Equity Portfolio Management

Question 1

The economy’s equilibrium level of real interest rates depends on… (Select 1-3)
A) The households’ willingness to save
B) The profitability of investments in PP&E and inventories for companies
C) The government monetary policy
D) The government fiscal and monetary policy

Answer 1

A) The households’ willingness to save - as reflected in the supply curve of funds
B) The profitability of investments in PPE and inventories for companies - as reflected in the demand curve of funds
D) The government fiscal AND monetary policy

Question 2

Which of the following is true?
A) Real Interest Rate = Nominal Interest Rate + Expected Rate of Inflation
B) Nominal Interest Rate = Real Interest Rate + Expected Rate of Inflation
C) Nominal Interest Rate = Real Interest Rate - Expected Rate of Inflation

Answer 2

B) Nominal Interest Rate = Real Interest Rate + Expected Rate of Inflation

In general, we can only directly observe nominal interest rates; from which, we must infer expected real rates, using inflation forecasts!

Question 3

The equilibrium expected rate of return on any security is the sum of the equilibrium real rate of interest, the expected rate of inflation, and a security-specific risk premium.

TRUE/ FALSE

Answer 3

TRUE.

Equilibrium expected return on any security = equilibrium real interest rate + expected inflation + security-specific risk premium.

Question 4

Historical returns on stocks exhibit somewhat more frequent large negative deviations from the mean than would be predicted from a normal distribution. Which of the following can help quantify the deviation from normality?
A) skew of the actual distribution
B) kurtosis of the actual distribution
C) VaR
D) lower partial standard deviation (LPSD) of the actual distribution
E) A, B, C
F) A, C, D
G) A, B, D

Answer 4

G) A, B, D:
The lower partial standard deviation (LPSD), skew, and kurtosis of the actual distribution quantify the deviation from normality.

Lower partial standard deviation (LPSD): Standard deviation computed using only the portion of the return distribution below a threshold such as the risk-free rate or the sample average.

Question 5

Widely used measures of tail risk are; (i) value at risk (VaR) and (ii) expected shortfall (ES). Which of the following statements are true? Select 1-4
A) VaR measures the loss that will be exceeded with a specified probability such as 1% or 5%.
B) Expected shortfall (ES) measures the expected rate of return conditional on the portfolio falling below a certain value: e.g., 1% ES is the expected value of the outcomes that lie in the bottom 1% of the distribution.
C) ES is always larger than VaR
D) VaR is always higher than ES

Answer 5

A) VaR measures the loss that will be exceeded with a specified probability such as 1% or 5%.
B) Expected shortfall (ES) measures the expected rate of return conditional on the portfolio falling below a certain value: e.g., 1% ES is the expected value of the outcomes that lie in the bottom 1% of the distribution.
C) ES is always larger than VaR

Question 6

Risk-free rate is the rate you would earn in risk-free assets. Which of the following options is NOT a risk-free asset?
A) T-bills
B) Money market funds
C) Certificates of Deposits (CD)
D) Yield obtained from bank depositing
E) All of the above options are considered risk-free

Answer 6

E) All of the above options are considered risk-free

Question 7

The following statement is NOT true about excess return:
A) Excess return represents the EXPECTED payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset
B) Excess return is the difference in any particular period between the ACTUAL rate of return on a risky asset and the actual risk-free rate.
C) The risk premium is the expected value of the excess return.
D) The standard deviation of the excess return is a measure of its risk.
E) All options are correct

Answer 7

WRONG OPTION: A
Excess return represents the ACTUAL payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset. It is the difference in any particular period between the ACTUAL rate of return on a risky asset and the actual risk-free rate.

Meanwhile, the RISK PREMIUM reflects the EXPECTED value of excess return.

Question 8

Following is NOT true about risk-averse investors: Select 1-4
A) they prioritize the safety of principal over the possibility of a higher return on their money
B) they prefer illiquid investments
C) they generally favor municipal and corporate bonds, CDs, and savings accounts
D) they take on additional risk if the excess return is above a certain threshold

Answer 8

WRONG OPTIONS: B and D
B) they prefer LIQUID investments. That is, their money can be accessed when needed, regardless of market conditions at the moment.
D) they DONT take on additional risk if the excess return is above a certain threshold, because they would rather be certain not to suffer losses on their principal

Question 9

Following is NOT true about normal distribution:
A) It is completely characterized by two parameters; the mean and SD
B) Investment management is far more tractable when rates of return can be well approximated by the normal distribution
C) the normal distribution is symmetric, i.e., the probability of any positive deviation above the mean is equal to that of a negative deviation of the same magnitude. Absent symmetry, the standard deviation is an incomplete measure of risk.
D) When assets with normally distributed returns are mixed to construct a portfolio, the corresponding portfolio return is not normally distributed.
E) when securities are normally distributed, the statistical relation between returns can be summarized with a single correlation coefficient. Absent normal distribution, such dependence is a complex, multilayered relationship

Answer 9

WRONG: D)
When assets with normally distributed returns are mixed to construct a portfolio, the portfolio return IS ALSO NORMALLY DISTRIBUTED.

Question 10

The Fisher equation claims that the real rate of interest is approximately equal to the nominal interest minus inflation rate. Given this, what if inflation rate was to increase from 3% to 5%, how will this affect nominal rate and real rate of interest, given all else equal?

If inflation increases, all else equal, the real interest rate will ____.
If inflation increases, all else equal, the nominal interest rate will ____.
A) Fall, rise
B) Rise, fall
C) Fall, fall
D) Rise, rise

Answer 10

CORRECT: A)
If inflation increases, all else equal, the real interest rate will FALL.
If inflation increases, all else equal, the nominal interest rate will RISE.

real=nominal - inflation
nominal= real + inflation

Question 11

Large historical datasets (large sample) is advantageous given a reasonably stable return distribution - why?
A) Assuming that the return distribution remains reasonably stable over the entire history, a longer sample period increases the precision of the estimate of the expected rate of return, since the standard error decreases as the sample size increases.
B) Given a volatile mean that randomly changes y-o-y in the sample, i.e., we are unable to determine the nature of this change, a large sample is still advantageous.
C) A large sample increases the expected return of the portfolio.

Answer 11

A) Assuming that the return distribution remains reasonably stable over the entire history, a longer sample period increases the precision of the estimate of the expected rate of return, since the standard error decreases as the sample size increases.

Explanation of B:if we assume that mean of the distribution of returns is changing over time randomly (we are unable to determine the nature of this change), the expected return must be estimated from a more RECENT part of the historical period. In this case, we must determine how far back to go in order to select the relevant sample. Thus, in this case, it is likely a disadvantage to use the entire dataset back to e.g., earlier decades such as 1880.

Question 12

You are considering two alternative two-year investments:
• You can invest in a risky asset with a positive risk premium and returns in each of the two years that will be identically distributed and uncorrelated,
• or you can invest in the risky asset for only one year and then invest the proceeds in a risk-free asset.
Which of the following statements about the first investment alternative (compared with the second) are true?
a. Its two-year risk premium is the same as the second alternative.
b. The standard deviation of its two-year return is the same.
c. Its annualized standard deviation is lower.
d. Its Sharpe ratio is higher.
e. It is relatively more attractive to investors who have lower degrees of risk aversion.

Answer 12

c. Its annualized standard deviation is lower - se pp. 9 in exam notes
Let σ=annual st.dev.of the risky investment, and σ1 = st.dev.of the first investment alternative over the two year period. Then, σ1=√2*σ
Therefore, the annualized standard deviation for the first investment alternative is equal to:
σ1 /2 = σ /√2 < σ

Question 13

If businesses become more pessimistic about future demand for their products and decide to reduce their capital spending, the real rate of interest will ______.

If households are induced to save more because of increased uncertainty about their future Social Security benefits, the real rate of interest will ______.

If the Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in order to increase the supply of money, the real rate of interest will ______.

A) rise, fall, rise
B) fall, rise rise
C) fall, fall fall
D) rise, rise rise

Answer 13

C)

If businesses become more pessimistic about future demand for their products and decide to
reduce their capital spending, the real rate of interest will FALL.

If households are induced to save more because of increased uncertainty about their future Social Security benefits, the real rate of interest will FALL.

If the Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in order to increase the supply of money, the real rate of interest will FALL.

Question 14

You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.

Which is the safer investment?

A) Conventional CD
B) Inflation-plus CD
C) Depends - cannot be determined based on the given information

Answer 14

B) Inflation-plus CD:
The safer investment will be the inflation-plus CD offering, since the investor will be appropriately compensated for any level of inflation rate to materialize over the next year. That is, the real interest rate that you will receive by investing in the inflation plus CD is 1.5% regardless of inflation.

Question 15

You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.

Can you tell which offers the higher expected return?

A) Conventional CD
B) Inflation-plus CD
C) Depends - cannot be determined based on the given information

Answer 15

C) Depends - cannot be determined based on the given information

The CD without inflation plus offers a higher expected return if the expected inflation rate will be lower than 3.5%. If the expected inflation rate is higher than 3.5%, then the inflation plus CD offers a higher expected return. In conclusion, the expected return on each investment depends on the expected inflation rate.

Question 16

You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.

If you expect the rate of inflation to be 3% over the next year, which is definitely the better investment?

A) Conventional CD
B) Inflation-plus CD
C) Depends - cannot be determined based on the given information

Answer 16

C) Depends - cannot be determined based on the given information.

All equal:
If the inflation rate is expected to be 3%, then the CD without inflation plus offers the highest expected return of 2%, versus 1.5% in the inflation-plus case.

E(r)_CD(Conventional) > E(r)_CD(Inflation Plus)

→ 2% > 1.5%

BUT, unless the inflation rate of 3% is certain, the conventional CD is yet the riskier option.

Therefore there is not a clearly/ definitely “better” investment of the two.

Question 17

If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5% on inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5% per year?

A) Yes
B) No
C) Depends

Answer 17

B) NO
We CANNOT assume that the entire difference between the risk-free nominal rate (on conventional CDs) of 5% and the real risk-free rate (on inflation-plus CDs) of 1.5% is the expected rate of inflation. Part of the difference is likely a risk premium associated with the uncertainty surrounding the real rate of return on conventional CDs. This implies that the expected rate of inflation is less than 3.5% per year.

Question 18

Which risk is non-diversifiable?

A) Systematic risk
B) Non-systematic risk

Answer 18

Systematic risk refers to macroeconomic risks. This is a common factor that affects all security returns. The market factor, m, measures unanticipated developments in the macroeconomy.

The systematic component of a portfolio variance, β_P^2 σ_M^2 depends on the average beta coefficient of the individual securities. This part of the risk depends on portfolio beta and σ_M^2 and will persist regardless of the extent of portfolio diversification. No matter how many stocks are held, their common exposure to the market will result in a positive portfolio beta and be reflected in portfolio systematic risk. I.e., systematic risk is non-diversifiable.

Question 19

Which of the following are examples of common economic factors? I.e., sources of systematic risk. Select 1-4
A) business cycles
B) stock repurchase
C) interest rates
D) cost of natural resources

Answer 19

Common economic factors/“Shocks” refers to unexpected changes to macroeconomic variables that cause, simultaneously, correlated shocks in the rates of return on stocks across the entire market.

ANSWER: all options are correct except B

Question 20

A scatter diagram plots returns of one security versus _____.

A) its price
B) returns of another security or benchmark
C) excess return of the same security, relative to the risk-free rate
D) excess return of the same security, relative to market excess return

Answer 20

CORRECT: B)
A scatter diagram plots returns of one security versus returns of another security (or benchmark such as a market). Each point represents one PAIR of returns for a given holding period.

Question 21

A regression equation describes the average relationship between a dependent variable and one or more explanatory variables. In this context, residuals captures______

A) Parts of stock returns are not explained by the explanatory variable. They measure the impact of firm-specific events during a particular period.
B) The risks that are non-diversifiable and therefore not captured by the explanatory variables.

Answer 21

A regression equation describes the average relationship between a dependent variable and one or more explanatory variables. In this context, residuals capture Parts of stock returns not explained by the explanatory variable. They measure the impact of firm-specific events during a particular period.

A IS CORRECT

Question 22

A security characteristic line (SCL) plots_____

A) the excess return on a security over the risk-free rate as a function of the excess return on the market.
B) the excess return on a security against its price
C) the returns of one security against the return of another security
D) the return of a security against the excess return of the same security relative to the risk-free rate

Answer 22

A) IS CORRECT:

A security characteristic line (SCL) plots the excess return on a security over the risk-free rate as a function of the excess return on the market.

Question 23

Following is NOT true about the Information Ratio:
A) It is a version of a reward-to-risk ratio (another example is Sharpe).
B) It divides the alpha of the portfolio by the systematic risk of the portfolio.
C) It quantifies the trade-off between alpha and diversifiable risk, and it measures abnormal return per unit of risk that in principle could be diversified away by holding a market.
D) All of the above are true

Answer 23

WRONG: B & D
B) It divides the alpha of the portfolio by the NON-systematic risk of the portfolio. This is the firm-specific risk of the portfolio, called “tracking error” in the industry - which CAN be diversified away. Thus, IR quantifies the trade-off between alpha and diversifiable risk, and it measures abnormal return per unit of risk that in principle could be diversified away by holding a market.

IR = α_p/ σ(e_P )

Question 24

What are the advantages of the index model compared to the Markowitz procedure for obtaining an efficiently diversified portfolio? What are its disadvantages?

Answer 24

Advantages:

• Reduced number of estimates required – the large number of estimates required for the Markowitz procedure can result in large aggregate estimation errors when implementing the procedure.
• Takes into account specialization of labor in security analysis. An advantage of the index model (relative to Markowitz model) is its simple way of computing covariances across industries.

Disadvantage:
- The index model’s assumption that return residuals are uncorrelated. This assumption will be incorrect if the index omits a significant risk factor.

Question 25

How does the magnitude of firm-specific risk affect the extent to which an active investor will be willing to depart from an indexed portfolio?
A) the higher the firm-specific risk of an asset, the higher the willingness to include a larger weight of this specific asset in an active risky portfolio
B) the higher the firm-specific risk of an asset, the lower the willingness to include a larger weight of this specific asset in an active risky portfolio

Answer 25

CORRECT: B)
the higher the firm-specific risk of an asset, the lower the willingness to include a larger weight of this specific asset in an active risky portfolio.

Other tings equal, w^0 (initial guess of asset weight in active portfolio) is smaller the greater the residual variance of a candidate asset for inclusion in the portfolio (σ^2 (e_Active)). Further, regardless of beta, when w^0 decreases, so does w*(the optimal asset weight in active portfolio).
Therefore, other things equal, the greater the residual variance of an asset, the smaller its position in the optimal risky portfolio. That is, increased firm-specific risk reduces the extent to which an active investor will be willing to depart from an indexed portfolio.

See pp. 28-29 in Exam Notes

Question 26

Why do we call alpha a “nonmarket” return premium?
A) it is the portion of the return premium that is independent of the market performance.
B) it is non-diversifiable and is correlated with the beta of the security
C) The lower the alpha (nonmarket risk), the higher the total risk premium
D) All of the above

Answer 26

CORRECT: A)
The total risk premium is equal to = α + (β * market risk premium)
We call alpha the non-market return premium due to the fact that it is the portion of the return premium that is independent from the market performance. That is, the alpha of an asset is DIVERSIFIABLE; as more and more stocks are added to the portfolio, the firm-specific components tend to cancel out, resulting in ever-smaller nonmarket risk.

Question 27

Why are high-alpha stocks desirable investments for active portfolio managers? Hint: think of the Sharpe Ratio for an optimal risky portfolio
A) A higher alpha entails a lower Sharpe Ratio, which is very desirable for risk-averse investors
B) A higher alpha entails a higher Sharpe Ratio, which is desirable for any active investors - even the risk-averse ones
C) A higher alpha of a security decreases the portfolio alpha, which is desirable for any active investors - even the risk-averse ones
D) None of the options are correct

Answer 27

CORRECT: B) A higher alpha entails a higher Sharpe Ratio, which is desirable for any active investors - even the risk-averse ones.

The Sharpe Ratio:
S_P^2 = S_M^2+[α_A/σ(e_A ) ]^2

Alpha (the numerator in the Sharpe Ratio) is a fixed number that is not affected by the standard deviation of returns (the denominator). Hence, an increase in alpha increases the Sharpe ratio, which indicates a higher reward-to-risk ratio. Since the portfolio alpha is the portfolio-weighted average of the securities’ alphas, then, holding all other parameters fixed, an increase in a security’s alpha results in an increase in the portfolio Sharpe ratio.

Question 28

In the index model (excess return), the firm-specific risk is measured by:\_\_\_\_
A) beta
B) residual standard deviation
C) R^2
D) market risk premium (r_m-r_f)

Answer 28

B) Firm-specific risk is measured by the residual standard deviation.
The higher the residual standard deviation, the higher the firm-specific risk of the stock according to the index model (excess return) regression of stocks.

Question 29

In the index model (excess return), the market risk of a stock is measured by:\_\_\_\_
A) beta
B) residual standard deviation
C) R^2
D) market risk premium (r_m-r_f)

Answer 29

A) Market risk is measured by beta, the slope coefficient of the regression. A stock with a larger beta coefficient indicates a larger market risk.

Question 30

In the index model (excess return), the fraction of total variance of return explained by the market return is indicated by: \_\_\_\_
A) beta
B) residual standard deviation
C) R^2
D) market risk premium (r_m-r_f)

Answer 30

C) In the index model (excess return), the fraction of total variance of return explained by the market return (explained variance) is indicated by R^2. This means that for a larger R^2, the market movement explains a greater fraction of the stock’s total return variability.

R_i^2 = (β_i^2 * σ_M^2) / (σ_i^2 ) =
(Explained Variance) / (Total Variance)

Question 31

Under the efficient market hypothesis, given an efficient market, which type of stock price analysis will likely generate the higher (more optimistic) stock price and development hereof?
A) Single-Index model
B) Technical analysis
C) Fundamental analysis (analysis of the underlying value of the firm, e.g., profitability and growth prospects)
D) Both technical analysis (B) and fundamental analysis (C) are based on public information, and thus, neither should generate excess profits if markets are operating efficiently.

Answer 31

D) Both technical analysis (B) and fundamental analysis (C) are based on public information, and thus, netiher should generate excess profits if markets are operating efficiently.

Question 32

Which of the following statements from the EMH chapter (11) is NOT true?
A) Technical analysis focuses on stock price patterns and on proxies for buy or sell pressure in the market
B) Fundamental analysis focuses on the determinants of the underlying value of the firm, such as current profitability and growth prospects
C) Evidence for market efficiency is that stock prices follow a random walk with no discernible predictable patterns that investors can exploit
D) Under market efficiency, only new information will move stock prices, and this information is more likely to be good news than bad news.
E) Market efficiency refers to when market prices reflect all currently available information

Answer 32

WRONG: D) Under market efficiency, only new information will move stock prices, and this information is EQUALLY (NOT MORE) likely to be good news than bad news - i.e., prices follow a RANDOM walk.

Question 33

Proponents of the efficient market hypothesis often advocate passive as opposed to active investment strategies.

TRUE/ FALSE

Why?

Answer 33

TRUE
The policy of passive investors is to buy and hold a broad-based market index. They expend resources neither on market research nor on frequent purchase and sale of stocks. Under the belief of complete market efficiency, it should be the case that no investors will be able to generate superior returns, because market prices should IMMEDIATELY reflect and react to new information.

Question 34

Which of the following is NOT true about active versus passive investment?
A) Passive investment is suggested under the strong assumption of market efficiency
B) Management fees are generally higher in passive investment vehicles than active investment vehicles
C) The degree of investment performance transparency for the client is lower under active than passive management
D) Active management entails high costs to personnel to be actively monitoring the market and trading oftentimes aggressively with short time spans, while in passive management, cost-cutting and efficiency are more important

Answer 34

WRONG: B) Management fees are generally higher in ACTIVE (NOT PASSIVE) investment vehicles. This is because active management entails higher costs for the funds (personnel, IT, etc.) and because it targets superior returns for the investors. Correspondingly, fees are higher. (Because of option D)

EXPLANATIONS OF OTHER OPTIONS:
A) Passive investment is suggested under the strong assumption of market efficiency because if an asset manager is confident that it can outsmart and outperform the market (which is only feasible under the absence of complete market efficiency), he/she would pursue an active investment strategy.
C) The degree of investment performance transparency for the client is lower under active than passive management because investors often get an update of the portfolio performance once a month, while you can see the current value of your passive investment holdings whenever preferred.

Question 35

Even if the market is efficient, an important role exists for portfolio management, which can be particularly valuable to investors. Which of the following is not one of such valuable tasks?
A) Portfolio management can be a valuable addition to the buyer in terms of consulting (which is unique from asset managers who simply invest on behalf of the client).
B) Helping the client understand the benefits of diversification, which is crucial even if the market is totally efficient.
C) Portfolio managers can have a crucial impact on clients in helping them understand and determine a level of risk of their portfolio that is appropriate given their risk tolerance.
D) Consulting on tax considerations for the client, which can be very important in order to improve the after-tax rate of return of the portfolio
E) All of the above are tasks that are valuable for investors, carried out by portfolio managers

Answer 35

CORRECT: E) All of the above are tasks that are valuable for investors, carried out by portfolio managers

EXPLANATION OF OPTIONS
B) Helping the client understand the benefits of diversification, which is crucial even if the market is totally efficient. According to the black model (chapter 8) about the combination of active and passive investment, lack of diversification is the price that you have to pay to pursue alpha. If you believe that there is no alpha, it makes no sense to have a small portfolio. The model argues that if there is no alpha, everything should be passive.

Question 36

While no market can be perfectly efficient, in well-functioning markets, anomalies ought to be self-destructing. As market participants learn of profitable trading strategies, their attempts to exploit them should move prices to levels at which abnormal profits are no longer available.
TRUE/ FALSE

Answer 36

TRUE

Abnormal returns: return on a stock beyond what would be predicted by market movements alone. E.g., due to announcement or the release of information of the firm.

Question 37

Predictability of market prices ______ over longer horizons.
A) increases
B) decreases
C) increases or decreases randomly

Answer 37

Predictability of market prices INCREASES (A) over longer horizons.

Research literature from the 80s indicates evidence in favor of predictability with a longer horizon - it is easier to predict e.g., on the yearly or multi-yearly level rather than the daily or weekly level.

Question 38

If markets are efficient, what should be the correlation coefficient between stock returns for two non-overlapping time periods?
A) 0
B) 1
C) -1
D) depends

Answer 38

If markets are efficient, the correlation coefficient between stock returns for two non-overlapping time periods should be 0 (A).

If this is not the case, one could use returns from one period to predict returns in later periods and make abnormal profits – which should not be possible in an efficient market.

Question 39

Assuming an efficient market:

For Steady Growth Industries that have never missed a dividend payment in its 94-year history, does this make it more attractive to you as a possible purchase for your stock portfolio?

Answer 39

No, the value of dividend predictability would be already reflected in the stock price

Question 40

The momentum effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.

Answer 40

The momentum effect is (B): The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.

Question 41

The book-to-market effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.

Answer 41

Book-to-market effect: (A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.

Question 42

The Small-firm effect effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.

Answer 42

The Small-firm effect effect is: D) The tendency of investments in stocks of small firms earning abnormal returns.

Question 43

The P/E effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.

Answer 43

P/E effect: C) low P/E stocks have exhibited higher average risk-adjusted returns than high P/E stocks. I.e., an investor could earn superior returns simply by buying low P/E securities. This is a market anomaly because it is a piece of information that can be used to improve investment performance, (which should not exist in an efficient market). One possible explanation for this effect is that the neglect to take into account the effect of risk.
- Suppose that we have two companies with the same expected earnings and different levels of risk. The riskier stock, in order to command higher returns, would sell at a lower price, causing its P/E ratio to be lower. Therefore, the P/E effect may simply reflect the effect of risk on stock returns.

Question 44

Reversal effect: the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals (a change in the opposite direction) in the following periods.

TRUE/ FALSE

Answer 44

TRUE

Question 45

Neglected-firm effect: investments in stock of less well-known firms have generated abnormal returns.

TRUE/ FALSE

Answer 45

TRUE

Question 46

Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis?
A) The average rate of return is significantly greater than zero.
B) The correlation between the return during a given week and the return during the following week is zero.
C) One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall.
D) One could have made higher-than-average capital gains by holding stocks with low dividend yields.

Answer 46

Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis?

C) One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. Buying stocks when prices are rising and selling them at lower prices can by definition not result in superior returns. Investors should always try to buy at a lower cost and sell at a higher price to make profit.

Question 47

Which of the following statements are true if the efficient market hypothesis holds?

a. It implies that future events can be forecast with perfect accuracy.
b. It implies that prices reflect all available information.
c. It implies that security prices change for no discernible reason.
d. It implies that prices do not fluctuate.

Answer 47

b. It implies that prices reflect all available information.

Question 48

Is the following phenomena consistent with of violation of the EMH?

Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year.

Answer 48

Consistent – simply based on pure luck, half of all managers should be able to beat the market in any year.

Question 49

Is the following phenomena consistent with of violation of the EMH?

Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform the market in the following year.

Answer 49

Inconsistent – following the notion of random walk, the outperformance in one year should not result in a likely outperformance of the market in the future. This would be the basis of an “easy money” rule: simply invest with last year’s best managers.

Question 50

Is the following phenomena consistent with of violation of the EMH?

Stock prices tend to be predictably more volatile in January than in other months.

Answer 50

Consistent – in contrast to predictable returns, predictable volatility does not convey a means to earn abnormal returns.

Question 51

Is the following phenomena consistent with of violation of the EMH?

Stock prices of companies that announce increased earnings in January tend to outperform the market in February

Answer 51

Inconsistent – under the EMH, abnormal performance ought to occur in January when earnings are announced – not later.

Question 52

Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

Answer 52

Yes - The market may have estimated even greater increase in earnings. Compared to expectations, the announcement may have been a disappointment.

Question 53

Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?

YES/ NO

Answer 53

NO

Positive CAPM alphas among thinly traded stocks do not necessarily violate the efficient market hypothesis since these higher alphas are actually risk premiums, not market inefficiencies. Less traded stocks entails lower liquidity, which results in investors requiring a higher expected return to compensate for the illiquidity/risk. Thus, a positive alpha reflects the higher risk connected to the stock, and does not necessarily entail a violation of EMH.

Question 54

Which of the following types of information processing errors concerns that investors are slow to update their beliefs and underreact to new information?
A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)

Answer 54

C) conservatism: investors are slow to update their beliefs and underreact to new information.

Question 55

Which of the following types of information processing errors concerns: putting too much weight on recent experiences. I.e., wrongfully projecting that recent economic events will be long-lasting and affect future economic conditions, rather than putting focus on observing the historical data for a longer period. This leads to forecasting errors.

A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)

Answer 55

A) memory bias

Question 56

If you trade actively as an investor, however, fail to overperform the market, it is a clear example of _____
A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)

Answer 56

if you trade actively as an investor, however, fail to overperform the market, it is a clear example of (B) OVERCONFIDENCE.

overconfidence: investors overestimate their abilities and the precision of their forecasts

Question 57

When investors are too quick to infer a pattern or trend from a small sample, which may lead to overreaction by looking at a too small sample and jump to conclusions. E.g., observing a slight positive trend and believing that the economy is booming. This is an example of which type of information processing error?

A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)

Answer 57

This is an example of REPRESENTATIVENESS (SAMPLE SIZE NEGLECT).
Sample size neglect (representativeness bias) is the tendency to believe that a small sample is reliably representative of a broad population and therefore to infer patterns too quickly.

Question 58

Which of the following types of behavioral bias in finance concerns:
presenting data in a way that is suitable to a given objective of the presenter, which can affect investors’ decisions.
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)

Answer 58

B) framing: when decisions are affected by how choices are described

Question 59

Which of the following types of behavioral bias in finance concerns:
When investors segregate accounts and take risks with their gains that they would not take with their principal.
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)

Answer 59

C) mental accounting: when individuals mentally segregate assets into independent accounts rather than viewing them as part of a unified portfolio.

Question 60

Which of the following types of behavioral bias in finance concerns:
A tendency of investors keeping certain stocks for too long because the return is negative. I.e., they are more willing to sell a stock that has increased in value than one which has decreased in value.
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)

Answer 60

D) loss aversion (prospect theory): If an investor makes money, he/she becomes more risk adverse, and if they lose, they are willing to take more risk. This explains why a stock that you hold decreases in value, you are reluctant to sell the stock and make a loss due to the belief that the stock price might bounce back up.

Question 61

Investors tend to blame themselves more when an unconventional or risky bet turns out badly rather than if they were to go for a more safe and conventional investment. Due to this preference to avoid regret and self-blame, investors may tend to allocate assets in more conventional investments. This is a case of:
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)

Answer 61

A) regret avoidance

Question 62

Which of the following limits to arbitrage concers:
Even if a security is mispriced, it still can be risky to attempt to exploit the mispricing. This risk lies in the intrinsic value and market value taking too long to converge.
A) Model risk
B) Implementation costs & cost of short-selling
C) Fundamental risk
D) Loss aversion

Answer 62

C) Fundamental risk: even if a security is mispriced, it still can be risky to attempt to exploit the mispricing. This risk lies in the intrinsic value and market value taking too long to converge.
“Markets can remain irrational longer than you can remain solvent”. The risk of “waiting” for the market to adjust to equilibrium may not be feasible, and therefore, exploiting arbitrage opportunities can be extremely risky if the time-horizon is limited.

Remember: the case in the Big Short, where the short sellers were waiting for the market to correct (the bubble to burst) - but almost went bankrupt in the meantime

Question 63

Transactions costs and restrictions on short selling can limit arbitrage activity. Especially when it comes to trading single stocks, it is difficult to play against the market. Meanwhile, the cost of short-selling is not cheap, and the activity itself can entail significant risks.
The above description is of which limit to arbitrage?

A) Model risk
B) Implementation costs & cost of short-selling
C) Fundamental risk
D) Loss aversion

Answer 63

B) Implementation costs & cost of short-selling

Question 64

Maybe your model is wrong, and the market value is actually correct. Maybe your calculation of the terminal value of the price is wrong, or the risk premium is mis-estimated, or there are sources of risk that other people have been able to identify that you have not.
The above description is of which limit to arbitrage?

A) Model risk
B) Implementation costs & cost of short-selling
C) Fundamental risk
D) Loss aversion

Answer 64

A) Model risk

Question 65

Behavioral finance concerns models of financial markets that emphasize implications of psychological factors affecting investor behavior.

TRUE/ FALSE

Answer 65

TRUE

Question 66

The tendency of investors to hold on to losing investments is referred to as:
A) momentum effect
B) firm-size effect
C) disposition effect
D) reversal effect

Answer 66

Disposition effect: The tendency of investors to hold on to losing investments.
This is often a byproduct of risk aversion behavioral bias (prospect theory).

Question 67

Relative strength refers to:
A) The volatiltiy of a security relative to either the market as a whole or its particular industry
B) The extent to which a security has outperformed or underperformed either the market as a whole or its particular industry
C) The pricing of a security relative to other securities in the market as a whole or its particular industry
D) The extent to which movements in the broad market index are reflected widely in movements of individual stock prices.

Answer 67

Relative strength refers to: B) the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry

Question 68

Breadth refers to the extent to which movements in the broad market index are reflected widely in movements of individual stock prices.
This is often measured as the spread between the number of stocks that advanced and declined in price on a given day in the market.

TRUE/ FALSE

Answer 68

TRUE

Question 69

According to the Dow Theory, there are trends in prices, and we can distinguish between the following trends:

• _____: long-term movement of prices, lasting from several months to several years.
• _____: short-term deviations of prices from the underlying trend line and are eliminated by corrections.
• _____: daily fluctuations of little importance

A) Primary trend, Secondary/ intermediate trend, Tertiary/ minor trends
B) Tertiary/ minor trends, Secondary/ intermediate trend, Primary trend
C) Secondary/ intermediate trend, Primary trend, Tertiary/ minor trends

Answer 69

A)

According to the Dow Theory, there are trends in prices, and we can distinguish between the following trends:

• Primary trend: long-term movement of prices, lasting from several months to several years.
• Secondary/ intermediate trend: short-term deviations of prices from the underlying trend line and are eliminated by corrections.
• Tertiary/ minor trends: daily fluctuations of little importance

Question 70

The ratio of trading volume in declining stocks/number of stocks declined, to the volume in advancing stocks/ number of stocks advanced, is referred to as:
Hint: it is used in technical analysis to identify bearish or bullish signals and to measure breadth.
A) Confindence index
B) Trin statistic
C) Put/call ratio

Answer 70

B) The ratio of trading volume in declining stocks/number of stocks declined, to the volume in advancing stocks/ number of stocks advanced, is referred to as: TRIN ratio

Trin = (Trading volume of declining stock/number stocks declining) / (Trading volume of advancing stock/number stocks advancing )

Question 71

Following is NOT true about the Confidence Index:
A) It is the ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds.
B) The ratio will always be below 1, because higher-rated bonds will offer lower promised yields to maturity.
C) When the confidence index values approach 0, it reflects a bullish signal
D) When the confidence index values approach 1, it reflects a bullish signal

Answer 71

WRONG: C) When the confidence index values approach 0, it reflects a bullish signal.

TRUE: When bond traders are optimistic about the economy, they require smaller default premiums on lower-rated debt – i.e., the low to high rated bond YTM spread goes down, indicating good sentiment. Hence, the confidence index will approach 1 due to the lower spread, indicating a bullish signal.

The lower confidence index values (approaching 0) reflect bearish signal: when bond traders are pessimistic about the economy, they require larger default premiums on lower-rated bonds. This indicates decreased sentiment.

Question 72

Which of the behavioral biases is arguably the one that is to the highest degree linked to technical analysts ability to detect and exploit inefficient market prices through technical analysis?
A) mental accounting
B) regret avoidance
C) prospect theory
D) conservatism bias
E) sample size neglect (representativeness bias)
F) framing

Answer 72

The professor argues that conservatism bias is that one element of behavioral finance that is most closely linked to technical analysis, while the prospect theory may also be to some degree creating room for detection and exploitation of inefficient market prices through technical analysis. The other behavioral elements are too general.

Question 73

______ believe that publicly available information (and, for advocates of strong-form efficiency, even insider information) is, at any point in time, reflected in securities prices, and that price adjustments to new information occur immediately/ very quickly. Consequently, prices are at fair levels, and active management (stock picking) is very unlikely to result in overperformance above that of a broadly diversified index portfolio.

A) Behavioral finance advocates
B) Efficeint market advocates

Answer 73

(B) Efficeint market advocates believe that publicly available information (and, for advocates of strong-form efficiency, even insider information) is, at any point in time, reflected in securities prices, and that price adjustments to new information occur immediately/ very quickly. Consequently, prices are at fair levels, and active management (stock picking) is very unlikely to result in overperformance above that of a broadly diversified index portfolio.

Question 74

______ identify a number of investor errors in information processing and decision making that could result in mispricing of securities. However, the literature in this area generally does not provide guidance as to how these investor errors can be exploited to generate excess profits. Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.

A) Behavioral finance advocates
B) Efficeint market advocates

Answer 74

(A) Behavioral finance advocates identify a number of investor errors in information processing and decision making that could result in mispricing of securities. However, the literature in this area generally does not provide guidance as to how these investor errors can be exploited to generate excess profits. Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.

Question 75

Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just holds on to them a little longer they will recover, at which time she will sell them. Which behavioral characteristic is the basis for Davis’s decision making?

a. Loss aversion.
b. Conservatism.
c. Representativeness.

Answer 75

a. Loss aversion.

Question 76

After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. Which behavioral characteristic is the basis for Shrum’s decision
making?
a. Fear of regret.
b. Representativeness.
c. Mental accounting.

Answer 76

a. Fear of regret: she wants to avoid the feeling of regret from having sold a stock that has increased in value since the sale

Question 77

All of the following actions are consistent with feelings of regret except:

a. Selling losers quickly.
b. Hiring a full-service broker.
c. Holding on to losers too long.

Answer 77

B) Hiring a full-service broker is NOT consistent with feelings of regret, because you will not have any regret since you have delegated the responsibility to a professional.

Question 78

Investors are slow to update their beliefs when given new evidence. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS

Answer 78

A) CONSERVATISM BIAS

Question 79

investors are reluctant to bear losses caused by their unconventional decisions.  This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS

Answer 79

B) REGRET AVOIDANCE

Question 80

Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS

Answer 80

C) MENTAL ACCOUNTING

Question 81

Investors are reluctant to sell stocks with “paper” losses. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS

Answer 81

D) DISPOSITION EFFECT: The tendency of investors to hold on to losing investments.

Question 82

Investors disregard sample size when forming views about the future from the past. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS

Answer 82

E) REPRESENTATIVENESS BIAS

Question 83

Following is NOT true about data mining:
A) refers to sorting through large amounts of historical data to uncover systematic patterns that can be used as the basis of a trading strategy.
B) the risk of data mining includes that historical relationships may break down when fundamental economic conditions change, or that the apparent patterns in the data may be due to pure chance.
C) patterns resulting from data mining may not reflect real relationships that can be counted on to persist in the future.
D) the larger the sample size/ data base, the higher the probability for data mining.
E) all of the above are true

Answer 83

WRONG: D) the SMALLER (not larger) the sample size/ data base, the higher the probability for data mining.

Question 84

Even if prices follow a random walk, they still may not be informationally efficient. Why may this be true, and why does it matter for the efficient allocation of capital in our economy?

Answer 84

Even if prices follow a random walk, the existence of irrational investors combined with the limits to arbitrage by arbitrageurs may allow persistent mispricing to be present (longer term deviation from instic values). This implies that capital will not be allocated efficiently.

Question 85

Calculate the trin ratio for the NASDAQ.
Of the total 2,981 stocks listed on NASDAQ,
• 1,905 advanced
• 896 declined
• 180 unchanged
The trading volume of the shares totaled 1,487,956, of which:
• 1,075,611 advanced
• 388,278 declined
• 24,067 unchanged

Is the trin ratio bullish or bearish?

Answer 85

Trin Ratio=(388,278/896 )/(1,075,611/1,905 )=(433.346)/(564.625)=0.7675
A trin ratio of 0.7675 indicates a BULLISH signal, since it is below 1.

Question 86

Calculate the BREADTH of NYSE using following data?
Of the total 3,182 stocks listed on NYSE,
• 2,070 advanced
• 1,003 declined
• 109 unchanged
The trading volume of the shares totaled 804,628 of which:
• 510,372 advanced
• 283,331 declined
• 10,925 unchanged

Answer 86

Breadth=no.advances-no.declines
Breadth=2,070-1,003=1,067

Since the breadth (spread) is positive, it indicates that a bullish signal. However, in practice, one would not use a one-day measure for the market signal being bullish/bearish.

Question 87

Baa-rated bonds currently yield 6%, while Aa-rated bonds yield 5%. Suppose that due to an increase in the expected inflation rate, the yields on both bonds increase by 1%.
Calculate confidence index before and after the 1% increase in YTM

Would this be interpreted as bullish or bearish by a technical analyst?

Answer 87

Confidence index=(average YTM of top 10 rated corporate bonds)/(average YTM of 10 intermeidate grade corporate bonds)<1

Confidence index_Before=0.05/0.06=0.833
Confidence index_After=0.06/0.07=0.857

The ratio will always be below 1, because higher-rated bonds will offer lower promised yields to maturity. Since the confidence index increases due to the YTM increase in both bonds amid increased expected inflation rate, theoretically it indicates a bullish market. However, the reason for the increase is not improved sentiment in the economy, but rather, increase expected inflation.

Question 88

On day 1, Comp Inc. traded at 19.63, while the industry index was at 50
On day 40, Comp Inc. traded at 28, while the industry index was at 56.1
Does Comp Inc. show relative strength over this period?

Answer 88

Relative strength: the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry.

Relative strengh=difference between (stock_i stock price at time t)/(Industry index at time t) and (stock_i stock price at time T)/(Industry index at time T)

At the beginning of the period, the price of Computers, Inc. divided by the industry index was:
19.63/50=0.393

By the end of the period, it appears that the firm outperformed other firms in its industry:
28/56.1=0.499

Therefore, the overall trend indicates relative strength

Question 89

The cumulativce breadth is calculated by summing the net advances of stock developments (advances - decreases) over the sample period.
TRUE/ FALSE

Answer 89

TRUE

Question 90

Trin stat of 1.068 indicates a bullish/bearish market?

Answer 90

A trin stat of 1.068 is slightly above 1, which signals a slightly bearish market.

Ratios above 1.0 are BEARISH
Ratios below 1.0 are BULLISH.

Trin=(Trading volume of declining stock/number stocks declining)/(Trading volume of advancing stock/number stocks advancing )

Question 91

The “small firm effect” refers to the fact that:

A) investments in stocks of large firms appear to have earned abnormal returns
B) investments in stocks of small firms appear to have earned abnormal returns
C) smaller firms are not as broadly covered by equity analysts, which results in the stock price of such firms not reflecting true value in as large degree as large firms
D) more than one of the options are correct

Answer 91

B) investments in stocks of small firms appear to have earned abnormal returns

Question 92

When unsuccessful funds that cease operation stop reporting returns and leave a database, leaving behind only the successful funds, resulting in the best managers being overrepresented in the sample since the worst managers being ignored - it is an example of:
A) Behavioral finance (bias)
B) Benchmark error
C) Survivorship bias
D) None of the above

Answer 92

C) Survivorship bias: bias in the average returns of a sample of funds induced by excluding past returns on funds that left the sample because they happened to be unsuccessful. This arises when build a sample from the end of history rather than from the beginning

Question 93

Use of an inappropriate proxy for the true market portfolio when testing a theory is referred to as:
A) data interpretation error
B) benchmark bias
C) survivorship bias
D) benchmark error

Answer 93

D) benchmark error: Use of an inappropriate/incorrect proxy for the true market portfolio when testing a theory

Question 94

Which of the following is NOT true about the Equity Premium Puzzle?
A) originates from the observation that equity returns exceeded the risk-free rate to an extent that is inconsistent with the covariance of returns with consumption risk and reasonable levels of risk aversion.
B) the equity premium puzzle is the result of applying a full rationality model of investor choice to equity investment.
C) a plausible explanation for the puzzle is survivorship bias
D) a plausible explanation for the puzzle is unexpected capital gain
E) all of the above are correct

Answer 94

E) all of the above are correct

Question 95

Even if the single-factor CCAPM (with a consumption-tracking portfolio used as the index) performs better than the CAPM, it is still possible that the consumption portfolio does not capture the size and growth characteristics captured by the SMB (i.c., small minus big capitalization) and HML (i.e., high minus low book-to-market ratio) factors of the Fama-French three-factor model. Therefore, it is expected that the Fama- French model with consumption provides a better explanation of returns than does the model with consumption alone.

TRUE/ FALSE

Answer 95

TRUE

Question 96

Following is NOT true about the put/call ratio:
A) Calls are options that gives the right to buy: a way to bet on rising prices.
B) Puts are options that gives the right to sell: a way to bet on falling prices.
C) A rising ratio may signal investor pessimism and a coming market decline (bearish market), and vice versa.
D) A rising ratio may signal investor optimistic and a coming market increase (bullish market), and vice versa.
E) Contrarian investors (a person who opposes or rejects popular opinion, especially in stock exchange dealing) see a rising ratio as a buying opportunity.

Answer 96

WRONG: D) A rising ratio may signal investor optimistic and a coming market increase (bullish market), and vice versa.
CORRECT INSTEAD: C) A rising ratio may signal investor pessimism and a coming market decline (bearish market), and vice versa.

Question 97

Which is NOT a hypotheses for the second-pass regression for a one-factor SML?
A) The intercept is zero
B) The slope is equal to the average return on the index portfolio
C) The factor slope coefficient equals the average return on the factor
D) All of the above are correct

Answer 97

WRONG: C) The factor slope coefficient equals the average return on the factor

Question 98

Which is NOT a hypotheses for the second-pass regression for a two-factor SML?
A) The intercept is zero
B) The slope is equal to the average return on the index portfolio
C) The factor slope coefficient equals the average return on the factor
D) All of the above are correct

Answer 98

D) All of the above are correct

Question 99

Concerning the conventional CAPM and CCAPM (consumption CAPM), which of the following statements are NOT true?
A) CCAPM differs from the conventional CAPM in the beta being measured relatively to consumption growth rather than market growth.
B) CCAPM argues that what matters to investors is not their wealth per se, but their lifetime flow of consumption.
C) The conventional CAPM focuses on the covariance of security returns with returns for the market portfolio (which in tracks aggregate wealth), while the consumption-based CAPM focuses on the covariance of security returns with returns for a portfolio that tracks consumption growth.
D) All of the options are correct

Answer 99

D) All of the options are correct

Question 100

Wealth and consumption should be positively correlated and, hence, market volatility and consumption volatility should also be positively correlated. Periods of high market volatility might coincide with periods of high consumption volatility.

Is this statement TRUE/FALSE?

Answer 100

TRUE

Question 101

Which of the following is NOT a determinants for stockholding (i.e., whether to hold stocks and how many stocks to hold) according to John Heaton and Debora Lucas (2000)?
A) Net worht
B) Market volatility
C) Relative business 
D) Age

Answer 101

WRONG: B) Market volatility is NOT a determinant for stockholding.
According to John Heaton and Debora Lucas (2000), significant explanatory variables for stockholding include:
• Net worth: wealthier people hold a larger proportion of stocks.
• Relative business: if you are a business man owning a company, you are less likely to hold stocks, because you are already running risk by running company - i.e., you are not incentivized to increase the risk of your portfolio by adding single stocks.
• Age of respondents: there is a positive coefficient, indicating that the older you are, the more likely you are to hold stocks.

Question 102

Which two ways are most commonly utilized when measuring Average Portfolio Return: 
A) time-weighted (average) returns
B) internal rate of return
C) dollar/ money- weighted returns
D) risk-adjusted return
E) CAPM

Answer 102

A) time-weighted (average) returns

C) dollar/ money- weighted returns

Question 103

When measuring risk-adjusted portfolio performance, which measure is most appropriate if the given portfolio under evaluation represents the entire investment fund of the investor (total investor wealth)?
A) Sharpe ratio
B) Treynor measure
C) Jensen's Alpha
D) Information Ratio

Answer 103

A) Sharpe is the most appropriate performance measure when the portfolio represents the entire investment fund of the investor.

Question 104

When measuring risk-adjusted portfolio performance, which measure is most appropriate when the portfolio under evaluation represents the active portfolio to be optimally mixed with the passive portfolio?
A) Sharpe ratio
B) Treynor measure
C) Jensen's Alpha
D) Information Ratio

Answer 104

D) Information Ratio is most approriate when measuring a portfolio that represents the active portfolio to be optimally mixed with the passive portfolio.

Question 105

When measuring risk-adjusted portfolio performance, which measure is most appropriate when the portfolio is one of many combined into a larger investment fund - i.e., if the portfolio represents one sub portfolio of many owned by the investor? Choose 1-4

A) Sharpe ratio
B) Treynor measure
C) Jensen’s Alpha
D) Information Ratio

Answer 105

If the portfolio is one of many combined into a larger investment fund, use the (C) Jensen’s alpha or (B) Treynor measure. The Treynor measure is appealing because it weighs excess returns against systematic risk. On the other hand, Jensen’s alpha makes inference easier.

Question 106

The evaluation process of portfolio returns is commonly very “noisy”. Therefore, even if the return distribution is stable with a constant mean and variance, many observations and long sample periods are required to eliminate the effect of the “luck of the draw” from the evaluation process.
TRUE/FALSE

Answer 106

TRUE
Think of the example with S&P 500 index compared to the The Markowill Group performance (page 90 in lecture notes). Here, we looked at the difference in relative performance of the Markowill group across horizons (quarter, 1Y, 3Y & 5Y).

Question 107

Following statement is NOT true about market timing:
A) involves movement of asset allocation e.g., (stocks or fixed income securities) and cash, so that the proportion of stocks in your portfolio changes tactically over time
B) entails active investment pursuing stock pricing
C) is mostly pursued by advocates of the efficient market hypothesis
D) actively managed portfolios (which is the case with market timing) make it difficult to assess performance, since it leads to shifting mean and risk, and an ever-changing portfolio beta

Answer 107

WRONG: C) is mostly pursued by advocates of the efficient market hypothesis
Strong belief of EMH entails lack of belief in the ability to beat the market. Therefore, such investors would not attempt to pursue market timing.

Question 108

The difference between the return on a managed portfolio and that of a benchmark portfolio against which the manager is evaluated is referred to as:
A) market timing
B) tracking error
C) bogey
D) comparison universe

Answer 108

B) Tracking error: The difference between the return on a managed portfolio and that of a benchmark portfolio against which the manager is evaluated

Question 109

Asset allocation in which the investment in the market is increased if one forecasts that the market will outperform T-bills. This is active investing, and is referred to as:
A) market timing
B) tracking error
C) bogey
D) comparison universe

Answer 109

A) Market timing: Asset allocation in which the investment in the market is increased if one forecasts that the market will outperform T-bills. This is active investing.
• Market timer: An investor who speculates on broad market moves rather than on specific securities.

Question 110

An average (often a geometric average) of the period-by-period holding-period returns of an investment, which is calculated as the product of the return for each period to the power of 1/n, is referred to as:
A) time-weighted average
B) tracking error
C) dollar-weighted average
D) comparison universe

Answer 110

A) time-weighted average

Question 111

The internal rate of return on an investment is also referred to as:
A) time-weighted average
B) tracking error
C) dollar-weighted average rate of return
D) comparison universe

Answer 111

C) dollar-weighted average rate of return = IRR

Question 112

A set of money managers employing similar investment styles and risk characteristics, used as a benchmark for assessing the relative performance of a portfolio manager, is referred to as _____:
A) time-weighted average
B) tracking error
C) dollar-weighted average rate of return
D) comparison universe

Answer 112

D) comparison universe
Comparing a portfolio’s return with the returns on a comparison universe is the simplest and most popular way to adjust returns for risk.

Question 113

The reward-to-volatility ratio; ratio of excess return to portfolio standard deviation is referred to as:
A) Treynor’s measure
B) Jensen's alpha
C) Information ratio
D) Sharpe ratio

Answer 113

D) Sharpe ratio: the reward-to-volatility ratio; ratio of excess return to portfolio standard deviation

Question 114

\_\_\_\_\_\_ expresses the ratio of the average excess return of the portfolio in respect to the weighted average beta of the portfolio (systematic risk). This indicates the average return in respect to systematic of total risk. The measure gives us the slope of the SML, going through the origin to the specific portfolio we are measuring.
A) Treynor’s measure
B) Jensen's alpha
C) Information ratio
D) Sharpe ratio

Answer 114

A) Treynor’s measure: ratio of average excess return of portfolio to the weighted average portfolio beta. This tells us the average return in respect to systematic of total risk

Question 115

_____ is the relation of the specific point relative to SML. If ____ is positive, the manager under evaluation is overperforming the market, and the point would be above the SML.

A) Treynor’s measure
B) Jensen’s alpha
C) Information ratio
D) Sharpe ratio

Answer 115

B) Jensen’s alpha: the alpha of an investment, which tells us whether the given portfolio manager is overperforming the market. (If alpha is positive: yes; if alpha is negative: no)

Question 116

\_\_\_\_\_\_ is a version of a reward-to-risk ratio, which divides the alpha of the portfolio by the nonsystematic/ firm-specific risk of the portfolio.  This ratio quantifies the trade-off between alpha and diversifiable risk, and it measures abnormal return per unit of risk that in principle could be diversified away by holding a market.
A) Treynor’s measure
B) Jensen's alpha
C) Information ratio
D) Sharpe ratio

Answer 116

Information ratio: Ratio of alpha to the standard deviation of diversifiable risk (firm-specific risk). It measures abnormal return (relative to market) per unit of risk that in principle could be diversified away by holding a market. This difference between the return on the portfolio and that of a benchmark portfolio against which the manager is evaluated is called “tracking error”.

Question 117

The return an investment manager is compared to for performance evaluation i referred to as a _____. It typically refers to a specific benchmark that is set by the fund company as a close comparison for the fund itself.

A) market timing
B) tracking error
C) bogey
D) information ratio

Answer 117

C) bogey

Question 118

In terms of “forward looking” statistics, the arithmetic average is the better estimate of expected rate of return (compared to geometric average return).
TRUE/FALSE

Answer 118

TRUE: In terms of “forward looking” statistics, the ARITHMETIC AVERAGE is the better estimate of expected rate of return (compared to geometric average return).

Question 119

When computing the parameter of average return, we always use _____, while we use the ____ when computing the increase in wealth.

A) Arithmetric average return; geometric average return
B) Geometric average return; arithmetric average return

Answer 119

This is important!!!
When computing the parameter of average return, we always use ARITHMETRIC AVERAGE RETURN, while we use the GEOMETRIC AVERAGE RETURN when computing the increase in wealth.

Question 120

The time weighted return differs from money-weighted return in that it puts equal weight on each period, while the money-weighted return puts a different weight on periods on the basis of the in- and outflows during each period.

TRUE/ FALSE

Answer 120

TRUE

Question 121

The arithmetic average is always greater than or equal to the geometric average; the greater the dispersion, the greater the difference – i.e., the higher the arithmetic average relative to geometric average.
TRUE/ FALSE

Answer 121

TRUE: The arithmetic average is always greater than or equal to the geometric average; the greater the dispersion, the greater the difference – i.e., the higher the arithmetic average relative to geometric average.

Question 122

If we are evaluating portfolios that will be invested alongside with an index portfolio (i.e., neither portfolio A or B will make up the investor’s total wealth allocated in not risk-free investments), we can utilize which measure? Select 1-4
A) Jensen’s alpha
B) Sharpe ratio
C) Information ratio
D) Treynor measure

Answer 122

A) Jensen’s alpha & D) Treynor measure.
If the portfolio under evaluation is one of many combined into a larger investment fund, we may use Jensen’s alpha or Treynor measure. The Treynor measure is appealing because it weighs excess returns against systematic risk. On the other hand, Jensen’s alpha makes inference easier.

Question 123

If the portfolio under evaluation is to represent the entire risky investment of the investor’s wealth (everything beyond risk-free investments), which measure of performance is most appropriate? Select 1-4
A) Jensen’s alpha
B) Sharpe ratio
C) Information ratio
D) Treynor measure

Answer 123

B) Sharpe ratio

If the portfolio under evaluation represents the entire risky investment, i.e., if investor is considering allocating capital in asset/portfolio A or B, and the given decision would completely change the total volatility profile of the investor’s wealth, then we use the Sharpe measure.

Question 124

If the alpha (jensen’s aplha) of portfolio A (under consideration) is equal to 1.4%, while the expected return on portfolio A is equal to 12%, which of the statements are then NOT true?
A) Portfolio A would allow the investor to gain additional 1.4% of return
B) The required return in order to compensate for taking on the systematic risk connected to allocating funds in portfolio A is met and exceeded
C) The required return in order for the investor to allocate assets in portfolio A is equal to 1.4%
D) the required return in order for the investor to allocate assets in portfolio A is equal to 10.6%

Answer 124

WRONG: C) The required return in order for the investor to allocate assets in portfolio A is equal to 1.4%
INSTEAD: D) the required return in order for the investor to allocate assets in portfolio A is equal to 10.6%:

Expected return - jensen’s alpha = required return for the investor:
12% - 1.4% = 10.6%

Question 125

If the alpha (jensen’s aplha) of portfolio B (under consideration) is equal to -0.2%, while the expected return on portfolio B is equal to 16%, which of the statements are then TRUE?
A) Portfolio B would allow the investor to gain additional 0.2% of return
B) The required return in order to compensate for taking on the systematic risk connected to allocating funds in portfolio B is met and exceeded - therefore, portfolio B would be a good investment
C) The required return in order for the investor to allocate assets in portfolio B is equal to 16.2%
D) the required return in order for the investor to allocate assets in portfolio B is equal to 0.2%

Answer 125

CORRECT: C) The required return in order for the investor to allocate assets in portfolio B is equal to 16.2%

All other answers are wrong.

Portfolio B would NOT allow the investor to meet the required return: with the negative alpha, it means that the investor’s required return in order to compensate for taking on the systematic risk connected to allocating funds in portfolio B is NOT met by its expected return of 16%. In this case, the investor would in fact require: 16%+0.2%=16.2%. Thus, he/she should not invest in portfolio B.

Question 126

Graphically, the alpha(intecept) indicates ______ , while the coefficient multiplying square (convex/ concave curve) indicates the _____

A) stock-picking ability; market timing
B) market timing; stock picking ability

Answer 126

Graphically, the alpha(intecept) indicates STOCK-PICKING ABILITY , while the coefficient multiplying square (convex/ concave curve) indicates the MARKET TIMING.

The higher the alpha(intercept), the better the stock-picking ability of an asset manager.

Question 127

A _____ curve entails good market timing - i.e., a good time to buy stocks, and a ____ curve entails poor market timing - i.e., a bad time to buy stocks
A) convex
B) concave

Answer 127

A CONVEX curve entails good market timing - i.e., a good time to buy stocks, and a CONCAVE curve entails poor market timing - i.e., a bad time to buy stocks

Question 128

Following is NOT true about Roll’s critique to testing CAPM using first- and second pass regressions.

A) Roll suggests that the problem begins with the market index, which is not the theoretical portfolio against which the second pass regression should hold. Instead, one should use the return of a zero-beta stock portfolio as a proxy for risk free rate.
B) According to Roll, even if the relationship is valid with respect to the true (unknown) index, we may not find it. As a result, the second pass relationship may be meaningless.
C) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low
D) According to Roll, we would need also data on the individual investors’ wealth. Not knowing the true composition of the market portfolio makes the CAPM untestable.

Answer 128

WRONG: C) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low. This is not part of Roll’s critique. Instead, Roll argues that due to lack of data on market portfolio composition, i.e., the wealth of the investor, CAPM is untestable. Instead, one should use a portfolio of zero-beta stocks as the theoretical portfolio against which the second pass regression should hold. This zero-beta portfolio return would be a substitute for the risk free rate.

Question 129

Following is NOT true about measurement error in CAPM test:
A) In reality, we cannot observe the true beta nor expected return, which we in turn need to estimate. By construct, an estimation entails some degree of measurement error.
B) If it was possible to observe the true beta, and the true expected return, it would be very easy to test for the CAPM due to no measurement error.
C) The effect of measurement errors can be reduced by looking at portfolios rather than individual securities, since the latter case, e.g., a high-beta security is more likely to be affected by a positive measurement error. Instead, in a portfolio of e.g., 50 stocks, it is more likely that a positive measurement error is offset by a negative measurement error in another stock. The basket is more stable than the individual components.
D) All options are correct

Answer 129

D) All options are correct

Question 130

Following is NOT true about bubbles:
A) The price of stocks can be explained on the basis of fundamentals such as expectations of dividends discounted by an appropriate discount rate, reflecting the time value of money and risk. Bubbles, however, to some extent, represent deviations from fundamental market efficiencies.
B) Bubbles is an extra component of the price that simply depends on the expectations that the price is moving up in the coming period. I.e., in the presence of a bubble, prices appear to differ from intrinsic values. It is suggested that the price of a stock in the market is equal to the sum of the fundamental value and the bubble (if there is one)
C) Bubbles are difficult to predict and exploit. We only know the price of the stock, not the actual value. Thus, we cannot determine accurately the size of the bubble, and it is difficult to determine whether there is a bubble, and if yes, how big.
D) Bubbles are easier to spot right before they burst
E) Bubbles are easier to spot after they burst

Answer 130

WRONG: D) Bubbles are easier to spot right before they burst.
INSTEAD: E) Bubbles are easier to spot after they burst

Question 131

Following is NOT trues about Technical analysis:
A) uses prices and volume information to predict stock price patterns and to proxy buy or sell pressure in the market.
B) is always more optimistic in predicting future stock prices than fundamental analysis provided that market is efficient
C) If we were able to show that technical analysis was actually successful in predicting stock prices, we would provide the results of a weak form of market efficiency, since we would be able to predict prices simply on the basis on past prices and volume.
D) All of the above are true

Answer 131

WRONG: B) Both technical analysis (B) and fundamental analysis (C) are based on public information, and thus, neither should generate excess profits if markets are operating efficiently.

Question 132

Following is NOT true about a “market neutral” investment strategy for hedge funds:

A) A market-neutral hedge fund would not be a good candidate for an investor’s entire retirement portfolio, because such fund is not a diversified portfolio.
B) The term “market neutral” refers to a portfolio position designed to exploit relative mispricing within a market but which is hedged to avoid taking a stance on the direction of the broad market.
C) Market neutral means that beta is equal to 0, and that the investment is risk free
D) A market neutral HF can be thought of as an possible approach for the investor to add alpha to a more passive investment position such as an index mutual fund.

Answer 132

WRONG: C) Market neutral means that beta is equal to 0, and that the investment is risk free

Market-neutral: A strategy designed to exploit relative mispricing within a market but which is hedged to avoid taking a stance on the direction of the broad market.

Question 133

Which of the following is NOT a reason for why it is harder to assess the performance of a hedge fund portfolio manager than that of a typical mutual fund manager?
A) Backfill bias: bias in the average returns of a sample of funds induced by including past returns on funds that entered the sample only if they happened to be successful. Hedge funds report returns only if they choose to, and they may do so only when their prior performance is good. This leads overstatement of the returns relative to what has actually materialized.
B) HFs tend to invest more in illiquid assets - so apparent positive alpha investments may be a compensation for illiquidity
C) HFs’ valuation of illiquid assets may be questionable (e.g., due to side pockets)
D) Survivorship bias: bias in the average returns of a sample of funds induced by excluding past returns on funds that left the sample because they happened to be unsuccessful. This arises when build a sample from the end of history rather than from the beginning.
E) All of the options are reasons that make HF managers’ performance more difficult to assess

Answer 133

E) All of the options are reasons that make HF managers’ performance more difficult to assess

Question 134

Which of the following is most accurate in describing the problems of survivorship bias and backfill bias in the performance evaluation of hedge funds?

a. Survivorship bias and backfill bias both result in upwardly biased hedge fund index returns.
b. Survivorship bias and backfill bias both result in downwardly biased hedge fund index returns.
c. Survivorship bias results in upwardly biased hedge fund index returns, but backfill bias results in downwardly biased hedge fund index returns.

Answer 134

a. Survivorship bias and backfill bias both result in upwardly biased hedge fund index returns.

Question 135

Which of the following would be the most appropriate benchmark to use for hedge fund evaluation?

a. A multifactor model
b. The S&P 500
c. The risk-free rate

Answer 135

b. The S&P 500: In the US, most HFs are benchmarked against the S&P 500, and it is said that the performance of the HF is good if it outperforms the S&P 500

Question 136

With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than that earned from an individual hedge fund because of:

a. Both the extra layer of fees and the higher liquidity offered.
b. No reason; funds of funds earn returns that are equal to those of individual hedge funds.
c. The extra layer of fees only.

Answer 136

C) The extra layer of fees only - FoF is not more liquid than direct investment in HFs.

Funds of funds invest in various best-performing hedge funds based on performance evaluation. For this “filtering service”, the fund managers of a fund-of-funds charge an extra layer of fees. This will decrease the net return for investors in FoF relative to direct investments in HFs.

Question 137

Which of the following hedge fund types is most likely to have a return that is closest to risk-free?

a. A market-neutral hedge fund.
b. An event-driven hedge fund.
c. A long/short hedge fund.

Answer 137

A) A market neutral HF uses a combination of long and short positions on assets to avoid risk and maximize returns. Thus, return can be said to closely mimic the risk-free market rate.

Question 138

Statistical arbitrage is not true arbitrage, because it does not involve establishing risk-free positions based on security mispricing. Statistical arbitrage is essentially a portfolio of risky bets. The hedge fund takes a large number of small positions based on apparent small, temporary market inefficiencies, relying on the probability that the expected return for the totality of these bets is positive.

TRUE/ FALSE

Answer 138

TRUE

Question 139

A hedge fund with net asset value of $62 per share currently has a high water mark of $66. Which of the following statements are TRUE? Choose 1-4
A) The incentive fee is less valuable if the high-water mark is $67 rather than $66
B) The current incentive fee paid out to the HF is higher now than if the HWM were at $67
C) The incentive fee is more valuable if the high-water mark is $67 rather than $66
D) The current incentive fee paid out to the HF is lower now than if the HWM were at $67

Answer 139

CORRECT: A) The incentive fee is LESS valuable if the high-water mark is $67 rather than $66. With a HWM of $67, the NAV of the fund must reach $67 before the HF can assess the incentive fee. The HWM for a HF is equivalent to the exercise price of a call option on an asset with a current market value equal to the NAV of the fund - I.E., IF EXERCISE PRICE OF CALL OPTION IS HIGHER, THE CALL OPTION VALUE IS LOWER.

NOTE: the HF will not be paid any incentive fees since the NAV is lower than both $67 and $66 (HWM). Thus, B and D are both wrong.

Question 140

A security market line (SML) plots:
A) the returns of one security against the return of another security: a pair of returns
B) the excess return on a security over the risk-free rate as a function of the excess return on the market over the risk-free rate.
C) the expected return of the asset against the systematic risk
D) the excess return on a security against its price

Answer 140

C) the expected return of the asset against the systematic risk

The SML is a graphical representation of the expected return–beta (systematic risk) relationship.

Question 141

_____ level is an upper price level for a security or commodity that is repeatedly reached but not exceeded due to resistance from the market.

A) Resistance
B) Support
C) Momentum
D) Abnormal

Answer 141

A) RESISTANCE level is an upper price level for a security or commodity that is repeatedly reached but not exceeded due to resistance from the market.

Example: stock XYZ is traded for several months at a price of $72 and then declined to $65. If the stock eventually begins to increase in price, $72 will be considered a resistance level, because investors who bought originally at $72 will be eager to sell their shares as soon as they can break even on their investment. Therefore, at prices near $72, a wave of selling pressure will occur. Such activity imparts a type of “memory” to the market that allows past price history to influence current stock prospects.

Question 142

____ levels refer to the price level that an asset does not fall below for a period of time.

A) Resistance
B) Support
C) Momentum
D) Abnormal

Answer 142

Support levels refer to the price level that an asset does not fall below for a period of time. It is the opposite of resistance level.

It indicates e.g., that if a stock is bought at a price of 65, and afterward increases to 72. Eventually, if the stock price again declines, a wave of buying investors will happen as the price falls to 65 (the support level).

Question 143

Cumulative abnormal return (CAR) is the total abnormal return for the period surrounding an announcement or the release of information.

TRUE/ FALSE

Answer 143

TRUE

Question 144

Anomalies: patterns of returns that seem to contradict the efficient market hypothesis.

TRUE/ FALSE

Answer 144

TRUE

Question 145

Jagannathan and Wang study shows two important deficiencies in tests of the single-index model. Which are not part of these two?
A) A human capital factor may be important in explaining returns. The study proves that the model including the human capital factor performs better than the CAPM
B) The study finds that beta is actually cyclical and changes over time depending on the market activity and the state of the economy - therefore, the CAPM and the index model, where we assume constant beta - are suboptimal.
C) if human capital factor and dynamic beta are incorporated in explaining expected returns, anomalies such as the size and book-to-market effects are mitigated
D) Net worth is a significant explanatory variable: wealthier people hold a larger proportion of stocks.

Answer 145

WRONG: D) Net worth is a significant explanatory variable: wealthier people hold a larger proportion of stocks. This is found in a study by John Heaton and Debora Lucas.

The other options correctly sum up Jagannathan and Wang’s study.

Question 146

According to John Heaton and Debora Lucas (2000), which of the following are determinants for stock holding? I.e., determinants that affect the attractiveness of holding stocks. Select 1-4:
A) Net worth: wealthier people hold a larger proportion of stocks
B) Relative business: if you are a businessman owning a company, you are less likely to hold liquid stocks because you are not incentivized to increase the risk of your portfolio by adding single stocks
C) Age of respondent: the older you are, the more likely you are to hold stocks
D) Investment experience: if you are a very experienced trader, the chances of holding stocks relative to market index is higher

Answer 146

A) Net worth: wealthier people hold a larger proportion of stocks
B) Relative business: if you are a businessman owning a company, you are less likely to hold liquid stocks because you are not incentivized to increase the risk of your portfolio by adding single stocks
C) Age of respondent: the older you are, the more likely you are to hold stocks

Question 147

The consumption-based asset pricing model (CCAPM) is exactly like the regular CAPM, but differs in the beta being measured relatively to consumption growth rather than market. It implies that what matters to investors is not their wealth per se, but their lifetime flow of consumption. Given this framework, the generalization of the standard CAPM is that instead of measuring systematic risk based on the covariance of returns with the market return (a measure that focuses only on wealth), we are better off using the covariance of returns with aggregate/ economywide consumption.

TRUE/ FALSE

Answer 147

TRUE

Question 148

How does variance (standard deviation) of portfolio return affect the geometric mean and arimethic mean?

Answer 148

The higher the dispersion (standard deviation), the lower the geometric mean is relative to the aritmetci mean - the larger the difference between the two.

The arithmetic average is always greater than or equal to the geometric average; the greater the dispersion, the greater the difference – i.e., the higher the arithmetic average relative to geometric average.

Question 149

Exchange rate risk imparts an extra source of uncertainty to investments denominated in foreign currencies. Much of that risk can be hedged in foreign exchange futures or forward markets, but a perfect hedge is not feasible unless the FOREIGN CURRENCY RATE OF RETURN is known.

TRUE/ FALSE

Answer 149

TRUE

Question 150

Interest rate parity relationship is the relation between spot and forward exchange rates and foreign and domestic interest rates that rules out arbitrage opportunities.

TRUE/ FALSE

Answer 150

TRUE

Question 151

In terms of hedge funds strategies, which of the following options refers to:
Bets on particular mispricing across two or more SECURITIES, with extraneous sources of risk such as general market exposure hedged away.

A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage

Answer 151

Pure plays: Bets on particular mispricing across two or more securities, with extraneous sources of risk such as general market exposure hedged away

Question 152

In terms of hedge funds strategies, which of the following options refers to:
Bets that one sector or another will outperform other sectors. I.e., directional funds take a stance on the performance of broad market sectors, NO HEDGING.

A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage

Answer 152

B) directional strategy

Question 153

In terms of hedge funds strategies, which of the following options refers to:
Exploiting temporary misalignments (mispricing) in relative valuation across SECTORS – this entails buying one type of security and selling another. Such hedge funds establish market-neutral positions on relative mispricing. However, even these hedged positions still present idiosyncratic risk.

A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage

Answer 153

C) nondirectional strategy

Question 154

In terms of hedge funds strategies, which of the following options refers to:
The use of quantitative systems to uncover many perceived misalignments in relative pricing and ensure profits by averaging over all of these small bets. It often uses datamining methods to uncover past patterns that form the basis for the investment positions.

A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage

Answer 154

D) statistical arbitrage

Question 155

A strategy in which a hedge fund invests in positive alpha positions, then hedge the systematic risk of that investment (you short the market) in order to isolate its alpha, and, finally, establish market exposure to desired market sectors by using passive indexes such as mutual funds or ETFs.

This strategy is referred to as?

Answer 155

Portable alpha

The idea is to transfer alpha from the sector where you find it to the asset class in which you ultimately establish exposure. You hedge against fall in the market and target absolute returns: if market goes up, you get alpha as return, and if market goes down, you still get alpha as return.

Question 156

In the context of hedge fund styles/strategies, a hedged investing in convertible securities, typically long convertible bonds and short stock. I.e., you buy the equities and the bond convertibles issued by the same company.
This is referred to as:

A) Convertible arbitrage
B) Dedicated short bias
C) Event-driven
D) (Equity) market neutral

Answer 156

A) Convertible arbitrage: a hedged investing in convertible securities, typically long convertible bonds and short stock. I.e., you buy the equities and the bond convertibles issued by the same company.
This is referred to as:

Question 157

(Equity) Market neutral DOES NOT refer to when hedge funds:

A) Commonly uses long/short hedges
B) Typically controls for industry, sector, size, and other exposures, and establishes market-neutral positions designed to exploit some market inefficiency (relative mispricing).
C) Commonly involves leverage.
D) Net short position, usually in equities, as opposed to pure short exposure.
E) Hedged to avoid taking a stance on the direction of the broad market.

Answer 157

WRONG: D) Net short position, usually in equities, as opposed to pure short exposure - this is a “dedicated short bias” strategy.

Question 158

Following is NOT true about the event-driven hedge fund strategy:
A) Attempts to profit from situations such as mergers, acquisitions, restructuring, bankruptcy, or reorganization
B) It is a market-neutral strategy
C) No anticipation, and action is taken first after the announcement of the corporate event.

Answer 158

WRONG: B) It is a market-neutral strategy

Question 159

A market-neutral hedge fund would NOT be a good candidate for an investor’s entire retirement portfolio, because such fund is not a diversified portfolio. The term “market neutral” refers to a portfolio position with respect to specified market inefficiency.
However, there could be a role for a market-neutral hedge fund in the investor’s overall portfolio; the market-neutral HF can be thought of as an approach for the investor to add alpha to a more passive investment position such as an index mutual fund.

TRUE/ FALSE

Answer 159

TRUE