Intermediate Investments

Practice set for test 1

1. Currently, the Dow Jones Industrial Average is computed by _________. 

A. adding the prices of 30 large "blue-chip" stocks and dividing by 30
B. calculating the total market value of the 30 firms in the index and dividing by 30
C. measuring the current total market value of the 30 stocks in the index relative to the total value on the
previous day
D. adding the prices of 30 large "blue-chip" stocks and dividing by a divisor adjusted for stock splits and large stock
dividends

2. A level _____ subscriber to the NASDAQ system may enter bid and ask prices. 
A. 1
B. 2
C. 3
D. 4

3. Which one of the following is not an example of a brokered market? 

A. Residential real estate market
B. Market for large block security transactions
C. Primary market for securities
D. NASDAQ

4. When matching orders from the public, a specialist is required to use the _______. 
A. lowest outstanding bid price and highest outstanding ask price
B. highest outstanding bid price and highest outstanding ask price
C. lowest outstanding bid price and lowest outstanding ask price
D. highest outstanding bid price and lowest outstanding ask price

5. The bid-ask spread exists because of _______________. 

A. market inefficiencies
B. discontinuities in the markets
C. the need for dealers to cover expenses and make a profit
D. lack of trading in thin markets

6. You purchased 200 shares of ABC common stock on margin at $50 per share. Assume the initial margin is 50% and
the maintenance margin is 30%. You will get a margin call if the stock drops below ________. (Assume the stock
pays no dividends, and ignore interest on the margin loan.) 
A. $26.55
B. $35.71
C. $28.95
D. $30.77

Solution: Value of your portfolio will be $10,000 (200 shares x $50 per share). Half of that amount will be financed
with debt (D=$5,000).
Recall that Margin = Equity / Value of portfolio, and it is determined to be 30%.

Margin = Equity / Value of portfolio = 0.3

Equity = Value of portfolio – Debt

Therefore: (Value of portfolio – Debt) / Value of portfolio = 0.3

(200 P – 5000) / 200P = 0.3
200P – 5000 = 60P
140P = 5000
P=35.71
7. Which one of the following measures time-weighted returns and allows for compounding?
a. dollar-weighted return
b. geometric average return
c. arithmetic average return
d. historical average return

8. An investor’s degree of risk aversion will determine his or her ______.

a. optimal mix of the risk-free asset and risky asset
b. capital allocation line
c. optimal risky portfolio
d. risk-free rate

9. Risk that can be eliminated through diversification is called ______ risk.

a. unique
b. firm-specific
c. diversifiable
d. all of these options

10. A portfolio with a 25% standard deviation generated a return of 15% last year when T-bills were paying 4.5%. This
portfolio had a Sharpe ratio of ____.
a. 0.22
b. 0.25
c. 0.42
d. 0.60

11. Market risk is also called __________ and _________.

a. unique risk; diversifiable risk
b. unique risk; nondiversifiable risk
c. systematic risk; nondiversifiable risk
d. systematic risk; diversifiable risk

12. Which of the following statistics cannot be negative?

a. covariance
b. variance
c. correlation coefficient
d. E®

13. The _______ decision should take precedence over the _____ decision.
a. asset allocation; stock selection
b. stock selection; asset allocation
c. bond selection; mutual fund selection
d. stock selection; asset allocation

14. Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means that ______.
a. the returns on the stock and bond portfolios tend to move together
b. the covariance of the stock and bond portfolios will be positive
c. the returns on the stock and bond portfolios tend to vary independently of each other
d. the returns on the stock and bond portfolios tend to move inversely

15. The complete portfolio refers to the investment in _________.

a. the risky portfolio
b. the risky portfolio and the index
c. the risk-free asset
d. the risk-free asset and the risky portfolio combined

16. 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 and the minimum-variance point on the efficient
frontier
III. The tangency point of the capital allocation 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. III and IV only
c. I and IV only
d. II and III only

17. Diversification is most effective when security returns are _________.

a. positively correlated
b. high
c. negatively correlated
d. uncorrelated

18. If enough investors decide to purchase stocks, they are likely to drive up stock prices, thereby causing
_____________ and ___________.

a. expected returns to fall; risk premiums to fall

b. expected returns to rise; risk premiums to fall
c. expected returns to rise; risk premiums to rise
d. expected returns to fall; risk premiums to rise

19. In a simple CAPM world which of the following statements is (are) correct?
I. All investors will choose to hold the market portfolio, which includes all risky assets in the world.
II. Investors' complete portfolio will vary depending on their risk aversion.
III. The return per unit of risk will be identical for all individual assets.
IV. The market portfolio will be on the efficient frontier, and it will be the optimal risky portfolio.

a. I, II, and III only

b. II, III, and IV only
c. I, III, and IV only
d. I, II, III, and IV

20. The beta of a security is equal to _________.

a. the covariance between the security and market returns divided by the variance of the market's returns
b. the covariance between the security and market returns divided by the standard deviation of the
market's returns
c. the variance of the security's returns divided by the covariance between the security and market
returns
d. the variance of the security's returns divided by the variance of the market's returns

21. The SML is valid for _______________, and the CML is valid for ______________.
a. only individual assets; well-diversified portfolios only
b. only well-diversified portfolios; only individual assets
c. both well-diversified portfolios and individual assets; both well-diversified portfolios and individual
assets
d. both well-diversified portfolios and individual assets; well-diversified portfolios only

22. The risk-free rate and the expected market rate of return are 6% and 16%, respectively. According to the capital
asset pricing model, the expected rate of return on security X with a beta of 1.2 is equal to _________.
a. 12%
b. 17%
c. 18%
d. 23%

23. The semistrong form of the EMH states that ________ must be reflected in the current stock price.
I. all security price and volume data
II. all publicly available information
III. all information, including inside information
IV. all costless information
 24. The expected return on the market portfolio is 15%. The risk-free rate is 8%. The forecast return on SDA Corp.
common stock is 16%. The beta of SDA Corp. common stock is 1.25. Within the context of the capital asset pricing
model, calculate the alpha of the stock.

Rm = 15%
Rf=8%
Er(SDA)=16%
Beta=1.25

CAPM predicted return = rf + beta (rm – rf) = 0.08 + 1.25 (0.15 – 0.08) = 16.75%

Expected return on the market for SDA = 16%

Alpha = 16% - 16.75% = -0.75%

This stock is considered to be overvalued.

Suppose the CAPM is true. Answer the following true/false questions and provide a brief explanation of your response.
Note: when a question asks about “expected returns,” this is a question about the CAPM’s predictions, not about
whether those predictions are necessarily born out in the market each and every period.

a. A more volatile stock (measured by variance of returns) has a higher expected return than a less volatile stock.

FALSE

b. If a security’s returns are not completely predictable (i.e., the variance of returns is greater than zero), then the security
must have an expected return that exceeds the risk-free rate.

FALSE. If a security has a negative beta, its return will be below the risk-free rate. Gold is an often cited example. Gold
returns are volatile (have high total risk, i.e. standard deviation of returns), and they historically exhibit a small negative
correlation relative to stock returns, so gold is a negative beta asset. We’ve seen in recent years that gold has done very
well when the stock market has suffered. However, over the very long run, returns on gold average out to be less than
returns on Treasury securities (i.e., less than the risk-free rate).

d. The expected risk premium on a stock that has a beta of 2.0 is double the expected risk premium on a stock that has a
beta of 1.0.

TRUE

e. A mutual fund that specializes in energy stocks has a beta of 0.9. The volatility of this fund’s returns will be less than the
volatility of the S&P500, which has a beta of 1.0

FALSE - In all likelihood the fund will have higher volatility than the S&P500 because the fund is not as well diversified as the
S&P500 is. The fact that the fund has a lower beta simply means that its systematic risk is lower than the market, but its
total risk (volatility) will almost certainly be higher.
Questions from warm-up quiz

1. Suppose that Fincorp trades in a dealer market. Bid price is 55.25 and asked price is 55.50.
If you submit an order to your broker to buy at market, at what price will your trade be executed?

55.50

2. The term inside quotes refers to _____.

a. the difference between the lowest bid price and the highest ask price in the limit order book
b. the difference between the lowest bid price and the lowest ask price in the limit order book.
c. the difference between the highest bid price and the highest ask price in the limit order book.
d. the difference between the highest bid price and the lowest ask price in the limit order book.

3. You purchased 200 shares of ABC common stock on margin at $50 per share. Assume the initial margin is 50% and the
maintenance margin is 30%. You will get a margin call if the stock drops below ________. (Assume the stock pays no
dividends, and ignore interest on the margin loan.). see first page
a. $35.71
b. $30.77
c. $28.95
d. $26.55

4. Level 3 NASDAQ subscribers _____.

a. are registered market makers
b. can post bid and ask prices
c. have the fastest execution of trades
d. all of these options

5. If an investor places a _________ order, the stock will be sold if its price falls to the stipulated level. If an investor
places a __________ order, the stock will be bought if its price rises above the stipulated level.
a. market; limit
b. limit; market
c. stop-loss; stop-buy
d. stop-buy; stop-loss

6. Maintenance requirements for margin accounts are set by ____.

a. the Federal Reserve System's Board of Governors
b. the Supreme Court
c. brokerage firms
d. the SEC

7. The _________ price is the price at which a dealer is willing to purchase a security.
BID

8. Which one of the following is a true statement regarding the Dow Jones Industrial Average?
a. It is a price-weighted average of 100 large stocks traded on the New York Stock Exchange
b. It is a value-weighted average of 30 large industrial stocks.
c. It is a value-weighted average of all stocks traded on the New York Stock Exchange.
d. It is a price-weighted average of 30 large industrial stocks.

9. You decide to purchase an equal number of shares of stocks of firms to create a portfolio. If you wanted to construct
an index to track your portfolio performance, your best match for your portfolio would be to construct ______.
a. an equally-weighted index
b. a value-weighted index
c. a bond price index
d. a price-weighted index

10. The inside quotes on a limit order book can be found ______.
a. at the top of the list
b. only by direct contact with the specialist who maintains the book
c. by taking the averages of the bid and ask prices on the list
d. at the bottom of the list