Chapter 3

Efficient Diversification

Question.1. Based on market history, what is the average annual standard

deviation of return for a single, randomly chosen stock? What is the average
annual standard deviation for an equally weighted portfolio of many stocks?

Answer. Based on market history, the average annual standard deviation of

return for a single, randomly chosen stock is about 50 percent. The average
annual standard deviation for an equally-weighted portfolio of many stocks is
about 20 percent.

Question.2. If the returns on two stocks are highly correlated, what does this
mean? If they have no correlation? If they are negatively correlated?

Answer. If the returns on two stocks are highly correlated, they have a strong
tendency to move up and down together. If they have no correlation, there is
no particular connection between the two. If they are negatively correlated,
they tend to move in opposite directions.

Question.3. What is an efficient portfolio?

Answer. An efficient portfolio is one that has the highest return for its level of
risk.

Question.4. If two stocks have the same expected return of 12 percent, then
any portfolio of the two stocks will also have an expected return of 12 percent.

Answer. True. Remember, portfolio return is a weighted average of individual

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Question.5. If two stocks have the same standard deviation of 45 percent, then
any portfolio of the two stocks will also have a standard deviation of 45
percent.

Answer. False. Remember the principle of diversification.

Question.6. You have a portfolio created from two assets. As you add more of
the lower risk asset to your portfolio, the risk of your portfolio increases. What
do you know about your current portfolio?

Answer. An investment with high volatility could actually reduce the risk of the
overall portfolio if its correlation to the existing assets is very low.

Question.7. Why is the minimum variance portfolio important in regard to the

Markowitz efficient frontier?

Answer. The importance of the minimum variance portfolio is that it

determines the lower bond of the efficient frontier. While there are portfolios
on the investment opportunity set to the right and below the minimum
variance portfolio, they are inefficient. That is, there is a portfolio with the
same level of risk and a higher return. No rational investor would ever invest in
a portfolio below the minimum variance portfolio.

Question.8. It is impossible for a single asset to lie on the Markowitz efficient

frontier.

Answer. False. Individual assets can lie on the efficient frontier depending on
its expected return, standard deviation, and correlation with all other assets.

Question.9. Suppose two assets have zero correlation and the same standard
deviation. What is true about the minimum variance portfolio?

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Answer. If two assets have zero correlation and the same standard deviation,
then evaluating the general expression for the minimum variance portfolio
shows that x = ½; in other words, an equally-weighted portfolio is minimum
variance.

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

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3. 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

4. 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

5. 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

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6. 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
 
7. Which of the following statistics cannot be negative? 
A. Covariance
B. Variance
C. E[r]
D. Correlation coefficient
 
8. 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
9. Diversification is most effective when security returns are _________. 
A. high
B. negatively correlated
C. positively correlated
D. uncorrelated

10. 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

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11. Beta is a measure of security responsiveness to _________. 
A. firm specific risk
B. diversifiable risk
C. market risk
D. unique risk

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

A. beta
B. firm specific risk
C. market risk
D. systematic risk
 
13. 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

14. 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

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15. Firm specific risk is also called __________ and __________. 
A. systematic risk, diversifiable risk
B. systematic risk, non-diversifiable risk
C. unique risk, non-diversifiable risk
D. unique risk, diversifiable risk
 
16. Which one of the following stock return statistics fluctuates the most over
time? 
A. Covariance of returns
B. Variance of returns
C. Average return
D. Correlation coefficient

17. 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

18. 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

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19. 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
 
20. 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

21. 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

22 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

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23. 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

Correlation =

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

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

25. 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 

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26. 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

27. 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
 
28. 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

29. 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

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=

30. 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
 
31. 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

 32. 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
 
33. Diversification can reduce or eliminate __________ risk. 
A. all
B. systematic
C. non-systematic
D. only an insignificant

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34. 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
 
35. 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

36. 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

37. 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.

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38. 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

39. 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
 
40. Which of the following correlations coefficients will produce the least
diversification benefit? 
A. -0.6
B. -0.3
C. 0.0
D. 0.8
 
41. Which of the following correlation coefficients will produce the most
diversification benefits? 
A. -0.6
B. -0.9
C. 0.0
D. 0.4

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42. 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

43. 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

44. 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
 
45. A portfolio of stocks fluctuates when the treasury yields change. Since this
risk cannot be eliminated through diversification, it is called __________. 
A. firm specific risk
B. systematic risk
C. unique risk
D. none of the above

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46. 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

47. 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

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