File: ch07, Chapter 7: Portfolio Theory

Type: Multiple Choice

1. Which of the following is not a reason why investors are interested in past returns?

a. Realized returns can help investors form expectations about expected (future) returns.
b. Realized returns are used directly to make decisions as to investment values.
c. Investors and portfolio managers want to measure the success of their past decisions.
d. Statistically, investors can use past data to form forecasts about the future.

Ans: b
Difficulty: Easy
Response: Historical, i.e. realized returns are important for several reasons, but they would have
no impact on current investment values.
Ref: Dealing with Uncertainty

2. Modern Portfolio Theory has the greatest impact on which of the following career
disciplines in the financial services industry:

a. investment banking.
b. stock brokerage.
c. portfolio management.
d. security analysis.

Ans: c
Difficulty: Easy
Response: Modern Portfolio Theory holds critical importance for portfolio managers who need
to properly diversify in order to adequately mitigate risk.
Ref: Dealing with Uncertainty

3. An analyst has estimated the return on XYZ stock in various economic states.

Economy Probability Return

Boom 0.1 30%
Good time 0.2 15%
Moderate 0.4 10%
Slow 0.2 0%
Recession 0.1 -20%

What is the expected return for XYZ?

a. 8%
b. 10%
c. 12%
d. 15%
Ans: a
Difficulty: Medium
Response: (0.1 x 30%) + (0.2 x 15%) + (0.4 x 10%) + (0.2) x 0% + (0.1 x –20%) = 3% + 3% +
4% + 0% - 2% = 8%.
Ref: Dealing with Uncertainty

4. An analyst has estimated the return on XYZ stock in various economic states.

Economy Probability Return

Boom 0.1 30%
Good time 0.2 15%
Moderate 0.4 10%
Slow 0.2 0%
Recession 0.1 -20%

What is the standard deviation of returns on XYZ?

a. 151%
b. 12.29%
c. 13.85%
d. 37.22%

Ans: b
Difficulty: Difficult
Response:
Economy Prob. Return R-EV Squares Sq. X Prob
Boom .1 30% 22% .0484 .00484
Good time .2 15% 7% .0049 .00098
Moderate .4 10% 2% .0004 .00016
Slow .2 0% -8% .0064 .00128
Recession .1 -20% -28% .0784 .00784
1.0 -5% 0.1385 .01510

Taking the square root of 0.0151 gives 0.12288 or 12.29%.

Ref: Dealing with Uncertainty

5. Sally has three investments, with the expected returns and portfolio proportions as shown
below:

Investment Proportion Expected Return

Treasuries 0.50 4%
Microsaft 0.30 7%
AT&D 0.20 6%
 What is the expected return for Sally’s portfolio?

a. 4%
b. 5.3%
c. 5.7%
d. 17%

Ans: b
Difficulty: Easy
Response:
Investment Proportion Expected Product
Return
Treasuries 0.50 4% 2.0%
Microsaft 0.30 7% 2.1%
AT&D 0.20 6% 1.2%
1.00 5.3%
Portfolio expected return is the weighted average of the securities’ expected returns.
Ref: Portfolio Return and Risk

6. Which of the following is not a measure of risk?

a. Standard deviation
b. Variance
c. Expected return
d. Dispersion

Ans: c
Difficulty: Easy
Response: Risk can be expressed using various measures, but expected return estimates future
returns, not risk.
Ref: Portfolio Return and Risk

7. Which of the following is true regarding a portfolio of two assets that are less than
perfectly correlated? The portfolio’s:

a. expected return is less than the weighted average of expected return of the two assets.
b. variance is equal to the weighted average of the variance of the two assets.
c. variance is less than the weighted average of the variance of the two assets.
d. variance is more than the weighted average of the variance of the two assets.

Ans: c
Difficulty: Easy
Response: Portfolio risk is always less than the weighted average of the risks of the securities in
the portfolio, unless the securities have outcomes that vary together exactly, an almost
impossible occurrence.
Ref: Portfolio Return and Risk
8. Which type of risk is reduced when assets are combined into portfolios?

a. Market risk
b. Systematic risk
c. Company-specific risk
d. Interest rate risk

Ans: c
Difficulty: Easy
Ref: Introduction to Modern Portfolio Theory

9. Which of the following is likely to cause some of the covariance between pairs of
securities’ returns?

a. The effects of the economy, such as interest rate changes.

b. The unique events that affect the two companies.
c. Each company will be impacted by business and financial risk.
d. Both companies have high company-specific risk.

Ans: a
Difficulty: Medium
Response: The movement of the returns of two securities is related (measured by covariance or
correlation) if the same events affect both securities.
Ref: The Components of Portfolio Risk

10. How many stocks are needed in a random portfolio to eliminate 55% of the portfolio’s
standard deviation?

a. 1
b. 16
c. 75
d. 100

Ans: b
Difficulty: Medium
Response: A portfolio with 75 random assets has a standard deviation equal to only 40% of the
standard deviation of a single stock, and a portfolio with only 16 assets has a standard deviation
equal to only 45% of the standard deviation of a single stock.
Ref: Analyzing Portfolio Risk

11. Consider a portfolio of Asset A and Asset B. Which level of correlation between the
returns of A and B will reduce the standard deviation of the portfolio the most?

a.  = +1.00
b.
c
d

Ans: d
Difficulty: Easy
Response: While any correlation less than 1.00 will reduce the portfolio standard deviation, if the
correlation is –1.0, all the portfolio standard deviation can be eliminated.
Ref: Analyzing Portfolio Risk

12. Which of the following best explains the difference between correlation and covariance?

a. Correlation measures how returns move together; covariance is the square root of
variance.
b. Correlation can be any number, positive or negative; covariance is somewhere between –
1 and +1 only.
c. Covariance measures how two variables move together; correlation divides covariance by
the product of the two standard deviations.
d. Correlation is used to calculate the portfolio standard deviation, but covariance cannot be
used in investment theory.

Ans: c
Difficulty: Difficult
Response: Both correlation and covariance measure how much two returns move together.
Ref: The Components of Portfolio Risk

13. A portfolio is formed with 50% Southeast Utilities (SU) and 50% Precision Instruments
(PI). If the portfolio’s standard deviation is half way between SU’s and PI’s standard
deviations then the:

a. correlation between the two securities is 0.

b. correlation between the two securities is +1.
c. correlation between the two securities is -1.
d. portfolio’s expected return is not half way between the two securities’ expected returns.

Ans: b
Difficulty: Medium
Response: Portfolio standard deviation becomes a weighted average only if the two securities are
perfectly positively correlated. Portfolio expected return is always a weighted average.
Ref: Calculating Portfolio Risk

14. Based on Modern Portfolio Theory, a portfolio’s risk is determined by which factors?

a. Standard deviations and portfolio weights

b. Variances and portfolio weights
c. Standard deviations and covariances
d. Variances, covariances and portfolio weights
Ans: d
Difficulty:
Response: Three factors determine overall portfolio risk: variance, covariance, and portfolio
weights.
Ref: The Components of Portfolio Risk

15. Which of the following statements regarding the importance of covariance is most
accurate? As the number of securities held in a portfolio:

a. increases, the importance of each individual security's risk (variance) decreases, while the
importance of the covariance relationships increases.
b. decreases, the importance of each individual security's risk (variance) decreases, while
the importance of the covariance relationships increases.
c. increases, the importance of each individual security's risk (variance) increases, while the
importance of the covariance relationships decreases.
d. decreases, the importance of each individual security's risk (variance) increases, while the
importance of the covariance relationships decreases

Ans: a
Difficulty: Difficult
Response: In a portfolio of 150 securities, for example, the contribution of each security's own
risk to the total portfolio risk will be extremely small; portfolio risk will consist almost entirely
of the covariance risk between securities.
Ref: The Components of Portfolio Risk

16. Risk reduction in the case of independent risk sources can be thought of as:

a. the law of large numbers.

b. the insurance principle.
c. random diversification.
d. modern portfolio theory.

Ans: b
Difficulty: Easy
Response: The insurance principle is named for the idea that an insurance company reduces its
risk by writing many policies against many independent sources of risk.
Ref: Analyzing Portfolio Risk

17. How many terms are in the formula for the variance of a three-security portfolio?

a. 4
b. 9
c. 16
d. 32

Ans: b
Difficulty: Medium
Response: The number of terms is the square of the number of securities.
Ref: Calculating Portfolio Risk

18. An investor has 50% of his portfolio in the risk free asset and 50% in Exxon Mobil stock.
The risk free rate is 0.2%, and Exxon’s expected return is 10% with a standard deviation
of 20%. What is the expected return and risk of this portfolio?

a. Expected return on the portfolio is 10.2%, standard deviation is 20%

b. Expected return on the portfolio is 5.1%, standard deviation is 1%
c. Expected return on the portfolio is 5.1%, standard deviation is 10%
d. Expected return on the portfolio is 5.1%, standard deviation of the portfolio is 20%

Ans: b
Difficulty: Difficult
Response: The standard deviation of the risk free rate is zero by definition (i.e., it is risk free).
Expected return on the portfolio is the weighted average of expected returns. Standard deviation
of the portfolio is ((0.5)2 * (20)2)0.5 = 10%.
Ref: Portfolio Return and Risk

Type: True False

1. Investment decisions involve estimations of future returns. But future returns are never
knowable in advance, with certainty.

Ans: True
Response: The return an investor will earn from investing is not known in advance.
Ref: Dealing with Uncertainty

2. A probability distribution shows all the possible outcomes, and the probability of each
outcome occurring.

Ans: True
Ref: Dealing with Uncertainty

3. The normal distribution is an example of a discrete distribution.

Ans: False
Response: The normal distribution is an example of a continuous distribution.
Ref: Dealing with Uncertainty

4. According to the Law of Large Numbers, the larger the sample size, the more likely it is
that the sample mean will be close to the population expected value.

Ans: True
Ref: Analyzing Portfolio Risk

5. The expected return on a portfolio is the expected return of each asset, multiplied by its
weight in the portfolio.

Ans: True
Ref: Portfolio Return and Risk

6. The standard deviation of a portfolio is the standard deviation of each asset, multiplied by
its weight in the portfolio.

Ans: False
Response: While the weighted average concept works for expected return, this approach does not
“work” for the standard deviation of a portfolio. A well-designed portfolio can have a standard
deviation lower than the weighted average of the individual standard deviations.
Ref: Calculating Portfolio Risk

7. If we want to build a portfolio with two assets whose returns are statistically independent,
we need to find two assets whose firm-specific risks are completely unrelated.

Ans: True
Ref: Portfolio Return and Risk

8. “Don’t put all your eggs in one basket” is a popular saying, which expresses the
fundamental idea of inefficient diversification.

Ans: True
Ref: Introduction to Modern Portfolio Theory

9. Although tedious, working through the 31,125 co-variances of a 250-security portfolio

can be handled easily by a computer.

Ans: True
Response: Note that Markowitz invented a primitive computer to handle this very problem.
Ref: Introduction to Modern Portfolio Theory

10. A portfolio formed from equal weights of two securities that are not perfectly positively
correlated will have a standard deviation that is lower than the lowest standard deviation
of the two securities.

Ans: False
Response: The standard deviation will be below the average of the two standard deviations, but
not necessarily below the lowest standard deviation.
Ref: Calculating Portfolio Risk
11. Asset weights must always be greater than or equal to zero, and the sum of all portfolio
weights must equal one.

Ans: False
Response: Weights can sometimes be negative, (i.e. you can have short positions in individual
securities in a portfolio), but the total of all assets in a portfolio must equal 1.
Ref: Dealing with Uncertainty

12. The number of covariances in the Markowitz model is n(n-1), and the number of unique
covariances is [n (n-1)]/2.

Ans: True.
Ref: Summary