File: Chap06, CHAPTER 6: PORTFOLIO SELECTION

Multiple Choice Questions

1.
The Capital Allocation Line can be described as the
A)
investment opportunity set formed with a risky asset and a risk-free asset.
B)
investment opportunity set formed with two risky assets.
C)
line on which lie all portfolios that offer the same utility to a particular investor.
D)
line on which lie all portfolios with the same expected rate of return and different
standard deviations.
E)
none of the above.
Answer:
A
Difficulty:
Moderate
Response:
The CAL has an intercept equal to the risk-free rate. It is a straight line through
the point representing the risk-free asset and the risky portfolio, in expected-return/standard
deviation space.

2.
Which of the following statements regarding the Capital Allocation Line (CAL) is
false?
A)
The CAL shows risk-return combinations.
B)
The slope of the CAL equals the increase in the expected return of a risky portfolio per
unit of additional standard deviation.
C)
The slope of the CAL is also called the reward-to-variability ratio.
D)
The CAL is also called the efficient frontier of risky assets in the absence of a risk-free
asset.
E)
both a and d are true.
Answer:
D
Difficulty:
Moderate
Response:
The CAL consists of combinations of a risky asset and a risk-free asset whose
slope is the reward-to-variability ratio; thus, all statements except d are true.

3.
A)
B)
C)
D)

Given the capital allocation line, an investor's optimal portfolio is the portfolio that
maximizes her expected profit.
maximizes her risk.
minimizes both her risk and return.
maximizes her expected utility.

E)

none of the above.

Answer:
D
Difficulty:
Moderate
Response:
By maximizing expected utility, the investor is obtaining the best risk-return
relationships possible and acceptable for her.

4.
An investor invests 30 percent of his wealth in a risky asset with an expected rate of
return of 0.15 and a variance of 0.04 and 70 percent in a T-bill that pays 6 percent. His
portfolio's expected return and standard deviation are __________ and __________,
respectively.
A)
0.114; 0.12
B)
0.087;0.06
C)
0.295; 0.12
D)
0.087; 0.12
E)
none of the above
Answer:
Difficulty:
Response:

B
Moderate
E(rP) = 0.3(15%) + 0.7(6%) = 8.7%; sP = 0.3(0.04)1/2 = 6%.

Reference: Case 6-1

You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation
of 0.15 and a T-bill with a rate of return of 0.05.

5.
What percentages of your money must be invested in the risky asset and the risk-free
asset, respectively, to form a portfolio with an expected return of 0.09?
A)
85% and 15%
B)
75% and 25%
C)
67% and 33%
D)
57% and 43%
E)
cannot be determined
Refer to: Case 6-1
Answer:
D
Difficulty:
Moderate
Response:
9% = w1(12%) + (1 - w1)(5%); 9% = 12%w1 + 5% - 5%w1; 4% = 7%w1; w1 =
0.57; 1 - w1 = 0.43; 0.57(12%) + 0.43(5%) = 8.99% .

6.
What percentages of your money must be invested in the risk-free asset and the risky
asset, respectively, to form a portfolio with a standard deviation of 0.06?
A)
30% and 70%
B)
50% and 50%
C)
60% and 40%
D)
40% and 60%
E)
cannot be determined
Refer to: Case 6-1
Answer:
Difficulty:
Response:

7.
A)
B)
C)
asset.
D)
E)

D
Moderate
0.06 = x(0.15); x = 40% in risky asset.

A portfolio that has an expected outcome of $115 is formed by

investing $100 in the risky asset.
investing $80 in the risky asset and $20 in the risk-free asset.
borrowing $43 at the risk-free rate and investing the total amount ($143) in the risky
investing $43 in the risky asset and $57 in the riskless asset.
Such a portfolio cannot be formed.

Refer to: Case 6-1

Answer:
C
Difficulty:
Difficult
Response:
For $100, (115-100)/100=15%; .15 = w1(.12) + (1 - w1)(.05); .15 = .12w1 + .05
- .05w1; 0.10 = 0.07w1; w1 = 1.43($100) = $143; (1 - w1)$100 = -$43.

8.
The slope of the Capital Allocation Line formed with the risky asset and the risk-free
asset is equal to
A)
0.4667
B)
0.8000
C)
2.14
D)
0.41667
E)
Cannot be determined.
Refer to: Case 6-1

Answer:
Difficulty:
Response:

A
Moderate
(0.12 - 0.05)/0.15 = 0.4667.

9.
Consider a T-bill with a rate of return of 5 percent and the following risky
securities:Security A: E(r) = 0.15; Variance = 0.04Security B:
E(r) = 0.10; Variance =
0.0225Security C:
E(r) = 0.12; Variance = 0.01Security D:
E(r) = 0.13; Variance =
0.0625From which set of portfolios, formed with the T-bill and any one of the 4 risky securities,
would a risk-averse investor always choose his portfolio?
A)
The set of portfolios formed with the T-bill and security A.
B)
The set of portfolios formed with the T-bill and security B.
C)
The set of portfolios formed with the T-bill and security C.
D)
The set of portfolios formed with the T-bill and security D.
E)
Cannot be determined.
Answer:
Difficulty:
Response:

C
Difficult
Security C has the highest reward-to-volatility ratio.

Reference: Case 6-2

You are considering investing $1,000 in a T-bill that pays 0.05 and a risky portfolio, P,
constructed with 2 risky securities, X and Y. The weights of X and Y in P are 0.60 and 0.40,
respectively. X has an expected rate of return of 0.14 and variance of 0.01, and Y has an
expected rate of return of 0.10 and a variance of 0.0081.

10.
If you want to form a portfolio with an expected rate of return of 0.11, what percentages
of your money must you invest in the T-bill and P, respectively?
A)
0.25; 0.75
B)
0.19; 0.81
C)
0.65; 0.35
D)
0.50; 0.50
E)
cannot be determined
Refer to: Case 6-2
Answer:
Difficulty:
Response:
(T-bills).

B
Moderate
E(rp) = 0.6(14%) + 0.4(10%) = 12.4%; 11% = 5x + 12.4(1 - x); x = 0.189 = 0.19

11.
If you want to form a portfolio with an expected rate of return of 0.10, what percentages
of your money must you invest in the T-bill, X, and Y, respectively if you keep X and Y in the
same proportions to each other as in portfolio P?
A)
0.25; 0.45; 0.30
B)
0.19; 0.49; 0.32
C)
0.32; 0.41; 0.27
D)
0.50; 0.30; 0.20
E)
cannot be determined
Refer to: Case 6-2
Answer:
C
Difficulty:
Difficult
Response:
E(rp) = .10; .10 = 5w + 12.4(1 - w); x = 0.32 (weight of T-bills); As composition
of X and Y are .6 and .4 of P, respectively, then for 0.68 weight in P, the respective weights
must be 0.41 and 0.27; .6(.68) = 41%; .4(.68) = 27%

12.
What would be the dollar values of your positions in X and Y, respectively, if you
decide to hold 40% percent of your money in the risky portfolio and 60% in T-bills?
A)
$240; $360
B)
$360; $240
C)
$100; $240
D)
$240; $160
E)
cannot be determined
Refer to: Case 6-2
Answer:
Difficulty:
Response:

D
Moderate
$400(0.6) = $240 in X; $400(0.4) = $160 in Y.

13.
What would be the dollar value of your positions in X, Y, and the T-bills, respectively,
if you decide to hold a portfolio that has an expected outcome of $1,200?
A)
Cannot be determined
B)
$54; $568; $378
C)
$568; $54; $378
D)
$378; $54; $568
E)
$108; $514; $378

Refer to: Case 6-2

Answer:
B
Difficulty:
Difficult
Response:
($1,200 - $1,000)/$1,000 = 12%; (0.6)14% + (0.4)10% = 12.4%; 12% = w5% +
12.4%(1 - w);w=.054; 1-w=.946; w = 0.054($1,000) = $54 (T-bills); 1 - w = 1 - 0.054 =
0.946($1,000) = $946; $946 x 0.6 = $568 in X; $946 x 0.4 = $378 in Y.

14.
A)
B)
C)
D)
E)

A reward-to-volatility ratio is useful in:

measuring the standard deviation of returns.
understanding how returns increase relative to risk increases.
analyzing returns on variable rate bonds.
assessing the effects of inflation.
none of the above.

Answer:
Difficulty:
Response:

15.
A)
B)
C)
D)
E)

B
Moderate
B is the only choice relevant to the reward-to-volatility ratio (risk and return).

The change from a straight to a kinked capital allocation line is a result of:
reward-to-volatility ratio increasing.
borrowing rate exceeding lending rate.
an investor's risk tolerance decreasing.
increase in the portfolio proportion of the risk-free asset.
none of the above.

Answer:
B
Difficulty:
Difficult
Response:
The linear capital allocation line assumes that the investor may borrow and lend
at the same rate (the risk-free rate), which obviously is not true. Relaxing this assumption and
incorporating the higher borrowing rates into the model results in the kinked capital allocation
line.

16.
A)
B)
C)
D)
E)

The first major step in asset allocation is:

assessing risk tolerance.
analyzing financial statements.
estimating security betas.
identifying market anomalies.
none of the above.

Answer:
A
Difficulty:
Moderate
Response:
A should be the first consideration in asset allocation. B, C, and D refer to
security selection.

17.
A)
B)
C)
D)
E)

Based on their relative degrees of risk tolerance

investors will hold varying amounts of the risky asset in their portfolios.
all investors will have the same portfolio asset allocations.
investors will hold varying amounts of the risk-free asset in their portfolios.
a and c.
none of the above.

Answer:
D
Difficulty:
Easy
Response:
By determining levels of risk tolerance, investors can select the optimum
portfolio for their own needs; these asset allocations will vary between amounts of risk-free and
risky assets based on risk tolerance.

18.
A)
B)
C)
D)
E)

Passive investing
may be accomplished by investing in index mutual funds.
involves considerable security selection.
involves considerable transaction costs.
a and c.
b and c.

Answer:
A
Difficulty:
Easy
Response:
Passive investing involves virtually no security selection and minimal
transaction costs if accomplished via investing in index mutual funds.

19.
A)
B)
C)
D)
E)

Asset allocation
may involve the decision as to the allocation between a risk-free asset and a risky asset.
may involve the decision as to the allocation among different risky assets.
may involve considerable security analysis.
a and b.
a and c.

Answer:
Difficulty:
Response:

D
Easy
A and B are possible steps in asset allocation. C is related to security selection.

20.
In the mean-standard deviation graph, the line that connects the risk-free rate and the
optimal risky portfolio, P, is called ______________
A)
the Security Market Line
B)
the Capital Allocation Line
C)
the Indifference Curve
D)
the investor's utility line
E)
none of the above
Answer:
B
Difficulty:
Moderate
Response:
The Capital Allocation Line (CAL) illustrates the possible combinations of a
risk-free asset and a risky asset available to the investor.

21.
A)
B)
C)
D)
E)

Treasury bills are commonly viewed as risk-free assets because

their short-term nature makes their values insensitive to interest rate fluctuations.
the inflation uncertainty over their time to maturity is negligible.
their term to maturity is identical to most investors' desired holding periods.
both a and b are true.
both b and c are true.

Answer:
D
Difficulty:
Easy
Response:
Treasury bills do not exactly match most investor's desired holding periods, but
because they mature in only a few weeks or months they are relatively free of interest rate
sensitivity and inflation uncertainty.

22.
When a portfolio consists of only a risky asset and a riskless asset, increasing the
fraction of the overall portfolio invested in the risky asset will
A)
increase the expected return on the portfolio.
B)
increase the standard deviation of the portfolio.
C)
not change the risk-reward ratio.
D)
neither a, b nor c are true.
E)
a, b and c are all true.
Answer:
E
Difficulty:
Easy
Response:
All three statements correctly describe a portfolio invested in a combination of a
risky asset and a riskless asset.

23.
In a top-down analysis of portfolio construction
A)
decisions about which executives will manage the portfolio are made first, then capital
allocation decisions are made.
B)
decisions about asset allocation are made first, then specific securities are chosen.
C)
decisions about specific securities are made first, then asset allocation decisions are
made.
D)
all securities transactions must be approved by upper-level management.
E)
an investor's first decision would be about how much to hold in her favorite stock.
Answer:
B
Difficulty:
Moderate
Response:
This is the approach most often used by institutional investors. Individual
investors typically follow a less-structured approach.

24.
When wealth is shifted from the risky portfolio to the risk-free asset, what happens to
the relative proportions of the various risky assets within the risky portfolio?
A)
They all decrease.
B)
Some increase and some decrease.
C)
They all increase.
D)
They are not changed.
E)
The answer depends on the specific circumstances.
Answer:
D
Difficulty:
Moderate
Response:
A shift in the proportion of the investor's portfolio that is held in the risky
portfolio (variable in the text) changes only the proportion held in the risk-free asset (1-y). The
composition of the underlying portfolio of risky assets remains unchanged.

Reference: Table 6-1

Your client, Bo Regard, holds a complete portfolio that consists of a portfolio of risky assets (P)
and T-Bills. The information below refers to these assets.
E(Rp)
Standard Deviation of P
T-Bill rate

12.00%
7.20%
3.60%

Proportion of Complete Portfolio in P

Proportion of Complete Portfolio in T-Bills

80%
20%

Composition of P:
Stock A
Stock B
Stock C
Total

25.
A)
B)
C)
D)
E)

40.00%
25.00%
35.00%
100.00%

What is the expected return on Bo's complete portfolio?

10.32%
5.28%
9.62%
8.44%
7.58%

Refer to: Table 6-1

Answer:
Difficulty:
Response:

26.
A)
B)
C)
D)
E)

A
Easy
E(rC) = .8*12.00% + .2*3.6% = 10.32%

What is the standard deviation of Bo's complete portfolio?

7.20%
5.40%
6.92%
4.98%
5.76%

Refer to: Table 6-1

Answer:
Difficulty:
Response:

27.
A)
B)
C)
D)
E)

E
Easy
Std. Dev. of C = .8*7.20% = 5.76%

What is the equation of Bo's Capital Allocation Line?

E(rC) = 7.2 + 3.6 * Standard Deviation of C
E(rC) = 3.6 + 1.167 * Standard Deviation of C
E(rC) = 3.6 + 12.0 * Standard Deviation of C
E(rC) = 0.2 + 1.167 * Standard Deviation of C
E(rC) = 3.6 + 0.857 * Standard Deviation of C

Refer to: Table 6-1

Answer:
B
Difficulty:
Moderate
Response:
The intercept is the risk-free rate (3.60%) and the slope is
(12.00%-3.60%)/7.20% = 1.167.

28.
A)
B)
C)
D)
E)

What are the proportions of Stocks A, B, and C, respectively in Bo's complete portfolio?
40%, 25%, 35%
8%, 5%, 7%
32%, 20%, 28%
16%, 10%, 14%
20%, 12.5%, 17.5%

Refer to: Table 6-1

Answer:
C
Difficulty:
Moderate
Response:
Proportion in A = .8 * 40% = 32%; proportion in B = .8 * 25% = 20%;
proportion in C = .8 * 35% = 28%.

29.
I)
II)
III)
IV)
A)
B)
C)
D)
E)

The Capital Market Line

is a special case of the Capital Allocation Line
represents the opportunity set of a passive investment strategy
has the one-month T-Bill rate as its intercept
uses a broad index of common stocks as its risky portfolio
I, III, and IV
II, III, and IV
III and IV
I, II, and III
I, II, III, and IV

Answer:
E
Difficulty:
Moderate
Response:
'The Capital Market Line is the Capital Allocation Line based on the one-month
T-Bill rate and a broad index of common stocks. It applies to an investor pursuing a passive
management strategy.

30.
A)

Market risk is also referred to as

systematic risk, diversifiable risk.

B)
C)
D)
E)

systematic risk, nondiversifiable risk.

unique risk, nondiversifiable risk.
unique risk, diversifiable risk.
none of the above.

Answer:
B
Difficulty:
Easy
Response:
Market, systematic, and nondiversifiable risk are synonyms referring to the risk
that cannot be eliminated from the portfolio. Diversifiable, unique, nonsystematic, and
firm-specific risks are synonyms referring to the risk that can be eliminated from the portfolio
by diversification.

31.
A)
B)
C)
D)
E)

Beta is the measure of

firm specific risk.
diversifiable risk.
market risk.
unique risk.
none of the above.

Answer:
C
Difficulty:
Easy
Response:
Beta is a measure of the market risk (or systematic or nondiversifiable risk) and
cannot be eliminated from the portfolio. A, B, and D are synonyms referring to the risk that can
be eliminated by diversification.

32.
A)
B)
C)
D)
E)

The risk that can be diversified away is

firm specific risk.
beta.
systematic risk.
market risk.
none of the above.

Answer:
Difficulty:
Response:

33.
A)
B)
C)

A
Easy
See explanations for 30 and 31 above.

The variance of a portfolio of risky securities

is a weighted sum of the securities' variances.
is the sum of the securities' variances.
is the weighted sum of the securities' variances and covariances.

D)
E)

is the sum of the securities' covariances.

none of the above.

Answer:
C
Difficulty:
Moderate
Response:
The variance of a portfolio of risky securities is a weighted sum taking into
account both the variance of the individual securities and the covariances between securities.

34.
A)
B)
C)
D)
E)

Other things equal, diversification is most effective when

securities' returns are uncorrelated.
securities' returns are positively correlated.
securities' returns are high.
securities' returns are negatively correlated.
b and c.

Answer:
D
Difficulty:
Moderate
Response:
Negative correlation among securities results in the greatest reduction of
portfolio risk, which is the goal of diversification.

35.
The efficient frontier of risky assets is
A)
the portion of the investment opportunity set that lies above the global minimum
variance portfolio.
B)
the portion of the investment opportunity set that represents the highest standard
deviations.
C)
the portion of the investment opportunity set which includes the portfolios with the
lowest standard deviation.
D)
the set of portfolios that have zero standard deviation.
E)
both a and b are true.
Answer:
A
Difficulty:
Moderate
Response:
Portfolios on the efficient frontier are those providing the greatest expected
return for a given amount of risk. Only those portfolios above the global minimum variance
portfolio meet this criterion.

36.
The Capital Allocation Line provided by a risk-free security and N risky securities is
A)
the line that connects the risk-free rate and the global minimum-variance portfolio of the
risky securities.

B)
the line that connects the risk-free rate and the portfolio of the risky securities that has
the highest expected return on the efficient frontier.
C)
the line tangent to the efficient frontier of risky securities drawn from the risk-free rate.
D)
the horizontal line drawn from the risk-free rate.
E)
none of the above.
Answer:
C
Difficulty:
Moderate
Response:
The Capital Allocation Line represents the most efficient combinations of the
risk-free asset and risky securities. Only C meets that definition.

37.
Consider an investment opportunity set formed with two securities that are perfectly
negatively correlated. The global minimum variance portfolio has a standard deviation that is
always
A)
greater than zero.
B)
equal to zero.
C)
equal to the sum of the securities' standard deviations.
D)
equal to -1.
E)
none of the above.
Answer:
B
Difficulty:
Difficult
Response:
If two securities were perfectly negatively correlated, the weights for the
minimum variance portfolio for those securities could be calculated, and the standard deviation
of the resulting portfolio would be zero.

38.
Which of the following statements is (are) true regarding the variance of a portfolio of
two risky securities?
A)
The higher the coefficient of correlation between securities, the greater the reduction in
the portfolio variance.
B)
There is a linear relationship between the securities' coefficient of correlation and the
portfolio variance.
C)
The degree to which the portfolio variance is reduced depends on the degree of
correlation between securities.
D)
a and b.
E)
a and c.
Answer:
Difficulty:
Response:
reduction.

C
Moderate
The less correlation between the returns of the securities, the more portfolio risk

39.
Efficient portfolios of N risky securities are portfolios that
A)
are formed with the securities that have the highest rates of return regardless of their
standard deviations.
B)
have the highest rates of return for a given level of risk.
C)
are selected from those securities with the lowest standard deviations regardless of their
returns.
D)
have the highest risk and rates of return and the highest standard deviations.
E)
have the lowest standard deviations and the lowest rates of return.
Answer:
B
Difficulty:
Moderate
Response:
Portfolios that are efficient are those that provide the highest expected return for
a given level of risk.

40.
Which of the following statement(s) is (are) true regarding the selection of a portfolio
from those that lie on the Capital Allocation Line?
A)
Less risk-averse investors will invest more in the risk-free security and less in the
optimal risky portfolio than more risk-averse investors.
B)
More risk-averse investors will invest less in the optimal risky portfolio and more in the
risk-free security than less risk-averse investors.
C)
Investors choose the portfolio that maximizes their expected utility.
D)
a and c.
E)
b and c.
Answer:
E
Difficulty:
Moderate
Response:
All rational investors select the portfolio that maximizes their expected utility;
for investors who are relatively more risk-averse, doing so means investing less in the optimal
risky portfolio and more in the risk-free asset.

Reference: Table 6-2

Consider the following probability distribution for stocks A and B:
State
1
2
3
4
5

Probability
0.10
0.20
0.20
0.30
0.20

Return on Stock A
10%
13%
12%
14%
15%

Return on Stock B
8%
7%
6%
9%
8%

41.
A)
B)
C)
D)
E)

The expected rates of return of stocks A and B are _____ and _____ , respectively.
13.2%; 9%.
14%; 10%
13.2%; 7.7%
7.7%; 13.2%
none of the above

Refer to: Table 6-2

Answer:
C
Difficulty:
Easy
Response:
E(RA) = 0.1(10%) + 0.2(13%) + 0.2(12%) + 0.3(14%) + 0.2(15%) = 13.2%;
E(RB) = 0.1(8%) + 0.2(7%) + 0.2(6%) + 0.3(9%) + 0.2(8%) = 7.7%.

42.
A)
B)
C)
D)
E)

The standard deviations of stocks A and B are _____ and _____, respectively.
1.5%; 1.9%
2.5%; 1.1%
3.2%; 2.0%
1.5%; 1.1%
none of the above

Refer to: Table 6-2

Answer:
D
Difficulty:
Moderate
Response:
sA = [0.1(10% - 13.2%)2 + 0.2(13% - 13.2%)2 + 0.2(12% - 13.2%)2 + 0.3(14% 2
13.2%) + 0.2(15% - 13.2%)2]1/2 = 1.5%; sB = [0.1(8% - 7.7%)2 + 0.2(7% - 7.7%)2 + 0.2(6% 7.7%)2 + 0.3(9% - 7.7%)2 + 0.2(8% - 7.7%)2 = 1.1%.

43.
A)
B)
C)
D)
E)

The coefficient of correlation between A and B is

0.47.
0.60.
0.58
1.20.
none of the above.

Refer to: Table 6-2

Answer:
Difficulty:

A
Difficult

Response:
covA,B = 0.1(10% - 13.2%)(8% - 7.7%) + 0.2(13% - 13.2%)(7% - 7.7%) +
0.2(12% - 13.2%)(6% - 7.7%) + 0.3(14% - 13.2%)(9% - 7.7%) + 0.2(15% - 13.2%)(8% - 7.7%)
= 0.76; rA,B = 0.76/[(1.1)(1.5)] = 0.47.

44.
If you invest 40% of your money in A and 60% in B, what would be your portfolio's
expected rate of return and standard deviation?
A)
9.9%; 3%
B)
9.9%; 1.1%
C)
11%; 1.1%
D)
11%; 3%
E)
none of the above
Refer to: Table 6-2
Answer:
B
Difficulty:
Difficult
Response:
E(RP) = 0.4(13.2%) + 0.6(7.7%) = 9.9%; sP = [(0.4)2(1.5)2 + (0.6)2(1.1)2 +
2(0.4)(0.6)(1.5)(1.1)(0.46)]1/2 = 1.1%.

45.
Let G be the global minimum variance portfolio. The weights of A and B in G are
__________ and __________, respectively.
A)
0.40; 0.60
B)
0.66; 0.34
C)
0.34; 0.66
D)
0.76; 0.24
E)
0.23; 0.77
Refer to: Table 6-2
Answer:
E
Difficulty:
Difficult
Response:
wA = [(1.1)2 - (1.5)(1.1)(0.46)]/[(1.5)2 + (1.1)2 - (2)(1.5)(1.1)(0.46) = 0.23; wB =
1 - 0.23 = 0.77.Note that the above solution assumes the solutions obtained in questions 13 and
14.

46.
The expected rate of return and standard deviation of the global minimum variance
portfolio, G, are __________ and __________, respectively.
A)
10.07%; 1.05%
B)
8.97%; 2.03%
C)
10.07%; 3.01%

D)
E)

8.97%; 1.05%
none of the above

Refer to: Table 6-2

Answer:
D
Difficulty:
Moderate
Response:
E(RG) = 0.23(13.2%) + 0.77(7.7%) = 8.97%; sG = [(0.23)2(1.5)2 + (0.77)2(1.1)2
+ (2)(0.23)(0.77)(1.5)(1.1)(0.46)]1/2 = 1.05%.

47.
A)
B)
C)
D)
E)

Which of the following portfolio(s) is (are) on the efficient frontier?

The portfolio with 20 percent in A and 80 percent in B.
The portfolio with 15 percent in A and 85 percent in B.
The portfolio with 26 percent in A and 74 percent in B.
The portfolio with 10 percent in A and 90 percent in B.
a and b are both on the efficient frontier.

Refer to: Table 6-2

Answer:
C
Difficulty:
Difficult
Response:
The Portfolio's E(Rp), sp, Reward/volatility ratios are 20A/80B: 8.8%,
1.05%, 8.38; 15A/85B:
8.53%, 1.06%, 8.07; 26A/74B:
9.13%, 1.05%, 8.70;
10A/90B:
8.25%, 1.07%, 7.73. The portfolio with 26% in A and 74% in B dominates all of
the other portfolios by the mean-variance criterion.

Reference: Case 6-3

Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of
return of 10% and a standard deviation of 16%. B has an expected rate of return of 8% and a
standard deviation of 12%.

48.
The weights of A and B in the global minimum variance portfolio are _____ and _____,
respectively.
A)
0.24; 0.76
B)
0.50; 0.50
C)
0.57; 0.43
D)
0.43; 0.57
E)
0.76; 0.24

Refer to: Case 6-3

Answer:
Difficulty:
Response:

49.
return.
A)
B)
C)
D)
E)

D
Moderate
wA = 12 /(16 + 12) = 0.4286; wB = 1 - 0.4286 = 0.5714.

The risk-free portfolio that can be formed with the two securities will earn _____ rate of
8.5%
9.0%
8.9%
9.9%
none of the above

Refer to: Case 6-3

Answer:
Difficulty:
Response:

50.
A)
B)
C)
D)
E)

C
Difficult
E(RP) = 0.43(10%) + 0.57(8%) = 8.86%.

Which of the following portfolio(s) is (are) most efficient?

45 percent in A and 55 percent in B.
65 percent in A and 35 percent in B.
35 percent in A and 65 percent in B.
a and b are both efficient.
a and c are both efficient.

Refer to: Case 6-3

Answer:
D
Difficulty:
Difficult
Response:
The Portfolio E(Rp), sp, and Reward/volatility ratios are 45A/55B: 8.9%,
0.6%, 14.83; 65A/35B: 9.3%, 6.2%, 1.5; 35A/65B: 8.7%, 2.2%, 3.95. Both A and B are
efficient according to the mean-variance criterion. A has a much higher Reward/volatility ratio.

51.
An investor who wishes to form a portfolio that lies to the right of the optimal risky
portfolio on the Capital Allocation Line must:
A)
lend some of her money at the risk-free rate and invest the remainder in the optimal
risky portfolio.
B)
borrow some money at the risk-free rate and invest in the optimal risky portfolio.

C)
D)
E)

invest only in risky securities.

such a portfolio cannot be formed.
b and c

Answer:
E
Difficulty:
Moderate
Response:
The only way that an investor can create portfolios to the right of the Capital
Allocation Line is to create a borrowing portfolio (buy stocks on margin). In this case, the
investor will not hold any of the risk-free security, but will hold only risky securities.

52.
Which one of the following portfolios cannot lie on the efficient frontier as described
by Markowitz?
Portfolio Expected Return Standard Deviation
W
9%
21%
X
5%
7%
Y
15%
36%
Z
12%
15%
A)
B)
C)
D)
E)

Only portfolio W cannot lie on the efficient frontier.

Only portfolio X cannot lie on the efficient frontier.
Only portfolio Y cannot lie on the efficient frontier.
Only portfolio Z cannot lie on the efficient frontier.
Cannot tell from the information given.

Answer:
A
Difficulty:
Moderate
Response:
When plotting the above portfolios, only W lies below the efficient frontier as
described by Markowitz. It has a higher standard deviation than Z with a lower expected return.

53.
A)
B)
C)
D)
E)

Portfolio theory as described by Markowitz is most concerned with:

the elimination of systematic risk.
the effect of diversification on portfolio risk.
the identification of unsystematic risk.
active portfolio management to enhance returns.
none of the above.

Answer:
B
Difficulty:
Moderate
Response:
Markowitz was concerned with reducing portfolio risk by combining risky
securities with differing return patterns.

54.
A)
B)
C)
D)
E)

The measure of risk in a Markowitz efficient frontier is:

specific risk.
standard deviation of returns.
reinvestment risk.
beta.
none of the above.

Answer:
B
Difficulty:
Moderate
Response:
Markowitz was interested in eliminating diversifiable risk (and thus lessening
total risk) and thus was interested in decreasing the standard deviation of the returns of the
portfolio.

55.
A)
B)
C)
D)
E)

A statistic that measures how the returns of two risky assets move together is:
variance.
standard deviation.
covariance.
correlation.
c and d.

Answer:
E
Difficulty:
Moderate
Response:
Covariance measures whether security returns move together or in opposition;
however, only the sign, not the magnitude, of covariance may be interpreted. Correlation,
which is covariance standardized by the product of the standard deviations of the two securities,
may assume values only between +1 and -1; thus, both the sign and the magnitude may be
interpreted regarding the movement of one security's return relative to that of another security.

56.
A)
B)
C)
D)
E)

The unsystematic risk of a specific security

is likely to be higher in an increasing market.
results from factors unique to the firm.
depends on market volatility.
cannot be diversified away.
none of the above.

Answer:
B
Difficulty:
Moderate
Response:
Unsystematic (or diversifiable or firm-specific) risk refers to factors unique to
the firm. Such risk may be diversified away; however, market risk will remain.

57.
Which statement about portfolio diversification is correct?
A)
Proper diversification can reduce or eliminate systematic risk.
B)
The risk-reducing benefits of diversification do not occur meaningfully until at least
50-60 individual securities have been purchased.
C)
Because diversification reduces a portfolio's total risk, it necessarily reduces the
portfolio's expected return.
D)
Typically, as more securities are added to a portfolio, total risk would be expected to
decrease at a decreasing rate.
E)
None of the above statements are correct.
Answer:
D
Difficulty:
Moderate
Response:
Diversification can eliminate only nonsystematic risk; relatively few securities
are required to reduce this risk, thus diminishing returns result quickly. Diversification does not
necessarily reduce returns.

58.
A)
B)
C)
D)
E)

The individual investor's optimal portfolio is designated by:

The point of tangency with the indifference curve and the capital allocation line.
The point of highest reward to variability ratio in the opportunity set.
The point of tangency with the opportunity set and the capital allocation line.
The point of the highest reward to variability ratio in the indifference curve.
None of the above.

Answer:
A
Difficulty:
Moderate
Response:
The indifference curve represents what is acceptable to the investor; the capital
allocation line represents what is available in the market. The point of tangency represents
where the investor can obtain the greatest utility from what is available.

59.
For a two-stock portfolio, what would be the preferred correlation coefficient between
the two stocks?
A)
+1.00.
B)
+0.50.
C)
0.00.
D)
-1.00.
E)
none of the above.
Answer:
Difficulty:
Response:
benefits.

D
Moderate
The correlation coefficient of -1.00 provides the greatest diversification

60.
In a two-security minimum variance portfolio where the correlation between securities
is greater than -1.0
A)
the security with the higher standard deviation will be weighted more heavily.
B)
the security with the higher standard deviation will be weighted less heavily.
C)
the two securities will be equally weighted.
D)
the risk will be zero.
E)
the return will be zero.
Answer:
B
Difficulty:
Difficult
Response:
The security with the higher standard deviation will be weighted less heavily to
produce minimum variance. The return will not be zero; the risk will not be zero unless the
correlation coefficient is -1.

61.
A)
B)
C)
D)
E)

Which of the following is not a source of systematic risk?

the business cycle.
interest rates.
personnel changes
the inflation rate.
exchange rates.

Answer:
C
Difficulty:
Easy
Response:
Personnel changes are a firm-specific event that is a component of
non-systematic risk. The others are all sources of systematic risk.

62.
The global minimum variance portfolio formed from two risky securities will be
riskless when the correlation coefficient between the two securities is
A)
0.0
B)
1.0
C)
0.5
D)
-1.0
E)
negative
Answer:
D
Difficulty:
Moderate
Response:
The global minimum variance portfolio will have a standard deviation of zero
whenever the two securities are perfectly negatively correlated.

63.
Security X has expected return of 12% and standard deviation of 20%. Security Y has
expected return of 15% and standard deviation of 27%. If the two securities have a correlation
coefficient of 0.7, what is their covariance?
A)
0.038
B)
0.070
C)
0.018
D)
0.013
E)
0.054
Answer:
Difficulty:
Response:

A
Moderate
Cov(rX, rY) = (.7)(.20)(.27) = .0378

64.
When two risky securities that are positively correlated but not perfectly correlated are
held in a portfolio,
A)
The portfolio standard deviation will be greater than the weighted average of the
individual security standard deviations.
B)
The portfolio standard deviation will be less than the weighted average of the individual
security standard deviations.
C)
The portfolio standard deviation will be equal to the weighted average of the individual
security standard deviations.
D)
The portfolio standard deviation will always be equal to the securities' covariance.
E)
None of the above are true.
Answer:
B
Difficulty:
Moderate
Response:
Whenever two securities are less than perfectly positively correlated, the
standard deviation of the portfolio of the two assets will be less than the weighted average of the
two securities' standard deviations. There is some benefit to diversification in this case.

65.
The line representing all combinations of portfolio expected returns and standard
deviations that can be constructed from two available assets is called the
A)
risk/reward tradeoff line
B)
Capital Allocation Line
C)
efficient frontier
D)
portfolio opportunity set
E)
Security Market Line
Answer:
Difficulty:

D
Easy

Response:
The portfolio opportunity set is the line describing all combinations of expected
returns and standard deviations that can be achieved by a portfolio of risky assets.

66.
Given an optimal risky portfolio with expected return of 14% and standard deviation of
22% and a risk free rate of 6%, what is the slope of the best feasible CAL?
A)
0.64
B)
0.14
C)
0.08
D)
0.33
E)
0.36
Answer:
Difficulty:
Response:

E
Moderate
Slope = (14-6)/22 = .3636

67.
The risk that can be diversified away in a portfolio is referred to as ___________.
diversifiable risk
unique risk
systematic risk
firm-specific risk
A)
I, III, and IV
B)
II, III, and IV
C)
III and IV
D)
I, II, and IV
E)
I, II, III, and IV
Answer:
D
Difficulty:
Moderate
Response:
All of these terms are used interchangeably to refer to the risk that can be
removed from a portfolio through diversification.

68.
In words, the covariance considers the probability of each scenario happening and the
interaction between
A)
securities' returns relative to their variances.
B)
securities' returns relative to their mean returns.
C)
securities' returns relative to other securities' returns.
D)
the level of return a security has in that scenario and the overall portfolio return.
E)
the variance of the security's return in that scenario and the overall portfolio variance.
Answer:

Difficulty:
Difficult
Response:
The covariance of the returns between two securities is the sum over all
scenarios of the product of: the probability that the scenario will happen and the squared
deviations of the securities' returns in that scenario from their own expected returns.

69.
when
A)
B)
C)
D)
E)

The standard deviation of a two-asset portfolio is a linear function of the assets' weights
the assets have a correlation coefficient less than zero.
the assets have a correlation coefficient equal to zero.
the assets have a correlation coefficient greater than zero.
the assets have a correlation coefficient equal to one.
the assets have a correlation coefficient less than one.

Answer:
D
Difficulty:
Moderate
Response:
When there is a perfect positive correlation (or a perfect negative correlation),
the equation for the portfolio variance simplifies to a perfect square. The result is that the
portfolio's standard deviation is linear relative to the assets' weights in the portfolio.

70.
A)
B)
C)
D)
E)

A two-asset portfolio with a standard deviation of zero can be formed when

the assets have a correlation coefficient less than zero.
the assets have a correlation coefficient equal to zero.
the assets have a correlation coefficient greater than zero.
the assets have a correlation coefficient equal to one.
the assets have a correlation coefficient equal to negative one.

Answer:
E
Difficulty:
Moderate
Response:
When there is a perfect negative correlation, the equation for the portfolio
variance simplifies to a perfect square. The result is that the portfolios standard deviation
equals |wA A wB B|, which can be set equal to zero. The solution wA = B/( A + B) and
wB = 1 wA will yield a zero-standard deviation portfolio.

71.
II)
III)
IV)
V)
A)

When borrowing and lending at a risk-free rate are allowed, which Capital Allocation I)
Line (CAL) should the investor choose to combine with the efficient frontier?
with the highest reward-to-variability ratio.
that will maximize his utility.
with the steepest slope.
with the lowest slope.
I and III

B)
C)
D)
E)

I and IV
II and IV
I only
I, II, and III

Answer:
E
Difficulty:
Difficult
Response:
The optimal CAL is the one that is tangent to the efficient frontier, as discussed
in relation to Figure 6.21 (text). This CAL offers the highest reward-to-variability ratio, which
is the slope of the CAL. It will also allow the investor to reach his highest feasible level of
utility, as depicted in Figure 6.23 (text).

72.
The separation property refers to the conclusion that
A)
the determination of the best risky portfolio is objective and the choice of the best
complete portfolio is subjective.
B)
the choice of the best complete portfolio is objective and the determination of the best
risky portfolio is objective.
C)
the choice of inputs to be used to determine the efficient frontier is objective and the
choice of the best CAL is subjective.
D)
the determination of the best CAL is objective and the choice of the inputs to be used to
determine the efficient frontier is subjective.
E)
investors are separate beings and will therefore have different preferences regarding the
risk-return tradeoff.
Answer:
A
Difficulty:
Difficult
Response:
The determination of the optimal risky portfolio is purely technical and can be
done by a manager. The complete portfolio, which consists of the optimal risky portfolio and
the risk-free asset, must be chosen by each investor based on preferences.

Short Answer Questions

73.
Discuss the differences between the asset allocation decision and the security
selection decision.
Answer:
The asset allocation decision involves the choice of the proportion of the
overall portfolio to be invested in broad general asset categories. In general, this decision
should be the first step in the portfolio management process (after determining the investor's
level of risk tolerance). The security selection decision describes the choice of which specific
securities to hold within each broad asset classification group.

Difficulty:
Easy
Response:
As asset allocation and security selection are the two major components of
portfolio formation, it is important that the student is able to distinguish between the two, and to
understand the roles of each in portfolio management.

74.
Discuss the characteristics of indifference curves, and the theoretical value of these
curves in the portfolio building process
Answer:
Indifference curves represent the trade-off between two variables. In portfolio
building, the choice is between risk and return. The investor is indifferent between all possible
portfolios lying on one indifference curve. However, indifference curves are contour maps,
with all curves parallel to each other. The curve plotting in the most northwest position is the
curve offering the greatest utility to the investor. However, this most desirable curve may not
be attainable in the market place. The point of tangency between an indifference curve
(representing what is desirable) and the capital allocation line (representing what is possible) is
the optimum portfolio for that investor.
Difficulty:
Moderate
Response:
This question is designed to ascertain that the student understands the concepts
of utility, what is desirable by the investor, what is possible in the market place, and how to
optimize an investor's portfolio, theoretically.

75.
Describe how an investor may combine a risk-free asset and one risky asset in order to
obtain the optimal portfolio for that investor.
Answer:
The investor may combine a risk-free asset (T-bills or a money market mutual
fund) and a risky asset, such as an indexed mutual fund in the proper portions to obtain the
desired risk-return relationship for that investor. The investor must realize that the risk-return
relationship is a linear one, and that in order to earn a higher return, the investor must be willing
to assume more risk. The investor must first determine the amount of risk that he or she can
tolerate (in terms of the standard deviation of the total portfolio, which is the product of the
proportion of total assets invested in the risky asset and the standard deviation of the risky
asset). One minus this weight is the proportion of total assets to be invested in the risk-free
asset. The portfolio return is the weighted averages of the returns on the two respective assets.
Such an asset allocation plan is probably the easiest, most efficient, and least expensive for the
individual investor to build an optimal portfolio.
Difficulty:
Moderate
Response:
This question is designed to insure that the student understands how, using the
simple strategy of combining two mutual funds, the investor can build an optimal portfolio,
based on the investor's risk tolerance.

76.
The optimal proportion of the risky asset in the complete portfolio is given by the
equation y* = [E(rP)-rf] / (.01A*Variance of P). For each of the variables on the right side of
the equation, discuss the impact the variable's effect on y* and why the nature of the
relationship makes sense intuitively. Assume the investor is risk averse.
Answer:
The optimal proportion in y is the one that maximizes the investor's utility.
Utility is positively related to the risk premium [E(rP)-rf]. This makes sense because the more
expected return an investor gets, the happier he is. The variable A represents the degree of
risk aversion. As risk aversion increases, A increases. This causes y* to decrease because we
are dividing by a higher number. It makes sense that a more risk-averse investor would hold a
smaller proportion of his complete portfolio in the risky asset and a higher proportion in the
risk-free asset. Finally, the standard deviation of the risky portfolio is inversely related to y*.
As P's risk increases, we are again dividing by a larger number, making y* smaller. This
corresponds with the risk-averse investor's dislike of risk as measured by standard deviation.
Difficulty:
Difficult
Response:
This allows the students to explore the nature of the equation that was derived by
maximizing the investor's expected utility. The student can illustrate an understanding of the
variables that supercedes the application of the equation in calculating the optimal proportion in
P.

77.
You are evaluating two investment alternatives. One is a passive market portfolio with
an expected return of 10% and a standard deviation of 16%. The other is a fund that is actively
managed by your broker. This fund has an expected return of 15% and a standard deviation of
20%. The risk-free rate is currently 7%. Answer the questions below based on this
information.
A)
What is the slope of the Capital Market Line?
B)
What is the slope of the Capital Allocation Line offered by your broker's fund?
C)
Draw the CML and the CAL on one graph.
D)
What is the maximum fee you broker could charge and still leave you as well off as if
you had invested in the passive market fund? (Assume that the fee would be a percentage of the
investment in the broker's fund, and would be deducted at the end of the year.)
E)
How would it affect the graph if the broker were to charge the full amount of the fee?
Answer:
A)
The slope of the CML is (10-7)/16 = 0.1875.
B)
The slope of the CAL is (15-7)/20= 0.40.
C)
On the graph, both the CML and the CAL have an intercept equal to the risk-free rate
(7%). The CAL, with a slope of 0.40, is steeper than the CML, with a slope of 0.1875.
D)
To find the maximum fee the broker can charge, the equation (15-7-fee)/20 = 0.1875 is
solved for fee. The resulting fee is 4.25%.
E)
If the broker charges the full amount of the fee, the CAL's slope would also be 0.1875,
so it would rotate down and be identical to the CML.
Difficulty:
Difficult

Response:
This question tests both the application of CAL/CML calculations and the
concepts involved.

78.
Theoretically, the standard deviation of a portfolio can be reduced to what level?
Explain. Realistically, is it possible to reduce the standard deviation to this level? Explain.
Answer:
Theoretically, if one could find two securities with perfectly negatively
correlated returns (correlation coefficient = -1), one could solve for the weights of these
securities that would produce the minimum variance portfolio of these two securities. The
standard deviation of the resulting portfolio would be equal to zero. However, in reality,
securities with perfect negative correlations do not exist.
Difficulty:
Moderate
Response:
The rationale for this question is to ascertain whether or not the student
understands the concept of the minimum variance portfolio, the theoretical zero risk portfolio,
and the probability of obtaining a zero risk portfolio.

79.
Discuss how the investor can use the separation theorem and utility theory to produce an
efficient portfolio suitable for the investor's level of risk tolerance.
Answer:
One can identify the optimum risky portfolio as the portfolio at the point of
tangency between a ray extending from the risk-free rate and the efficient frontier of risky
securities. Below the point of tangency on this ray from the risk-free rate, the efficient
portfolios consist of both the optimum risky portfolio and risk-free investments (T-bills); above
the point of tangency, the efficient portfolios consist of the optimum risky portfolio purchased
on margin. If the investor's indifference curve, which reflects that investor's preferences
regarding risk and return, is superimposed on the ray from the risk-free rate, the resulting point
of tangency represents the appropriate combination of the optimum risky portfolio and either
risk-free assets or margin buying for that investor. Thus, the separation theorem separates the
investing and financing decisions. That is, all investors will invest in the same optimal risky
portfolio, and adjust the risk level of the portfolio by either lending (investing in U. S.
Treasuries, i.e., lending to the U. S. government) or borrowing (buying risky securities on
margin).
Difficulty:
Moderate
Response:
The purpose of this question is to ascertain whether the student understands the
basic principles of utility theory, the optimal risky portfolio, and the separation theorem, as
these concepts relate to constructing the ideal portfolio for a particular investor.

80.
Draw graphs that represent each of the following situations:
Investors face an efficient frontier of risky assets. There is no borrowing or lending allowed
at a risk-free rate. Using indifference curves, show an example of the optimal portfolio

choice for Investor A, who has a strong aversion to risk, and one for Investor B, who is
much less risk-averse. Label points A and B clearly.
Investors face an efficient frontier of risky assets. Borrowing and lending at a risk-free rate
are allowed. Using indifference curves, show an example of Investor C, who chooses to put
100% of his investment in the optimal risky portfolio. Show an example of Investor D, who
chooses to put 75% of her investment in the optimal risky portfolio. Label points C and D
clearly.
Investors face an efficient frontier of risky assets. Lending at a risk-free rate is allowed, and
investors can borrow at a slightly higher rate. Using an indifference curve, show an
example of Investor E, who chooses to borrow. Label this point E. On the same graph show
where the investor's indifference curve would be if she could borrow at the lending rate.
Label this point F.

Answer:
The graph of investors A and B should resemble Figure 6.22 in text. The graph
of investors C and D should look like text Figure 6.23, with C lying to the right of P and point D
to the left of P. The graph with points E and F should resemble text Figure 6.26.
Difficulty:
Moderate
Response:
The students should be able to illustrate their grasp of the chapter's concepts
through these graphs. An additional discussion portion may be added to the question.

81.
State Markowitz's mean-variance criterion. Give some numerical examples of how the
criterion would be applied.
Answer:
The mean-variance criterion states that asset A dominates asset B if and only if
E(RA) is greater than or equal to E(RB) and the standard deviation of A's returns is less than or
equal to the standard deviation of B's returns, with at least one strict inequality holding.
Students can give examples of securities dominating others on the basis of expected return or
standard deviation, and can also give examples of comparisons where neither security is
inefficient.
Difficulty:
Easy
Response:
The mean-variance criterion is the basis of the chapter material. It is essential
that students have a firm grasp of this material.

82.
Draw a graph of a typical efficient frontier. Explain why the efficient frontier is shaped
the way it is.
Answer:
The efficient frontier has a curved appearance, as shown throughout the chapter.
The typical shape results from the fact that assets' returns are not perfectly (positively or
negatively) correlated.
Difficulty:
Moderate

Response:
This question relates to the fundamentals of assets' relationships and their
impact on the efficient frontier. Sometimes students get used to seeing the efficient frontier as it
is depicted in subsequent graphs and forget its origin.