take.

chapter reference 4A3

Question 3

Ryan has been used to conducting a detailed technical analysis of UK listed companies in his job. Charlotte, his new boss, is keen to move him away from this approach as she thinks it is unnecessary. This would indicate that Charlotte is an exponent of:

Select one:

a. the arbitrage pricing theory.
b. the capital asset pricing model.
c. modern portfolio theory.
d. the efficient market hypothesis.

Answer 3

d. the efficient market hypothesis.

chapter reference 4D

Question 4

When the price of share A rises, the price of share B also rises but by a much smaller margin. Share B is said to have:

Select one:

a. a positive correlation.
b. a negative correlation.
c. no correlation.
d. an upward correlation.

Answer 4

a. a positive correlation.

chapter reference 4A2C

Question 5

When security prices adjust to all publicly available information very rapidly and in an unbiased way, this best describes which form of the efficient market hypothesis?

Select one:

a. Weak form efficiency.
b. Semi-strong form efficiency.
c. Strong form efficiency.
d. Semi-weak form efficiency.

Answer 5

b. Semi-strong form efficiency.

chapter reference 4D1

Question 6

Which would be the best choice when selecting a risk-free asset for use with the capital asset pricing model?

Select one:

a. Long dated gilts.
b. Medium dated gilts.
c. Corporate bonds.
d. 91 day Treasury bills.

Answer 6

d. 91 day Treasury bills.

chapter reference 4B4

Question 7

Geoff tends to underestimate the likelihood of a bad investment outcome over which he has no control. Paul is frustrated because he keeps selling stocks too early in case they fall in value. Fred is psychologically far more affected by losses than he is to gains. In terms of behavioural finance, which of the following statements is totally correct regarding these observations?

Select one:

a. Paul displays overconfidence, Geoff displays regret and Fred displays loss aversion.
b. Geoff displays overconfidence, Fred displays regret and Paul displays loss aversion.
c. Fred displays overconfidence, Paul displays regret and Geoff displays loss aversion.
d. Geoff displays overconfidence, Paul displays regret and Fred displays loss aversion.

Answer 7

d. Geoff displays overconfidence, Paul displays regret and Fred displays loss aversion.

chapter reference 4E1

Question 8

What is NOT a limitation of using the efficient frontier to consider the risks and returns from different types of investment?

Select one:

a. It assumes that systematic risk can be removed.
b. Transaction costs are ignored.
c. Investors may have constraints and so may choose alternative portfolios.
d. Calculations often use historic data.

Answer 8

a. It assumes that systematic risk can be removed.

chapter reference 4A3A

Question 9

James has two shares that are both increasing in value but at a different rate. This is known as:

Select one:

a. positive correlation.
b. negative correlation.
c. perfect negative correlation.
d. perfect positive correlation.

Answer 9

a. positive correlation.

chapter reference 4A2C

Question 10

Which factor is UNLIKELY to influence security returns?

Select one:

a. Unanticipated changes in the return of long-term government bonds over Treasury bills.
b. Changes in the expected level of industrial production.
c. Changes in the default risk premium on bonds.
d. Anticipated inflation at outset.

Answer 10

d. Anticipated inflation at outset.

chapter reference 4C1

Question 11

In respect of the capital asset pricing model, a:

Select one:

a. portfolio’s beta is not an indicator of the expected return.
b. portfolio with a beta of more than one will be expected to underperform the market.
c. portfolio with a beta of one will be expected to return the same as the market.
d. portfolio with a beta of less than one will be expected to outperform the market.

Answer 11

c. portfolio with a beta of one will be expected to return the same as the market.

chapter reference 4B1

Question 12

Mitre Holdings plc has a beta of 1.6. If the expected return on a Treasury bill is 3% and the expected return on the market portfolio is 7.5%, what is the expected return for Mitre Holdings according to the capital asset pricing model equation?

Select one:

a. 4.8%.
b. 12%.
c. 10.2%.
d. 10.5%.

Answer 12

c. 10.2%.

chapter reference 4B2

Question 13

According to the Fama and French multi-factor model, it is UNLIKELY that:

Select one:

a. value stocks will outperform growth stocks.
b. small cap stocks will outperform large cap stocks.
c. the securities they favour will be more volatile than the market.
d. large cap stocks will outperform small cap stocks.

Answer 13

d. large cap stocks will outperform small cap stocks.

chapter reference 4C

Question 14

Mike made money on one of his holdings but a loss on the other. Fundamental analysis of the two companies showed them to be as good as each other, but he sells the one making a profit in case it goes down and holds on to the one making a loss in the hope it will go up. Which behavioural bias does this demonstrate?

Select one:

a. Loss reluctance.
b. Loss aversion.
c. Overconfidence.
d. Over reaction.

Answer 14

b. Loss aversion.

chapter reference 4E1A

Question 15

According to the efficient market hypothesis [EMH], the LEAST efficient of these markets is:

Select one:

a. government bonds.
b. mid-listed stocks.
c. venture capital.
d. large-listed stocks.

Answer 15

c. venture capital.

chapter reference 4D2

Question 16

What is NOT taken into account when calculating the expected return on a risky investment using the capital asset pricing model?

Select one:

a. Rate of return on a risk-free asset.
b. Beta value for the investment.
c. Standard deviation of the investment.
d. Expected return of the market portfolio.

Answer 16

c. Standard deviation of the investment.

chapter reference 4B2

Question 17

Bert is using the Fama & French model to try to estimate the required return on his portfolio. In addition to the company’s beta value, the model takes account of:

Select one:

a. changes in gross domestic profit and inflation.
b. changes in interest rates.
c. company size and value.
d. the proportion of high value stocks held.

Answer 17

c. company size and value.

chapter reference 4C

Question 18

Axel Investments has a beta of 1.2 while Bold Investments has a beta of 1.4, which means that:

Select one:

a. both funds will always perform better than the market.
b. Bold Investments is expected to be more volatile than Axel Investments.
c. both funds are expected to have an inferior performance when compared with the market.
d. Axel Investments will always have lower volatility than Bold Investments.

Answer 18

b. Bold Investments is expected to be more volatile than Axel Investments.

chapter reference 4B1

Question 19

According to the efficient market hypothesis, the most efficient market is the:

Select one:

a. corporate bond market.
b. small capital stocks market.
c. government bond market.
d. large capital stocks market.

Answer 19

c. government bond market.

chapter reference 4D2

Question 20

The returns from an investment have achieved an average return of 5%. If the investment has a standard deviation of 5%, approximately what percentage of returns are expected to be positive?

Select one:

a. 84%.
b. 95%.
c. 16%.
d. 68%.

Answer 20

a. 84%.

chapter reference 4A1

Question 21

The Earth Star Fund has a standard deviation of 14 and a beta of 1.3. The return on Treasury bills is 3% and the return on the market is 7%. What is the expected return under the capital asset pricing model?

Select one:

a. 0.29%.
b. 9.1%.
c. 14%.
d. 8.2%.

Answer 21

d. 8.2%.

chapter reference 4B2

Question 22

Identified as an element of behavioural finance, investors guilty of ‘fear of regret’ will tend to:

Select one:

a. hold on to a falling stock for too long.
b. favour tracker funds.
c. not invest in asset-backed securities.
d. sell a falling stock too quickly.

Answer 22

a. hold on to a falling stock for too long.

chapter reference 4E1B

Question 23

According to research, all of the following are important factors that influence security returns, APART from:

Select one:

a. changes in the expected level of industrial production.
b. changes in the default risk premium on bonds.
c. unanticipated inflation.
d. unanticipated changes in short-term interest rates.

Answer 23

d. unanticipated changes in short-term interest rates.

chapter reference 4C1

Question 24

If Steph believes in a strong form of efficient market hypothesis, she believes that current security prices reflect:

Select one:

a. recent historical price and trading volume information.
b. all publicly available information, including the company’s financial statements and announcements.
c. all historical price and trading volume information.
d. all information available, including that only available to certain individuals.

Answer 24

d. all information available, including that only available to certain individuals.4

chapter reference 4D1

Question 25

Two of the variables needed to calculate the expected return of a risky asset using the capital asset pricing model are:

Select one:

a. standard deviation and the risk-free rate of return.
b. beta and standard deviation.
c. beta and variance.
d. beta and the risk-free rate of return.

Answer 25

d. beta and the risk-free rate of return.

chapter reference 4B2

Question 26

The value of a portfolio of UK equities can be hedged by:

Select one:

a. selling both FTSE 100 future contracts and FTSE 100 put options.
b. buying FTSE 100 futures contracts or selling FTSE 100 put options.
c. buying both FTSE 100 future contracts and FTSE 100 put options.
d. selling FTSE 100 futures contracts or buying FTSE 100 put options.

Answer 26

d. selling FTSE 100 futures contracts or buying FTSE 100 put options.

chapter reference 4A2A

Question 27

Having at least 15 - 20 randomly selected securities should help eliminate the impact on a portfolio of a:

Select one:

a. terrorist attack.
b. technological breakthrough making a product obsolete.
c. change in the fiscal policy of a government.
d. change in the monetary policy of a government.

Answer 27

b. technological breakthrough making a product obsolete.

chapter reference 4A4

Question 28

Andy and Murray, both rational investors, have portfolios that sit on the efficient frontier. Andy’s portfolio is situated to the left of Murray’s. This is most likely because:

Select one:

a. Andy needs to obtain higher potential rewards than Murray.
b. Andy is a contrarian investor.
c. Andy is more risk averse compared with Murray.
d. Murray is more risk averse compared with Andy.

Answer 28

c. Andy is more risk averse compared with Murray.

chapter reference 4A3

Question 29

Julie owns a portfolio of UK equities and has been advised to sell FTSE 100 future contracts. What would be the purpose of this advice?

Select one:

a. To add positively correlated assets to her portfolio.
b. To ensure Julie will achieve positive alpha.
c. To help Julie achieve the maximum possible return.
d. To help Julie hedge her portfolio.

Answer 29

d. To help Julie hedge her portfolio.

chapter reference 4A2A

Question 30

Ivan believes that fund managers do not add any value to the performance of a fund. His beliefs would be mostly linked to:

Select one:

a. behavioural finance.
b. correlation analysis.
c. the efficient market hypothesis.
d. modern portfolio theory.

Answer 30

c. the efficient market hypothesis.

chapter reference 4D

Question 31

Ahmed has been studying the capital asset pricing model equation. Which variable would NOT form part of this equation?

Select one:

a. Beta.
b. Alpha.
c. The return generated from the risk-free asset.
d. The expected return of the market.

Answer 31

b. Alpha.

chapter reference 4B2

Question 32

Investment A has a standard deviation of 2 and investment B has a standard deviation of 5. This means that:

Select one:

a. the returns from investment A must be higher.
b. investment B has been less volatile.
c. investment A has been less volatile.
d. the returns from investment B must be higher.

Answer 32

c. investment A has been less volatile.

chapter reference 4A1

Question 33

Gina holds shares in a number of UK companies. Which event would be an example of a systematic risk?

Select one:

a. A scandal involving the Chief Executive of one of her holdings.
b. A change in credit rating of one of the companies she owns shares in.
c. An increase in UK unemployment.
d. A strike over pay and conditions at one of the companies she owns shares in.

Answer 33

c. An increase in UK unemployment.

chapter reference 4A4

Question 34

According to the capital asset pricing model, what is the expected return for a share with a beta of 1.5, if the expected return on a Treasury bill is 4% and the expected return on the market portfolio is 7%?

Select one:

a. 6%.
b. 8.5%.
c. 11%.
d. 10.5%.

Answer 34

b. 8.5%.

chapter reference 4B2

Question 35

Using the capital asset pricing model, what is the expected return for a share with a beta of 1.4, if the expected return on a Treasury bill is 3% and the expected return on the market portfolio is 7.5%?

Select one:

a. 9.3%.
b. 7.5%.
c. 6.3%.
d. 3.5%.

Answer 35

a. 9.3%.

chapter reference 4B2

Question 36

If the mean return on an investment is 9%, the standard deviation is 4% and the data is normally distributed, then 95% of the returns can be expected to fall between:

Select one:

a. 1% and 17%.
b. 5% and 13%.
c. 3% and 15%.
d. -3% and 21%.

Answer 36

a. 1% and 17%.

chapter reference 4A1

Question 37

An investment has a mean return of 7% and a standard deviation of 3%. Roughly 95% of its returns will fall between:

Select one:

a. 1% and 13%.
b. -2% and 16%.
c. 7% and 13%.
d. 4% and 10%.

Answer 37

a. 1% and 13%.

chapter reference 4A1

Question 38

If Johnny follows the principles of modern portfolio theory and there were assets available offering an equal return, he would choose the asset with:

Select one:

a. positive correlation.
b. the lowest alpha.
c. the greatest risk.
d. the lowest standard deviation.

Answer 38

d. the lowest standard deviation.

chapter reference 4A1

Question 39

It might it be appropriate for Roger, an investor, to use the efficient frontier to plot the optimum portfolio for him because he:

Select one:

a. wants to know the lowest level of risk he can afford to take to achieve a given expected return.
b. wants know the lowest level of return he can expect to achieve by taking a higher risk.
c. is happy to match the return achieved by tracker funds.
d. is inexperienced and has never invested in the past.

Answer 39

a. wants to know the lowest level of risk he can afford to take to achieve a given expected return.

chapter reference 4A3

Question 40

An investment has a beta of 1.2. This means that:

Select one:

a. it is theoretically 20% more volatile than the market.
b. it is theoretically 20% less volatile than the market.
c. the performance will be 20% greater than the market.
d. the performance will be 20% less than the market.

Answer 40

a. it is theoretically 20% more volatile than the market.

chapter reference 4B1

Question 41

An investment has achieved an average return of 6% with a standard deviation of 2%. Statistically, what percentage of returns will be expected to fall OUTSIDE the range of 2% to 10%?

Select one:

a. Roughly 32%.
b. Roughly 68%.
c. Roughly 95%.
d. Roughly 5%.

Answer 41

d. Roughly 5%.

chapter reference 4A1

Question 42

The efficient market hypothesis states that security prices will only move significantly when:

Select one:

a. the economy is moving out of a recession.
b. new information becomes available.
c. interest rates are falling.
d. inflation is rising.

Answer 42

b. new information becomes available.

chapter reference 4D

Question 43

Bridget owns a mixture of equities and corporate bond investments. She is seeking investments with no correlation to these assets as far as possible. The best way she could achieve this would be to invest in:

Select one:

a. cash deposits.
b. more convertible bonds.
c. gilts.
d. the FTSE 100.

Answer 43

a. cash deposits.

chapter reference 4A2C

Question 44

Which of these events would be described as an example of market risk?

Select one:

a. A company being downgraded by a credit rating agency.
b. A new competitor beginning to offer a very similar product.
c. The UK government changing corporation tax rates.
d. A technological breakthrough making an existing product obsolete.

Answer 44

c. The UK government changing corporation tax rates.

chapter reference 4A4

Question 45

A company is regarded in its market as an ‘aggressive security’. As a result, its beta would most likely be:

Select one:

a. 1.
b. 0.8.
c. 1.1.
d. 1.8.

Answer 45

d. 1.8.

chapter reference 4B1

Question 46

Donna wishes to hedge her equity portfolio against a fall in the market in the next few months. Which strategy would be the LEAST effective in reducing market risk?

Select one:

a. Buying put options.
b. Diversifying into other asset classes with a negative correlation to equities.
c. Selling an equity futures contract.
d. Buying an equity futures contract.

Answer 46

d. Buying an equity futures contract.

chapter reference 4A2