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Multiple Choice Questions
1. Market risk is also referred to as A) systematic risk, diversifiable risk. B) systematic risk, nondiversifiable risk. C) unique risk, nondiversifiable risk. D) unique risk, diversifiable risk. E) none of the above.
Answer: B Difficulty: Easy
Rationale: 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.
2. The risk that can be diversified away is A) firm specific risk. B) beta. C) systematic risk. D) market risk. E) none of the above.
Answer: A Difficulty: Easy
Rationale: See explanations for 1 and 2 above.
3. The variance of a portfolio of risky securities A) is a weighted sum of the securities' variances. B) is the sum of the securities' variances. C) is the weighted sum of the securities' variances and covariances. D) is the sum of the securities' covariances. E) none of the above.
Answer: C Difficulty: Moderate
Rationale: 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.
4. The expected return of a portfolio of risky securities A) is a weighted average of the securities' returns. B) is the sum of the securities' returns. C) is the weighted sum of the securities' variances and covariances. D) A and C. E) none of the above.
Answer: A Difficulty: Easy
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5. Other things equal, diversification is most effective when A) securities' returns are uncorrelated.
B) securities' returns are positively correlated. C) securities' returns are high.
D) securities' returns are negatively correlated. E) B and C.
Answer: D Difficulty: Moderate
Rationale: Negative correlation among securities results in the greatest reduction of portfolio
risk, which is the goal of diversification.
6. 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
Rationale: 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.
7. 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
Rationale: The Capital Allocation Line represents the most efficient combinations of the
risk-free asset and risky securities. Only C meets that definition.
8. 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.
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D) equal to -1.
E) none of the above.
Answer: B Difficulty: Difficult
Rationale: 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.
9. 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: C Difficulty: Moderate
Rationale: The lower the correlation between the returns of the securities, the more portfolio
risk is reduced.
10. 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
Rationale: Portfolios that are efficient are those that provide the highest expected return for a
given level of risk.
11. 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.
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