JUN18L1PMA/C02

Question 1
Which of the following is least likely to be considered a limitation of the CAPM?
a) It is complicated to apply.
b) Estimates of betas are not always accurate.
c) It assumes portfolios are sufficiently well diversified to eliminate unsystematic risk.
One of the advantages of the CAPM is that it is an easy model to apply.

Question 2
The point at which the capital allocation line tangents the efficient frontier is the:
a) Optimal portfolio for a risk-averse investor.
b) Optimal risky portfolio for all investors irrespective of their risk preferences.
c) Optimal portfolio for all investors irrespective of their risk preferences.
The point at which the capital allocation line tangents the efficient frontier is the optimal risky portfolio for all investors
irrespective of their risk preferences.

Question 3
The following statements were made by a portfolio manager:
When the correlation between the securities is +1, an increase in the returns of the portfolio can happen only with an
increase in the risk of the portfolio.
When the correlation between the securities is 0 or −1, an increase in the returns of the portfolio can happen despite a
decrease in the risk of the portfolio.
Which of the following is true?
a) Only Statement I is correct.
b) Only Statement II is correct.
c) Both the statements are correct.
When the correlation between the securities is +1, an increase in the returns of a portfolio can happen only with an
increase in the risk of the portfolio. When the correlation between the securities is 0 or −1, an increase in the returns
of a portfolio can happen despite a decrease in the risk of the portfolio.

Question 4
Based on the following information, Oahu's Treynor ratio is closest to:
Asset Return (Percentage) Standard Deviation (Percentage) Beta
Oahu 13.0 20 0.8
Market 15.0 25 1.0
Risk free rate 03.0

a) 0.005
b) 0.125
c) 0.500
Treynor ratio Oahu = (ROahu,− R f ) / βOahu = (0.13 − 0.03) / 0.8 = 0.125

Question 5
Jane is currently in the process of allocating assets according to her new client's investment policy statement. She is
engaging in which type of asset allocation practice?
a) Tactical allocation.
b) Strategic allocation.
c) Portfolio allocation.
Strategic asset allocation refers to the guidelines set forth in an investor's IPS, whereas tactical allocations are short-
term deviations from the strategic asset allocation.

Question 6
An analyst observes three portfolios with different asset allocations as follows:
Portfolio Cash (%) Bonds (%) Stocks (%) Alternative Assets (%)
1 10 40 30 20
2 0 50 30 20
3 20 10 50 20
The portfolio most appropriate for a client with a low risk tolerance is:
 a) Portfolio 1.
b) Portfolio 2.
c) Portfolio 3.
Portfolio 1 offers the most diversification in that it holds assets in all investment types and has the lowest
concentration in any particular type. In addition, Portfolio 1 has a higher weight in cash and a lower weight in bonds
than Portfolio 2. Cash is less risky than bonds, making Portfolio 1 relatively less risky.

Question 7
A balanced fund typically invests in:
a) Debt securities only.
b) Short-term debt securities only.
c) Debt and equity securities.
Balanced or hybrid funds invest in both bonds and equity securities.

Question 8
Systematic risk:
a) Can be decreased through diversification.
b) Is the risk that is particular to a specific asset.
c) Is the added risk of a security to a well-diversified portfolio.
The first choice is incorrect. Only unsystematic risk can be decreased through diversification.
The second choice is incorrect. This describes unsystematic risk.
The third choice is correct. This describes systematic risk.

Question 9
An analyst gathered the following information regarding three investments:
Investment Expected Return Standard Deviation
Investment A 11% 18%
Investment B 18% 24%
Investment C 14% 22%
Investment D 22% 29%
Utility formula:
U = E(R)–(1/2 × A σ2)
A risk-loving investor will most likely choose:
a) Investment A.
b) Investment B.
c) Investment D.
A risk-loving investor likes both higher risk and higher return. Therefore, she will choose Investment D.

Question 10
A very wealthy investor is most likely to structure her portfolio with which of the following investment vehicles?
a) Mutual fund.
b) Exchange-traded fund.
c) Separately managed account.
High-net-worth investors prefer SMAs to other investment vehicles because they allow them to customize their
exposures and negotiate preferential fees with money managers. It also allows them to accommodate tax needs as
well.

Question 11
The following information is available regarding the portfolio performance of three investment managers:
Manager Return Standard Deviation Beta
A 19% 27% 0.7
B 14% 22% 1.2
C 16% 19% 0.9
Market (M) 11% 24%
Risk-free rate 5%
Manager A’s Sharpe ratio is closest to:
a) 0.5185
 b) 0.4091
c) 0.2000
Sharpe ratio = (RA – Rf) / σA = (0.19 – 0.05) / 0.27 = 0.5185

Question 12
For a three-year period, the stocks of Elem Company have the following returns: 5%, 8%, 2%, while the stocks of HS
Company have the following returns: 7%, 4%, 1%. What is the covariance between the returns of the stocks of Elem
Company and HS Company?
a) 00045
b) 00345
c) 01225
Mean(EC) = (5 + 8 + 2)/3 = 5%.
Mean(HC) = (7 + 4 + 1)/3 = 4%.
Cov(ECHC) = [(.05 – .05)(.07 – .04) + (.08 – .05)(.04 – .04) + (.02 – .05)(.01 – .04)]/(3 – 1) = 0.00045

Question 13
Investors who are cautions will tend to have:
a) Flat indifference curves.
b) Steep indifference curves.
c) Negatively sloping indifference curves.
The most risk-averse investors will require high additional returns for taking on extra risk, which leads to steep
indifference curves.

The following information relates to Questions 14-15.

A portfolio has the following two securities:
Stock Portfolio Weight Return Standard Deviation
X 20% 46%
Y 80% 31%
Question 14
If the standard deviation of the portfolio returns is 30.91%, compute the correlation coefficient of returns between the
two stocks.
a) 0.46
b) 0.56
c) 0.66
Portfolio return standard deviation:
[(0.2)2 (0.46)2 +(0.8)2 (0.31)2 +2(0.2)(0.8)(ρ)(0.46)(0.31)]1/2 =0.3091, solve ρ=0.56.

Question 15
If the standard deviation of the portfolio returns is 32.07%, compute the covariance of returns between the two stocks.
a) 0.1027
b) 0.1543
c) 0.2025
Portfolio return standard deviation:
[(0.2) 2 (0.46) 2 +(0.8) 2 (0.31) 2 +2(0.2)(0.8)(COV 12 )] 1/2 =0.3207,solveCOV 12 =0.1027.

Question 16
Determining the portfolio’s asset allocation is part of the:
a) Planning phase.
b) Execution phase.
c) Feedback phase.
Determining the portfolio’s asset allocation is part of the execution phase of constructing a portfolio.

Question 17
Do increases in correlation coefficients between different asset class pairs during a financial crisis provide
diversification benefits to investors?
a) Yes. Higher correlation results in more diversification benefits.
b) Changes in correlation coefficients do not impact diversification benefits.
c) No. As correlation coefficients increase during a crisis, the diversification benefit is reduced because all
assets tend to move together during crisis.
The level of correlation coefficient and the effectiveness of diversification are negatively correlated. High correlation
coefficients suggest low quality in diversification.

Question 18
Which of the following statements is false?
Statement 1: A security's historical returns should be consistent with the CAPM and the SML.
Statement 2: The expected return on an overvalued asset should plot below the SML.
a) Statement 1 only
b) Statement 2 only
c) None of the above
The first choice is correct. Statement 1 is false because CAPM and SML can provide a security's expected return
based on its beta. Statement 2 is true.

Question 19
In a defined contribution plan:
a) The employee accepts the investment risk in the portfolio.
b) The employee is responsible for ensuring that there are enough funds in the plan to meet employers' needs
upon retirement.
c) The employer has an obligation to pay a certain annual amount to its employees when they retire.
In a defined contribution plan, the employee accepts the investment risk and is responsible for ensuring that there are
enough funds in the plan to meet their needs upon retirement.

Question 20
Taking advantage of perceived short-term opportunities through varying from strategic asset allocation weights is:
a) Security selection.
b) Tactical asset allocation.
c) This is not possible.
Security selections are deviations from index weights on individual securities within an asset class.