Chapter 3: Modern portfolio theory

Self test questions

1. The disadvantage(s) of using variance as risk measure is(are):

(a) It ignores higher moments (skewness)

(b) It gives equal weight to upward and downward deviations from the expectation
(c) It can be used in a forward and backward looking way

2. The expected return of a portfolio of assets is:

(a) The sum of the expected asset returns

(b) The weighted average of the expected asset returns
(c) The weighted average of the expected asset returns corrected for correlation
(d) None of the above

3. The variance of a portfolio of assets is:

(a) The sum of the asset variances

(b) The weighted average of the asset variances
(c) The weighted sum of the asset variances and covariances
(d) None of the above

4. Unsystematic risk is:

(a) The risk that disappears through diversication

(b) Market risk
(c) The total risk of a poorly diversied portfolio
(d) None of the above

5. Systematic risk is:

(a) The risk that disappears through diversication

(b) Market risk
(c) The total risk of a poorly diversied portfolio
(d) None of the above

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 6. The variance of a poorly diversied portfolio measures:

(a) The risk that disappears through diversication

(b) Market risk
(c) The total risk of that portfolio
(d) None of the above

7. The diversication eect reduces:

(a) The total risk of a portfolio

(b) The systematic risk of a portfolio
(c) The unsystematic risk of a portfolio

8. The diversication eect increases with the number of assets in a portfolio because:

(a) Asset variances tend to cancel out

(b) Asset returns tend to cancel out
(c) The number of covariances increases faster than the number of variances

9. The of a poorly diversied portfolio measures:

(a) The risk that disappears through diversication

(b) Market risk
(c) The total risk of a portfolio
(d) None of the above

10. The of an individual asset measures:

(a) The assets contribution to portfolio variance

(b) The assets sensitivity for changes in portfolio returns
(c) The assets systematic risk
(d) The ratio of the assets covariance with the portfolio and the portfolio variance

11. Variances are additive (total variance=weighted sum of the variances of the parts) across:

(a) Assets in a portfolio

(b) Projects and activities in a company
(c) Debt and equity in a company
(d) All of the above
(e) None of the above

12. s are additive (total =weighted sum of the s of the parts) across:

(a) Assets in a portfolio

(b) Projects and activities in a company
(c) Debt and equity in a company
(d) All of the above
(e) None of the above

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13. The diversication eect of combining 2 assets is maximal if:

(a) Their correlation coe cient is -1

(b) Their correlation coe cient is +1
(c) Their correlation coe cient is 0
(d) None of the above

14. The market risk of a portfolio increases if:

(a) An asset with a < 1 is added to the portfolio

(b) An asset with a > 1 is added to the portfolio
(c) An asset with a = 1 is added to the portfolio
(d) None of the above

15. Markowitz e cient portfolios cannot be replaced by portfolios that:

(a) Oer a higher expected return for the same risk

(b) Oer a higher expected return for a higher risk
(c) Oer a lower expected return for a lower risk
(d) Oer a lower risk for the same expected return
(e) Oer a lower expected return for the same risk

16. A risk free asset has a of:

(a) =1
(b) =0
(c) = 1
(d) None of the above

17. If the market is in equilibrium then:

(a) All assets are held

(b) Demand equals supply
(c) There is no excess demand or supply
(d) There may be investors who want to invest more at market prices
(e) There may be assets that remain unsold at market prices
(f) Everybody who invests in risky assets holds a fraction of the market portfolio
(g) Two fund separation obtains

18. In equilibrium, the locus of the market portfolio M is chosen such that:

(a) It gives the highest possible expected return per additional unit of risk
(b) It expresses the average risk aversion in the market
(c) It contains all assets in the risky investment universe
(d) The Capital Market Line has the steepest possible slope

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19. An individual whose indierence curve has a tangency point with the Capital Market
Line to the left of the market portfolio M:

(a) Borrows money risk free to invest more than his own money in risky assets
(b) Invests a fraction of his money in the risk free asset and the rest in risky assets
(c) Only holds a fraction of the market portfolio M
(d) None of the above

20. An individual whose indierence curve has a tangency point with the Capital Market
Line to the right of the market portfolio M:

(a) Borrows money risk free to invest more than his own money in risky assets
(b) Invests a fraction of his money in the risk free asset and the rest in risky assets
(c) Only holds a fraction of the market portfolio M
(d) None of the above

21. The Capital Market Line depicts the expected return of:

(a) Any investment as a function of its standard deviation

(b) E cient portfolios as a function of portfolio standard deviation
(c) Any investment as a function of its
(d) None of the above

22. The Security Market Line depicts the expected return of:

(a) Any investment as a function of its standard deviation

(b) E cient portfolios as a function of portfolio standard deviation
(c) Any investment as a function of its
(d) None of the above

23. The market price of risk, (E(rm ) rf )= , is the price per unit of risk of:

(a) The Capital Market Line

(b) The Security Market Line
(c) All of the above
(d) None of the above

24. The Sharpe ratio:

(a) Uses total risk ( )

(b) Uses systematic risk ( )
(c) Is better suited to evaluate an investors total portfolio
(d) Is better suited to evaluate sub-portfolios

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25. The Treynor ratio:

(a) Uses total risk ( )

(b) Uses systematic risk ( )
(c) Is better suited to evaluate an investors total portfolio
(d) Is better suited to evaluate sub-portfolios

26. Jensens alpha:

(a) Uses total risk ( )

(b) Uses systematic risk ( )
(c) Is better suited to evaluate an investors total portfolio
(d) Is better suited to evaluate sub-portfolios

27. A company has an equity of 1:7: The risk free rate is 3% and the expected return on
the market portfolio is 7:6%. What is the companys expected return on equity?

(a) 8:1%
(b) 15:92%
(c) 7:82%
(d) 10:82%

28. Markowitz mean-variance optimization is equivalent to the more general behavioural

assertion of expected utility maximization if:

(a) Asset returns are jointly normally distributed

(b) Investors are risk neutral
(c) Investors have quadratic utility functions
(d) Investors have logarithmic utility functions

29. Which of the following empirical ndings contradict(s) the CAPM?

(a) Smaller rms have higher returns than large rms

(b) Risky rms have higher returns than safe rms
(c) Value stocks have higher returns than growth stocks
(d) The relation between and return is linear
(e) The estimated return when = 0 is higher than the risk free interest rate
(f) The estimated risk premium (rm rf ) is close to zero

30. An arbitrage strategy:

(a) Is buying something cheaply in one country and selling it at high price in another
(b) Costs nothing today and gives a positive or zero payo later
(c) Gives a payo today and no net obligations later
(d) Is very protable but can involve high risk
(e) Prots from mispricing

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31. Arbitrage Pricing Theory (APT):

(a) Assumes that the market portfolio is e cient

(b) Includes size and book-to-market as additional risk factors besides the market risk
(c) Only prices systematic risk, not unsystematic risk
(d) Allows for other risk factors than the market as a whole
(e) Does not specify what, or even how many, risk factors there are