Chapter 06 - Efficient Diversification

Chapter 06 - Efficient Diversification
Chapter 06
Efficient Diversification

Multiple Choice Questions

1. Risk that can be eliminated through diversification is called ______ risk.

A. unique
B. firm-specific
C. diversifiable
D. all of the above
2. The _______ decision should take precedence over the _____ decision.
A. asset allocation, stock selection
B. bond selection, mutual fund selection
C. stock selection, asset allocation
D. stock selection, mutual fund selection
3. Many current and retired Enron Corp. employees had their 401k retirement accounts wiped
out when Enron collapsed because ___.
A. they had to pay huge fines for obstruction of justice
B. their 401k accounts were held outside the company
C. their 401k accounts were not well diversified
D. none of the above
6-1
4. Based on the outcomes in the table below choose which of the statements is/are correct:

I. The covariance of Security A and Security B is zero
II. The correlation coefficient between Security A and C is negative
III. The correlation coefficient between Security B and C is positive
A. I only
B. I and II only
C. II and III only
D. I, II and III
5. Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has
an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would
prefer a portfolio using the risk-free asset and ______.
A. asset A
B. asset B
C. no risky asset
D. can't tell from the data given
6. Adding additional risky assets to the investment opportunity set will generally move the
efficient frontier _____ and to the ______.
A. up, right
B. up, left
C. down, right
D. down, left
7. An investor's degree of risk aversion will determine his or her ______.
A. optimal risky portfolio
B. risk-free rate
C. optimal mix of the risk-free asset and risky asset
D. capital allocation line
6-2
8. The ________ is equal to the square root of the systematic variance divided by the total
variance.
A. covariance
B. correlation coefficient
C. standard deviation
D. reward-to-variability ratio
9. Which of the following statistics cannot be negative?

A. Covariance
B. Variance
C. E[r]
D. Correlation coefficient
10. Asset A has an expected return of 20% and a standard deviation of 25%. The risk free rate
is 10%. What is the reward-to-variability ratio?
A. .40
B. .50
C. .75
D. .80
11. The correlation coefficient between two assets equals to _________.

A. their covariance divided by the product of their variances
B. the product of their variances divided by their covariance
C. the sum of their expected returns divided by their covariance
D. their covariance divided by the product of their standard deviations
12. Diversification is most effective when security returns are _________.

A. high
B. negatively correlated
C. positively correlated
D. uncorrelated
6-3
13. The expected rate of return of a portfolio of risky securities is _________.

A. the sum of the securities' covariances
B. the sum of the securities' variances
C. the weighted sum of the securities' expected returns
D. the weighted sum of the securities' variances
14. Beta is a measure of security responsiveness to _________.

A. firm specific risk
B. diversifiable risk
C. market risk
D. unique risk
15. The risk that can be diversified away is __________.

A. beta
B. firm specific risk
C. market risk
D. systematic risk
16. To eliminate the bias in calculating the variance and covariance of returns from historical
data the average squared deviation must be multiplied by _________.
A. n/(n - 1)
B. n * (n - 1)
C. (n - 1)/n
D. (n - 1) * n
17. 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. equal to the sum of the securities standard deviations
B. equal to -1
C. equal to 0
D. greater than 0
6-4
18. Market risk is also called __________ and _________.

A. systematic risk, diversifiable risk
B. systematic risk, nondiversifiable risk
C. unique risk, nondiversifiable risk
D. unique risk, diversifiable risk
19. Firm specific risk is also called __________ and __________.

B. systematic risk, non-diversifiable risk
C. unique risk, non-diversifiable risk
20. Which one of the following stock return statistics fluctuates the most over time?
A. Covariance of returns
B. Variance of returns
C. Average return
21. Harry Markowitz is best known for his Nobel prize winning work on _____________.
A. strategies for active securities trading
B. techniques used to identify efficient portfolios of risky assets
C. techniques used to measure the systematic risk of securities
D. techniques used in valuing securities options
22. Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means
that ______.
A. the returns on the stock and bond portfolio tend to move inversely
B. the returns on the stock and bond portfolio tend to vary independently of each other
C. the returns on the stock and bond portfolio tend to move together
D. the covariance of the stock and bond portfolio will be positive
6-5
23. You put half of your money in a stock portfolio that has an expected return of 14% and a
standard deviation of 24%. You put the rest of you money in a risky bond portfolio that has an
expected return of 6% and a standard deviation of 12%. The stock and bond portfolio have a
correlation 0.55. The standard deviation of the resulting portfolio will be ________________.
A. more than 18% but less than 24%
B. equal to 18%
C. more than 12% but less than 18%
D. equal to 12%
24. On a standard expected return vs. standard deviation graph investors will prefer portfolios
that lie to the _____________ of the current investment opportunity set.
A. left and above
B. left and below
C. right and above
D. right and below
25. The term "complete portfolio" refers to a portfolio consisting of _________________.

A. the risk-free asset combined with at least one risky asset
B. the market portfolio combined with the minimum variance portfolio
C. securities from domestic markets combined with securities from foreign markets
D. common stocks combined with bonds
26. Rational risk-averse investors will always prefer portfolios _____________.

A. located on the efficient frontier to those located on the capital market line
B. located on the capital market line to those located on the efficient frontier
C. at or near the minimum variance point on the efficient frontier
D. that are risk-free to all other asset choices
6-6
27. The optimal risky portfolio can be identified by finding ____________.

I. the minimum variance point on the efficient frontier
II. the maximum return point on the efficient frontier the minimum variance point on the
efficient frontier
III. the tangency point of the capital market line and the efficient frontier
IV. the line with the steepest slope that connects the risk free rate to the efficient frontier
A. I and II only
B. II and III only
C. III and IV only
D. I and IV only
28. Reward-to-variability ratios are ________ on the ________ capital market line.

A. lower; steeper
B. higher; flatter
C. higher; steeper
D. the same; flatter
29. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of
return of 24% while stock B has a standard deviation of return of 18%. Stock A comprises
60% of the portfolio while stock B comprises 40% of the portfolio. If the variance of return
on the portfolio is .0380, the correlation coefficient between the returns on A and B is
_________.
A. 0.583
B. 0.225
C. 0.327
D. 0.128
30. The standard deviation of return on investment A is .10 while the standard deviation of
return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation
coefficient between the returns on A and B is _________.
A. .12
B. .36
C. .60
D. .77
6-7
return of 35% while stock B has a standard deviation of return of 15%. The correlation
coefficient between the returns on A and B is 0.45. Stock A comprises 40% of the portfolio
while stock B comprises 60% of the portfolio. The standard deviation of the return on this
portfolio is _________.
A. 23.00%
B. 19.76%
C. 18.45%
D. 17.67%
return on investment B is .04. If the correlation coefficient between the returns on A and B is
-.50, the covariance of returns on A and B is _________.
A. -.0447
B. -.0020
C. .0020
D. .0447
33. Consider two perfectly negatively correlated risky securities, A and B. Security A has an
expected rate of return of 16% and a standard deviation of return of 20%. B has an expected
rate of return of 10% and a standard deviation of return of 30%. The weight of security B in
the minimum variance portfolio is _________.
A. 10%
B. 20%
C. 40%
D. 60%
An investor can design a risky portfolio based on two stocks, A and B. Stock A has an
expected return of 18% and a standard deviation of return of 20%. Stock B has an expected
return of 14% and a standard deviation of return of 5%. The correlation coefficient between
the returns of A and B is 0.50. The risk-free rate of return is 10%.
6-8
34. The proportion of the optimal risky portfolio that should be invested in stock A is
_________.
A. 0%
B. 40%
C. 60%
D. 100%
35. The expected return on the optimal risky portfolio is _________.

A. 14.0%
B. 15.6%
C. 16.4%
D. 18.0%
36. The standard deviation of return on the optimal risky portfolio is _________.

A. 0%
B. 5%
C. 7%
D. 20%
37. The proportion of the optimal risky portfolio that should be invested in stock B is
approximately _________.
A. 29%
B. 44%
C. 56%
D. 71%
6-9

A. 14%
B. 16%
C. 18%
D. 19%
39. The standard deviation of the returns on the optimal risky portfolio is _________.
A. 25.5%
B. 22.3%
C. 21.4%
D. 20.7%
40. An investor can design a risky portfolio based on two stocks, A and B. The standard
deviation of return on stock A is 24% while the standard deviation on stock B is 14%. The
correlation coefficient between the return on A and B is 0.35. The expected return on stock A
is 25% while on stock B it is 11%. The proportion of the minimum variance portfolio that
would be invested in stock B is approximately _________.
A. 45%
B. 67%
C. 85%
D. 92%
expected return on stock A is 20% while on stock B it is 10%. The correlation coefficient
between the return on A and B is 0%. The expected return on the minimum variance portfolio
is approximately _________.
A. 10.00%
B. 13.60%
C. 15.00%
D. 19.41%
6-10
correlation coefficient between the return on A and B is 0%. The standard deviation of return
on the minimum variance portfolio is _________.
A. 0%
B. 6%
C. 12%
D. 17%
43. A measure of the riskiness of an asset held in isolation is ____________.

A. beta
B. standard deviation
C. covariance
D. semi-variance
44. Semitool Corp has an expected excess return of 6% for next year. However for every
unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it
turns out the economy and the stock market do better than expected by 1.5% and Semitool's
products experience more rapid growth than anticipated, pushing up the stock price by
another 1%. Based on this information what was Semitool's actual excess return?
A. 7.00%
B. 8.50%
C. 8.80%
D. 9.25%
45. The part of a stock's return that is systematic is a function of which of the following
variables?
I. Volatility in excess returns of the stock market
II. The sensitivity of the stock's returns to changes in the stock market
III. The variance in the stock's returns that is unrelated to the overall stock market
A. I only
B. I and II only
C. II and III only
D. I, II and III
6-11
46. Stock A has a beta of 1.2 and Stock B has a beta of 1. The returns of Stock A are ______
sensitive to changes in the market as the returns of Stock B.
A. 20% more
B. slightly more
C. 20% less
D. slightly less
47. Which risk can be diversified away as additional securities are added to a portfolio?
I. Total risk
II. Systematic risk
III. Firm specific risk
A. I only
B. I and II only
C. I, II, and III
D. I and III
48. According to Tobin's separation property, portfolio choice can be separated into two
independent tasks consisting of __________ and __________.
A. identifying all investor imposed constraints; identifying the set of securities that conform
to the investor's constraints and offer the best risk-return tradeoffs
B. identifying the investor's degree of risk aversion; choosing securities from industry groups
that are consistent with the investor's risk profile
C. identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and
the optimal risky portfolio based on the investor's degree of risk aversion
D. choosing which risky assets an investor prefers according to their risk aversion level;
minimizing the CAL by lending at the risk-free rate
49. You are constructing a scatter plot of excess returns for Stock A versus the market index.
If the correlation coefficient between Stock A and the index is -1 you will find that the points
of the scatter diagram ______________________ and the line of best fit has a
______________.
A. all fall on the line of best fit; positive slope
B. all fall on the line of best fit; negative slope
C. are widely scattered around the line; positive slope
D. are widely scattered around the line; negative slope
6-12
50. The term excess-return refers to ______________.

A. returns earned illegally by means of insider trading
B. the difference between the rate of return earned and the risk-free rate
C. the difference between the rate of return earned on a particular security and the rate of
return earned on other securities of equivalent risk
D. the portion of the return on a security which represents tax liability and therefore cannot be
reinvested
51. You are recalculating the risk of ACE stock in relation to the market index and you find
the ratio of the systematic variance to the total variance has risen. You must also find that the
____________.
A. covariance between ACE and the market has fallen
B. correlation coefficient between ACE and the market has fallen
C. correlation coefficient between ACE and the market has risen
D. unsystematic risk of ACE has risen
52. A stock has a correlation with the market of 0.45. The standard deviation of the market is
21% and the standard deviation of the stock is 35%. What is the stock's beta?
A. 1.00
B. 0.75
C. 0.60
D. 0.55
53. The values of beta coefficients of securities are __________.

A. always positive
B. always negative
C. always between positive 1 and negative 1
D. usually positive, but are not restricted in any particular way
54. A security's beta coefficient will be negative if ____________.

A. its returns are negatively correlated with market index returns
B. its returns are positively correlated with market index returns
C. its stock price has historically been very stable
D. market demand for the firm's shares is very low
6-13
55. The market value weighted average beta of firms included in the market index will always
be _____________.
A. 0
B. between 0 and 1
C. 1
D. There is no particular rule concerning the average beta of firms included in the market
index
56. Diversification can reduce or eliminate __________ risk.

A. all
B. systematic
C. non-systematic
D. only an insignificant
57. In order to construct a riskless portfolio using two risky stocks, one would need to find
two stocks with a correlation coefficient of ________.
A. 1.0
B. 0.5
C. 0
D. -1.0
58. Some diversification benefits can be achieved by combining securities in a portfolio as

long as the correlation between the securities is _____________.
A. 1
B. less than 1
C. between 0 and 1
D. less than or equal to 0
59. If an investor does not diversify their portfolio and instead puts all of their money in one
stock, the appropriate measure of security risk for that investor is the ________.
A. stock's standard deviation
B. variance of the market
C. stock's beta
D. covariance with the market index
6-14
60. Which of the following provides the best example of a systematic risk event?
A. A strike by union workers hurts a firm's quarterly earnings.
B. Mad Cow disease in Montana hurts local ranchers and buyers of beef.
C. The Federal Reserve increases interest rates 50 basis points.
D. A senior executive at a firm embezzles $10 million and escapes to South America.
61. Which of the following statements is true regarding time diversification?

I. The standard deviation of the average annual rate of return over several
years will be smaller than the one-year standard deviation.
II. For a longer time horizon, uncertainty compounds over a greater number
of years.
III. Time diversification does not reduce risk.
A. I only
B. II only
C. II and III only
D. I, II and III
E. None of the statements are correct
62. You find that the annual standard deviation of a stock's returns is equal to 25%. For a 3
year holding period the standard deviation of your total return would equal _______.
A. 75%
B. 25%
C. 43%
D. 55%
6-15

63. The beta of this stock is ____.

A. 0.12
B. 0.35
C. 1.32
D. 4.05
64. This stock has greater systematic risk than a stock with a beta of ___.
A. 0.50
B. 1.50
C. 2.00
D. 3.00
65. The characteristic line for this stock is Rstock = ___ + ___ Rmarket.
A. 0.35, 0.12
B. 4.05, 1.32
C. 15.44, 0.97
D. 0.26, 1.36
6-16
66. ____ percent of the variance is explained by this regression.

A. 12
B. 35
C. 4.05
D. 80
67. The stock is ______ riskier than the typical stock.

A. 32%
B. 15.44%
C. 12%
D. 38%
68. Decreasing the number of stocks in a portfolio from 50 to 10 would likely

_________________________.
A. increase the systematic risk of the portfolio
B. increase the unsystematic risk of the portfolio
C. increase the return of the portfolio
D. decrease the variation in returns the investor faces in any one year
69. If you want to know the portfolio standard deviation for a three stock portfolio you will
have to
A. calculate two covariances and one trivariance
B. calculate only two covariances
C. calculate three covariances
D. average the variances of the individual stocks
70. Which of the following correlations coefficients will produce the least diversification
benefit?
A. -0.6
B. -0.3
C. 0.0
D. 0.8
6-17
71. Which of the following correlation coefficients will produce the most diversification
benefits?
A. -0.6
B. -0.9
C. 0.0
D. 0.4
72. What is the most likely correlation coefficient between a stock index mutual fund and the
S&P 500?
A. -1.0
B. 0.0
C. 1.0
D. 0.5
73. Investing in two assets with a correlation coefficient of -0.5 will reduce what kind of risk?
A. Market risk
B. Non-diversifiable risk
C. Systematic risk
D. Unique risk
74. Investing in two assets with a correlation coefficient of 1.0 will reduce which kind of
risk?
A. Market risk
B. Unique risk
C. Unsystematic risk
D. With a correlation of 1.0, no risk will be reduced
75. A portfolio of stocks fluctuates when the treasury yields change. Since this risk can not be
eliminated through diversification, it is called __________.
B. systematic risk
C. unique risk
6-18
76. As you lengthen the time horizon of your investment period and decide to invest for
multiple years you will find that ________.
I. the average risk per year may be smaller over longer investment horizons
II. the overall risk of your investment will compound over time
III. your overall risk on the investment will fall
A. I only
B. I and II only
C. III only
D. I, II and III
77. You are considering adding a new security to your portfolio. In order to decide whether
you should add the security you need to know the security's _______.
I. expected return
II. standard deviation
III. correlation with your portfolio
A. I only
B. I and II only
C. I and III only
D. I, II and III
78. Which of the following is a correct expression concerning the formula for the standard
deviation of returns of a two asset portfolio where the correlation coefficient is positive?
A. 2rp < (W1212 + W2222)
B. 2rp = (W1212 + W2222)
C. 2rp = (W1212 - W2222)
D. 2rp > (W1212 + W2222)
79. What is the standard deviation of a portfolio of two stocks given the following data? Stock
A has a standard deviation of 18%. Stock B has a standard deviation of 14%. The portfolio
contains 40% of stock A and the correlation coefficient between the two stocks is -.23.
A. 9.7%
B. 12.2%
C. 14.0%
D. 15.6%
6-19
contains 60% of stock A and the correlation coefficient between the two stocks is -1.0.
A. 0.0%
B. 10.8%
C. 18.0%
D. 24.0%
81. The expected return of portfolio is 8.9% and the risk free rate is 3.5%. If the portfolio
standard deviation is 12.0%, what is the reward to variability ratio of the portfolio?
A. 0.0
B. 0.45
C. 0.74
D. 1.35
82. A project has a 60% chance of doubling your investment in one year and a 40% chance of
losing half your money. What is the standard deviation of this investment?
A. 25%
B. 50%
C. 62%
D. 73%
losing half your money. What is the expected return on this investment project?
A. 0%
B. 25%
C. 50%
D. 75%
6-20
The figures below show plots of monthly excess returns for two stocks plotted against excess
returns for a market index.

84. Which stock is likely to further reduce risk for an investor currently holding his portfolio
in a well diversified portfolio of common stock?
A. Stock A
B. Stock B
C. There is no difference between A or B
D. You cannot tell from the information given.
85. Which stock is riskier to a non-diversified investor who puts all his money in only one of
these stocks?
A. Stock A is riskier
B. Stock B is riskier
C. Both stocks are equally risky
Chapter 06 Efficient Diversification Answer Key

Multiple Choice Questions

6-21
1. Risk that can be eliminated through diversification is called ______ risk.

A. unique
B. firm-specific
C. diversifiable
D. all of the above
Difficulty: Easy

2. The _______ decision should take precedence over the _____ decision.
A. asset allocation, stock selection
B. bond selection, mutual fund selection
C. stock selection, asset allocation
D. stock selection, mutual fund selection
Difficulty: Medium

3. Many current and retired Enron Corp. employees had their 401k retirement accounts wiped
out when Enron collapsed because ___.
A. they had to pay huge fines for obstruction of justice
B. their 401k accounts were held outside the company
C. their 401k accounts were not well diversified
Difficulty: Easy

6-22
4. Based on the outcomes in the table below choose which of the statements is/are correct:

I. The covariance of Security A and Security B is zero
II. The correlation coefficient between Security A and C is negative
III. The correlation coefficient between Security B and C is positive
A. I only
B. I and II only
C. II and III only
D. I, II and III
Difficulty: Hard

5. Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has
an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would
prefer a portfolio using the risk-free asset and ______.
A. asset A
B. asset B
C. no risky asset
D. can't tell from the data given
Difficulty: Medium

6. Adding additional risky assets to the investment opportunity set will generally move the
efficient frontier _____ and to the ______.
A. up, right
B. up, left
C. down, right
D. down, left
Difficulty: Medium

6-23
7. An investor's degree of risk aversion will determine his or her ______.
A. optimal risky portfolio
B. risk-free rate
C. optimal mix of the risk-free asset and risky asset
D. capital allocation line
Difficulty: Medium

8. The ________ is equal to the square root of the systematic variance divided by the total
variance.
A. covariance
B. correlation coefficient
C. standard deviation
D. reward-to-variability ratio
Difficulty: Medium

9. Which of the following statistics cannot be negative?

A. Covariance
B. Variance
C. E[r]
Difficulty: Easy

6-24
10. Asset A has an expected return of 20% and a standard deviation of 25%. The risk free rate
is 10%. What is the reward-to-variability ratio?
A. .40
B. .50
C. .75
D. .80
Difficulty: Medium

11. The correlation coefficient between two assets equals to _________.

A. their covariance divided by the product of their variances
B. the product of their variances divided by their covariance
C. the sum of their expected returns divided by their covariance
D. their covariance divided by the product of their standard deviations
Difficulty: Medium

12. Diversification is most effective when security returns are _________.

A. high
B. negatively correlated
C. positively correlated
D. uncorrelated
Difficulty: Easy

13. The expected rate of return of a portfolio of risky securities is _________.

A. the sum of the securities' covariances
B. the sum of the securities' variances
C. the weighted sum of the securities' expected returns
D. the weighted sum of the securities' variances
Difficulty: Easy

6-25
14. Beta is a measure of security responsiveness to _________.

B. diversifiable risk
C. market risk
D. unique risk
Difficulty: Easy

15. The risk that can be diversified away is __________.

A. beta
B. firm specific risk
C. market risk
D. systematic risk
Difficulty: Easy

16. To eliminate the bias in calculating the variance and covariance of returns from historical
data the average squared deviation must be multiplied by _________.
A. n/(n - 1)
B. n * (n - 1)
C. (n - 1)/n
D. (n - 1) * n
Difficulty: Medium

17. 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. equal to the sum of the securities standard deviations
B. equal to -1
C. equal to 0
D. greater than 0
Difficulty: Medium

6-26
18. Market risk is also called __________ and _________.

B. systematic risk, nondiversifiable risk
C. unique risk, nondiversifiable risk
Difficulty: Easy

19. Firm specific risk is also called __________ and __________.

B. systematic risk, non-diversifiable risk
C. unique risk, non-diversifiable risk
Difficulty: Easy

20. Which one of the following stock return statistics fluctuates the most over time?
A. Covariance of returns
B. Variance of returns
C. Average return
Difficulty: Medium

21. Harry Markowitz is best known for his Nobel prize winning work on _____________.
A. strategies for active securities trading
B. techniques used to identify efficient portfolios of risky assets
C. techniques used to measure the systematic risk of securities
D. techniques used in valuing securities options
Difficulty: Easy

6-27
22. Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means
that ______.
A. the returns on the stock and bond portfolio tend to move inversely
B. the returns on the stock and bond portfolio tend to vary independently of each other
C. the returns on the stock and bond portfolio tend to move together
D. the covariance of the stock and bond portfolio will be positive
Difficulty: Easy

23. You put half of your money in a stock portfolio that has an expected return of 14% and a
standard deviation of 24%. You put the rest of you money in a risky bond portfolio that has an
expected return of 6% and a standard deviation of 12%. The stock and bond portfolio have a
correlation 0.55. The standard deviation of the resulting portfolio will be ________________.
A. more than 18% but less than 24%
B. equal to 18%
C. more than 12% but less than 18%
D. equal to 12%
2p = 0.02592 = (.52)(.242) + (.52)(.122) + 2(.5)(.5)(.24)(.12)0.55;  = 16.1%
Difficulty: Hard

24. On a standard expected return vs. standard deviation graph investors will prefer portfolios
that lie to the _____________ of the current investment opportunity set.
A. left and above
B. left and below
C. right and above
D. right and below
Difficulty: Easy

6-28
25. The term "complete portfolio" refers to a portfolio consisting of _________________.

A. the risk-free asset combined with at least one risky asset
B. the market portfolio combined with the minimum variance portfolio
C. securities from domestic markets combined with securities from foreign markets
D. common stocks combined with bonds
Difficulty: Easy

26. Rational risk-averse investors will always prefer portfolios _____________.

A. located on the efficient frontier to those located on the capital market line
B. located on the capital market line to those located on the efficient frontier
C. at or near the minimum variance point on the efficient frontier
D. that are risk-free to all other asset choices
Difficulty: Easy

27. The optimal risky portfolio can be identified by finding ____________.

I. the minimum variance point on the efficient frontier
II. the maximum return point on the efficient frontier the minimum variance point on the
efficient frontier
III. the tangency point of the capital market line and the efficient frontier
IV. the line with the steepest slope that connects the risk free rate to the efficient frontier
A. I and II only
B. II and III only
C. III and IV only
D. I and IV only
Difficulty: Medium

28. Reward-to-variability ratios are ________ on the ________ capital market line.

A. lower; steeper
B. higher; flatter
C. higher; steeper
D. the same; flatter
Difficulty: Medium

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return of 24% while stock B has a standard deviation of return of 18%. Stock A comprises
60% of the portfolio while stock B comprises 40% of the portfolio. If the variance of return
on the portfolio is .0380, the correlation coefficient between the returns on A and B is
_________.
A. 0.583
B. 0.225
C. 0.327
D. 0.128
0.0380 = (.62)(.242) + (.42)(.182) + 2(.6)(.4)(.24)(.18) ;  = 0.583
Difficulty: Hard

return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation
coefficient between the returns on A and B is _________.
A. .12
B. .36
C. .60
D. .77
Correlation =
Difficulty: Medium

6-30
return of 35% while stock B has a standard deviation of return of 15%. The correlation
coefficient between the returns on A and B is 0.45. Stock A comprises 40% of the portfolio
while stock B comprises 60% of the portfolio. The standard deviation of the return on this
portfolio is _________.
A. 23.00%
B. 19.76%
C. 18.45%
D. 17.67%
2p = (.402)(.352) + (.602)(.15)2 + (2)(.4)(.6)(.35)(.15)(.45)

2p = .039046
p = 19.76%

Difficulty: Medium

return on investment B is .04. If the correlation coefficient between the returns on A and B is
-.50, the covariance of returns on A and B is _________.
A. -.0447
B. -.0020
C. .0020
D. .0447
Difficulty: Medium

6-31
33. Consider two perfectly negatively correlated risky securities, A and B. Security A has an
expected rate of return of 16% and a standard deviation of return of 20%. B has an expected
rate of return of 10% and a standard deviation of return of 30%. The weight of security B in
the minimum variance portfolio is _________.
A. 10%
B. 20%
C. 40%
D. 60%
Difficulty: Hard

34. The proportion of the optimal risky portfolio that should be invested in stock A is
_________.
A. 0%
B. 40%
C. 60%
D. 100%
Difficulty: Hard

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A. 14.0%
B. 15.6%
C. 16.4%
D. 18.0%
Difficulty: Hard

36. The standard deviation of return on the optimal risky portfolio is _________.

A. 0%
B. 5%
C. 7%
D. 20%
Difficulty: Hard

6-33
37. The proportion of the optimal risky portfolio that should be invested in stock B is
approximately _________.
A. 29%
B. 44%
C. 56%
D. 71%
WB = 71%
Difficulty: Hard


A. 14%
B. 16%
C. 18%
D. 19%
E[rp] = (.29)(.21) + (.71)(.14) = 16%
Difficulty: Hard

39. The standard deviation of the returns on the optimal risky portfolio is _________.
A. 25.5%
B. 22.3%
C. 21.4%
D. 20.7%
2rp = (.292)(.392) + (.712)(.202) + 2(.29)(.71)(.39)(.20).4

2rp = .045804
rp = 21.4%

Difficulty: Hard

6-34
correlation coefficient between the return on A and B is 0.35. The expected return on stock A
is 25% while on stock B it is 11%. The proportion of the minimum variance portfolio that
would be invested in stock B is approximately _________.
A. 45%
B. 67%
C. 85%
D. 92%
WB = ; COVAB = ABAB = (.35)(.24)(.14) = .01176
WB =
Difficulty: Hard

expected return on stock A is 20% while on stock B it is 10%. The correlation coefficient
between the return on A and B is 0%. The expected return on the minimum variance portfolio
is approximately _________.
A. 10.00%
B. 13.60%
C. 15.00%
D. 19.41%
Difficulty: Hard

6-35
correlation coefficient between the return on A and B is 0%. The standard deviation of return
on the minimum variance portfolio is _________.
A. 0%
B. 6%
C. 12%
D. 17%
Difficulty: Hard

43. A measure of the riskiness of an asset held in isolation is ____________.

A. beta
B. standard deviation
C. covariance
D. semi-variance
Difficulty: Easy

44. Semitool Corp has an expected excess return of 6% for next year. However for every
unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it
turns out the economy and the stock market do better than expected by 1.5% and Semitool's
products experience more rapid growth than anticipated, pushing up the stock price by
another 1%. Based on this information what was Semitool's actual excess return?
A. 7.00%
B. 8.50%
C. 8.80%
D. 9.25%
6% + (1.5%)(1.2) + 1% = 8.8%
Difficulty: Medium

6-36
45. The part of a stock's return that is systematic is a function of which of the following
variables?
I. Volatility in excess returns of the stock market
II. The sensitivity of the stock's returns to changes in the stock market
III. The variance in the stock's returns that is unrelated to the overall stock market
A. I only
B. I and II only
C. II and III only
D. I, II and III
Difficulty: Easy

46. Stock A has a beta of 1.2 and Stock B has a beta of 1. The returns of Stock A are ______
sensitive to changes in the market as the returns of Stock B.
A. 20% more
B. slightly more
C. 20% less
D. slightly less
Difficulty: Easy

47. Which risk can be diversified away as additional securities are added to a portfolio?
I. Total risk
II. Systematic risk
III. Firm specific risk
A. I only
B. I and II only
C. I, II, and III
D. I and III
Difficulty: Easy

6-37
48. According to Tobin's separation property, portfolio choice can be separated into two
independent tasks consisting of __________ and __________.
A. identifying all investor imposed constraints; identifying the set of securities that conform
to the investor's constraints and offer the best risk-return tradeoffs
B. identifying the investor's degree of risk aversion; choosing securities from industry groups
that are consistent with the investor's risk profile
C. identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and
the optimal risky portfolio based on the investor's degree of risk aversion
D. choosing which risky assets an investor prefers according to their risk aversion level;
minimizing the CAL by lending at the risk-free rate
Difficulty: Medium

49. You are constructing a scatter plot of excess returns for Stock A versus the market index.
If the correlation coefficient between Stock A and the index is -1 you will find that the points
of the scatter diagram ______________________ and the line of best fit has a
______________.
A. all fall on the line of best fit; positive slope
B. all fall on the line of best fit; negative slope
C. are widely scattered around the line; positive slope
D. are widely scattered around the line; negative slope
Difficulty: Medium

50. The term excess-return refers to ______________.

A. returns earned illegally by means of insider trading
B. the difference between the rate of return earned and the risk-free rate
C. the difference between the rate of return earned on a particular security and the rate of
return earned on other securities of equivalent risk
D. the portion of the return on a security which represents tax liability and therefore cannot be
reinvested
Difficulty: Easy

6-38
51. You are recalculating the risk of ACE stock in relation to the market index and you find
the ratio of the systematic variance to the total variance has risen. You must also find that the
____________.
A. covariance between ACE and the market has fallen
B. correlation coefficient between ACE and the market has fallen
C. correlation coefficient between ACE and the market has risen
D. unsystematic risk of ACE has risen
Difficulty: Medium

52. A stock has a correlation with the market of 0.45. The standard deviation of the market is
21% and the standard deviation of the stock is 35%. What is the stock's beta?
A. 1.00
B. 0.75
C. 0.60
D. 0.55
=
Difficulty: Medium

53. The values of beta coefficients of securities are __________.

A. always positive
B. always negative
C. always between positive 1 and negative 1
D. usually positive, but are not restricted in any particular way
Difficulty: Easy

6-39
54. A security's beta coefficient will be negative if ____________.

A. its returns are negatively correlated with market index returns
B. its returns are positively correlated with market index returns
C. its stock price has historically been very stable
D. market demand for the firm's shares is very low
Difficulty: Easy

55. The market value weighted average beta of firms included in the market index will always
be _____________.
A. 0
B. between 0 and 1
C. 1
D. There is no particular rule concerning the average beta of firms included in the market
index
Difficulty: Easy

56. Diversification can reduce or eliminate __________ risk.

A. all
B. systematic
C. non-systematic
D. only an insignificant
Difficulty: Easy

57. In order to construct a riskless portfolio using two risky stocks, one would need to find
two stocks with a correlation coefficient of ________.
A. 1.0
B. 0.5
C. 0
D. -1.0
Difficulty: Easy

6-40
58. Some diversification benefits can be achieved by combining securities in a portfolio as

long as the correlation between the securities is _____________.
A. 1
B. less than 1
C. between 0 and 1
D. less than or equal to 0
Difficulty: Easy

59. If an investor does not diversify their portfolio and instead puts all of their money in one
stock, the appropriate measure of security risk for that investor is the ________.
A. stock's standard deviation
B. variance of the market
C. stock's beta
D. covariance with the market index
Difficulty: Medium

60. Which of the following provides the best example of a systematic risk event?
A. A strike by union workers hurts a firm's quarterly earnings.
B. Mad Cow disease in Montana hurts local ranchers and buyers of beef.
C. The Federal Reserve increases interest rates 50 basis points.
D. A senior executive at a firm embezzles $10 million and escapes to South America.
Difficulty: Easy

6-41
61. Which of the following statements is true regarding time diversification?

I. The standard deviation of the average annual rate of return over several
years will be smaller than the one-year standard deviation.
II. For a longer time horizon, uncertainty compounds over a greater number
of years.
III. Time diversification does not reduce risk.
A. I only
B. II only
C. II and III only
D. I, II and III
E. None of the statements are correct
Difficulty: Medium

62. You find that the annual standard deviation of a stock's returns is equal to 25%. For a 3
year holding period the standard deviation of your total return would equal _______.
A. 75%
B. 25%
C. 43%
D. 55%
Difficulty: Easy

6-42
63. The beta of this stock is ____.

A. 0.12
B. 0.35
C. 1.32
D. 4.05
Beta equals slope coefficient = 1.32
Difficulty: Easy

64. This stock has greater systematic risk than a stock with a beta of ___.
A. 0.50
B. 1.50
C. 2.00
D. 3.00
0.50 < 1.32
Difficulty: Easy

65. The characteristic line for this stock is Rstock = ___ + ___ Rmarket.
A. 0.35, 0.12
B. 4.05, 1.32
C. 15.44, 0.97
D. 0.26, 1.36
Intercept equals 4.05 and slope equals 1.32.
Difficulty: Medium

6-43
66. ____ percent of the variance is explained by this regression.

A. 12
B. 35
C. 4.05
D. 80
R2 = 12 means 12% of the variance is explained by the regression.
Difficulty: Medium

67. The stock is ______ riskier than the typical stock.

A. 32%
B. 15.44%
C. 12%
D. 38%
Beta of 1.32 means that this stock is 32% riskier than the market.
Difficulty: Medium

68. Decreasing the number of stocks in a portfolio from 50 to 10 would likely

_________________________.
A. increase the systematic risk of the portfolio
B. increase the unsystematic risk of the portfolio
C. increase the return of the portfolio
D. decrease the variation in returns the investor faces in any one year
Difficulty: Medium

6-44
69. If you want to know the portfolio standard deviation for a three stock portfolio you will
have to
A. calculate two covariances and one trivariance
B. calculate only two covariances
C. calculate three covariances
D. average the variances of the individual stocks
Difficulty: Medium

70. Which of the following correlations coefficients will produce the least diversification
benefit?
A. -0.6
B. -0.3
C. 0.0
D. 0.8
Difficulty: Easy

71. Which of the following correlation coefficients will produce the most diversification
benefits?
A. -0.6
B. -0.9
C. 0.0
D. 0.4
Difficulty: Easy

72. What is the most likely correlation coefficient between a stock index mutual fund and the
S&P 500?
A. -1.0
B. 0.0
C. 1.0
D. 0.5
Difficulty: Easy

6-45
73. Investing in two assets with a correlation coefficient of -0.5 will reduce what kind of risk?
A. Market risk
B. Non-diversifiable risk
C. Systematic risk
D. Unique risk
Difficulty: Easy

74. Investing in two assets with a correlation coefficient of 1.0 will reduce which kind of
risk?
A. Market risk
B. Unique risk
C. Unsystematic risk
D. With a correlation of 1.0, no risk will be reduced
Difficulty: Easy

75. A portfolio of stocks fluctuates when the treasury yields change. Since this risk can not be
eliminated through diversification, it is called __________.
B. systematic risk
C. unique risk
Difficulty: Easy

6-46
76. As you lengthen the time horizon of your investment period and decide to invest for
multiple years you will find that ________.
I. the average risk per year may be smaller over longer investment horizons
II. the overall risk of your investment will compound over time
III. your overall risk on the investment will fall
A. I only
B. I and II only
C. III only
D. I, II and III
Difficulty: Medium

77. You are considering adding a new security to your portfolio. In order to decide whether
you should add the security you need to know the security's _______.
I. expected return
II. standard deviation
III. correlation with your portfolio
A. I only
B. I and II only
C. I and III only
D. I, II and III
Difficulty: Medium

78. Which of the following is a correct expression concerning the formula for the standard
deviation of returns of a two asset portfolio where the correlation coefficient is positive?
A. 2rp < (W1212 + W2222)
B. 2rp = (W1212 + W2222)
C. 2rp = (W1212 - W2222)
D. 2rp > (W1212 + W2222)
Difficulty: Medium

6-47
contains 40% of stock A and the correlation coefficient between the two stocks is -.23.
A. 9.7%
B. 12.2%
C. 14.0%
D. 15.6%
Difficulty: Medium

contains 60% of stock A and the correlation coefficient between the two stocks is -1.0.
A. 0.0%
B. 10.8%
C. 18.0%
D. 24.0%
Difficulty: Medium

81. The expected return of portfolio is 8.9% and the risk free rate is 3.5%. If the portfolio
standard deviation is 12.0%, what is the reward to variability ratio of the portfolio?
A. 0.0
B. 0.45
C. 0.74
D. 1.35
Reward to variability ratio = (.089 - .035)/.12 = 0.45
Difficulty: Medium

6-48
losing half your money. What is the standard deviation of this investment?
A. 25%
B. 50%
C. 62%
D. 73%
E[rp] = (.60)(1) + (.40)(-.5) = .40

2rp = (.60)(1 - .40)2 + (.40)(-.5 - .40)2 = .54
rp = .73
Difficulty: Medium

losing half your money. What is the expected return on this investment project?
A. 0%
B. 25%
C. 50%
D. 75%
E[rp] = (.5)(100) + (.5)(-50) = 25%
Difficulty: Easy

The figures below show plots of monthly excess returns for two stocks plotted against excess
returns for a market index.

6-49
84. Which stock is likely to further reduce risk for an investor currently holding his portfolio
in a well diversified portfolio of common stock?
A. Stock A
B. Stock B
C. There is no difference between A or B
Difficulty: Medium

85. Which stock is riskier to a non-diversified investor who puts all his money in only one of
these stocks?
A. Stock A is riskier
B. Stock B is riskier
C. Both stocks are equally risky
Difficulty: Medium

6-50

Chapter 06 - Efficient Diversification

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Chapter 06 - Efficient Diversification

Multiple Choice Questions

1. Risk that can be eliminated through diversification is called ______ risk.

9. Which of the following statistics cannot be negative?

11. The correlation coefficient between two assets equals to _________.

12. Diversification is most effective when security returns are _________.

13. The expected rate of return of a portfolio of risky securities is _________.

14. Beta is a measure of security responsiveness to _________.

15. The risk that can be diversified away is __________.

18. Market risk is also called __________ and _________.

19. Firm specific risk is also called __________ and __________.

25. The term "complete portfolio" refers to a portfolio consisting of _________________.

26. Rational risk-averse investors will always prefer portfolios _____________.

27. The optimal risky portfolio can be identified by finding ____________.

28. Reward-to-variability ratios are ________ on the ________ capital market line.

35. The expected return on the optimal risky portfolio is _________.

36. The standard deviation of return on the optimal risky portfolio is _________.

38. The expected return on the optimal risky portfolio is _________.

43. A measure of the riskiness of an asset held in isolation is ____________.

50. The term excess-return refers to ______________.

53. The values of beta coefficients of securities are __________.

54. A security's beta coefficient will be negative if ____________.

56. Diversification can reduce or eliminate __________ risk.

58. Some diversification benefits can be achieved by combining securities in a portfolio as

61. Which of the following statements is true regarding time diversification?

63. The beta of this stock is ____.

66. ____ percent of the variance is explained by this regression.

67. The stock is ______ riskier than the typical stock.

68. Decreasing the number of stocks in a portfolio from 50 to 10 would likely