Learning Module: Portfolio Risk and Return: Part I

Disclaimer: Following are the questions provided by CFA Institute to its registered
candidates for practice purpose.

1. With respect to trading costs, liquidity is least likely to impact the:

A. stock price.
B. bid–ask spreads.
C. brokerage commissions.

2. Evidence of risk aversion is best illustrated by a risk–return relationship that is:

A. negative.
B. neutral.
C. positive.

3. With respect to risk-averse investors, a risk-free asset will generate a numerical

utility that is:
A. the same for all individuals.
B. positive for risk-averse investors.
C. equal to zero for risk seeking investors.

4. With respect to utility theory, the most risk-averse investor will have an indifference
curve with the:
A. most convexity.
B. smallest intercept value.
C. greatest slope coefficient.

5. With respect to an investor’s utility function expressed as: U = E (r) − 0.5A𝜎 ! , which
of the following values for the measure for risk aversion has the least amount of risk
aversion?
A. −4.
B. 0.
C. 4.

The following information relates to questions 6-7

A financial planner has created the following data to illustrate the application of utility
theory to portfolio selection:

6. A risk-neutral investor is most likely to choose:

A. Investment 1.
B. Investment 2.
 Portfolio Risk and Return: Part I

C. Investment 3.

7. If an investor’s utility function is expressed as U = E (r) − 0.5A𝜎 ! and the measure

for risk aversion has a value of −2, the risk-seeking investor is most likely to choose:
A. Investment 2.
B. Investment 3.
C. Investment 4.

8. If an investor’s utility function is expressed as U = E (r) − 0.5A𝜎 ! and the measure

for risk aversion has a value of 2, the risk-averse investor is most likely to choose:
A. Investment 1.
B. Investment 2.
C. Investment 3.

9. If an investor’s utility function is expressed as U = E (r) − 0.5A𝜎 ! and the measure

for risk aversion has a value of 4, the risk-averse investor is most likely to choose:
A. Investment 1.
B. Investment 2.
C. Investment 3.

10. With respect to the mean–variance portfolio theory, the capital allocation line, CAL,
is the combination of the risk-free asset and a portfolio of all:
A. risky assets.
B. equity securities.
C. feasible investments.

11. Two individual investors with different levels of risk aversion will have optimal
portfolios that are:
A. below the capital allocation line.
B. on the capital allocation line.
C. above the capital allocation line.

12. With respect to capital market theory, which of the following asset characteristics
is least likely to impact the variance of an investor’s equally weighted portfolio?
A. Return on the asset.
B. Standard deviation of the asset.
C. Covariances of the asset with the other assets in the portfolio.

13. A portfolio manager creates the following portfolio:

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 Portfolio Risk and Return: Part I

If the correlation of returns between the two securities is 0.40, the expected
standard deviation of the portfolio is closest to:
A. 10.7%.
B. 11.3%.
C. 12.1%.

14. A portfolio manager creates the following portfolio:

If the covariance of returns between the two securities is −0.0240, the expected
standard deviation of the portfolio is closest to:
A. 2.4%.
B. 7.5%.
C. 9.2%.

The following information relates to questions 15-16

A portfolio manager creates the following portfolio:

15. If the standard deviation of the portfolio is 14.40%, the correlation between the two
securities is equal to:
A. −1.0.
B. 0.0.
C. 1.0.

16. If the standard deviation of the portfolio is 14.40%, the covariance between the two
securities is equal to:
A. 0.0006.
B. 0.0240.
C. 1.0000.

The following information relates to questions 17-19

A portfolio manager creates the following portfolio:

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 Portfolio Risk and Return: Part I

17. If the portfolio of the two securities has an expected return of 15%, the proportion
invested in Security 1 is:
A. 25%.
B. 50%.
C. 75%.

18. If the correlation of returns between the two securities is −0.15, the expected
standard deviation of an equal-weighted portfolio is closest to:
A. 13.04%.
B. 13.60%.
C. 13.87%.

19. If the two securities are uncorrelated, the expected standard deviation of an equal-
weighted portfolio is closest to:
A. 14.00%.
B. 14.14%.
C. 20.00%.

The following information relates to questions 20-21

An analyst has made the following return projections for each of three possible outcomes
with an equal likelihood of occurrence:

20. If the analyst constructs two-asset portfolios that are equally-weighted, which pair
of assets has the lowest expected standard deviation?
A. Asset 1 and Asset 2.
B. Asset 1 and Asset 3.
C. Asset 2 and Asset 3.

21. If the analyst constructs two-asset portfolios that are equally weighted, which pair
of assets provides the least amount of risk reduction?
A. Asset 1 and Asset 2.
B. Asset 1 and Asset 3.
C. Asset 2 and Asset 3.

22. As the number of assets in an equally-weighted portfolio increases, the contribution

of each individual asset’s variance to the volatility of the portfolio:
A. increases.
B. decreases.
C. remains the same.

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 Portfolio Risk and Return: Part I

23. With respect to an equally weighted portfolio made up of a large number of assets,
which of the following contributes the most to the volatility of the portfolio?
A. Average variance of the individual assets.
B. Standard deviation of the individual assets.
C. Average covariance between all pairs of assets.

24. The correlation between assets in a two-asset portfolio increases during a market
decline. If there is no change in the proportion of each asset held in the portfolio or
the expected standard deviation of the individual assets, the volatility of the
portfolio is most likely to:
A. increase.
B. decrease.
C. remain the same.

25. Which of the following statements is least accurate? The efficient frontier is the
set of all attainable risky assets with the:
A. highest expected return for a given level of risk.
B. lowest amount of risk for a given level of return.
C. highest expected return relative to the risk-free rate.

26. The portfolio on the minimum-variance frontier with the lowest standard deviation
is:
A. unattainable.
B. the optimal risky portfolio.
C. the global minimum-variance portfolio.

27. The set of portfolios on the minimum-variance frontier that dominates all sets of
portfolios below the global minimum-variance portfolio is the:
A. capital allocation line.
B. Markowitz efficient frontier.
C. set of optimal risky portfolios.

28. The dominant capital allocation line is the combination of the risk-free asset and the:
A. optimal risky portfolio.
B. levered portfolio of risky assets.
C. global minimum-variance portfolio.

29. Compared to the efficient frontier of risky assets, the dominant capital allocation
line has higher rates of return for levels of risk greater than the optimal risky
portfolio because of the investor’s ability to:
A. lend at the risk-free rate.
B. borrow at the risk-free rate.
C. purchase the risk-free asset.

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 Portfolio Risk and Return: Part I

30. With respect to the mean–variance theory, the optimal portfolio is determined by
each individual investor’s:
A. risk-free rate.
B. borrowing rate.
C. risk preference.

31. All else held constant, a lower correlation between the assets in a portfolio most
likely results in higher:
A. diversification.
B. volatility.
C. portfolio return.

32. John Smith is given two investment options. Option A is a payment with a 50% chance
of getting $100 and a 50% chance of getting $0. Option B is a guaranteed payment
of $50. If Smith chooses Option A over Option B, his risk preference is best
described as risk:
A. seeking.
B. averse.
C. neutral.

33. If Investor A has a lower risk aversion coefficient than Investor B, on the capital
allocation line, will Investor B’s optimal portfolio most likely have a higher expected
return?
A. Yes
B. No, because Investor B has a higher risk tolerance
C. No, because Investor B has a lower risk tolerance

34. A portfolio contains equal weights of two securities having the same standard
deviation. If the correlation between the returns of the two securities was to
decrease, the portfolio risk would most likely:
A. increase.
B. remain the same.
C. decrease.

35. Which of the following portfolios of risky assets is most likely the global minimum-
variance portfolio?

A. Portfolio C
B. Portfolio A

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 Portfolio Risk and Return: Part I

C. Portfolio B

36. Which of the following is least likely an assumption underlying the capital asset
pricing model (CAPM)?
A. Investors analyze securities according to their own future cash flow estimates
and probability distributions.
B. There are no restrictions on short selling assets.
C. The amount invested in an asset can be as much or as little as the investor wants.

37. The covariance of the assets in the following portfolio is closest to:

A. 1.8%
B. 0.4%
C. 2.3%

38. Based on the following historical data, which is closest to the standard deviation for
the two-asset portfolio shown in the table?

A. 6.5%
B. 5.0%
C. 5.5%

39. Consider a portfolio with two assets. Asset A comprises 25% of the portfolio and has
a standard deviation of 17.9%. Asset B comprises 75% of the portfolio and has a
standard deviation of 6.2%. If the correlation of these two investments is 0.5, the
portfolio standard deviation is closest to:
A. 6.45%.
B. 7.90%.
C. 9.13%.

40. When considering a portfolio that is optimal for one investor, a second investor with
a higher risk aversion would most likely:
A. expect a higher variance for the portfolio.
B. derive a lower utility from the portfolio.

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C. have a lower return expectation for the portfolio.

41. When constructing the optimal portfolios for investors with different risk
preferences, the investor with the higher risk aversion is most likely to have a:
A. lower expected return.
B. steeper capital allocation line.
C. flatter indifference curve.

42. The point of tangency between the capital allocation line (CAL) and the efficient
frontier of risky assets most likely identifies the:
A. optimal risky portfolio.
B. optimal investor portfolio.
C. global minimum-variance portfolio.

43. The correlation between the historical returns of Stock A and Stock B is 0.75. If
the variance of Stock A is 0.16 and the variance of Stock B is 0.09, the covariance
of returns of Stock A and Stock B is closest to:
A. 0.01.
B. 0.09.
C. 0.16.

Solutions
1. C is correct. Brokerage commissions are negotiated with the brokerage firm. A
security’s liquidity impacts the operational efficiency of trading costs. Specifically,
liquidity impacts the bid–ask spread and can impact the stock price (if the ability to
sell the stock is impaired by the uncertainty associated with being able to sell the
stock).

2. C is correct. Historical data over long periods of time indicate that there exists a
positive risk–return relationship, which is a reflection of an investor’s risk aversion.

3. A is correct. A risk-free asset has a variance of zero and is not dependent on whether
the investor is risk neutral, risk seeking or risk averse. That is, given that the utility
function of an investment is expressed as U = E (r) − 0.5A𝜎 ! , where A is the measure
of risk aversion, then the sign of A is irrelevant if the variance is zero (like that of
a risk-free asset).

4. C is correct. The most risk-averse investor has the indifference curve with the
greatest slope.

5. A is correct. A negative value in the given utility function indicates that the investor
is a risk seeker.

6. C is correct. Investment 3 has the highest rate of return. Risk is irrelevant to a risk-
neutral investor, who would have a measure of risk aversion equal to 0. Given the

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utility function, the risk-neutral investor would obtain the greatest amount of utility
from Investment 3.

7. C is correct. Investment 4 provides the highest utility value (0.2700) for a risk-
seeking investor, who has a measure of risk aversion equal to −2.

8. B is correct. Investment 2 provides the highest utility value (0.1836) for a risk-
averse investor who has a measure of risk aversion equal to 2.

9. A is correct. Investment 1 provides the highest utility value (0.1792) for a risk-averse
investor who has a measure of risk aversion equal to 4.

10. A is correct. The CAL is the combination of the risk-free asset with zero risk and
the portfolio of all risky assets that provides for the set of feasible investments.
Allowing for borrowing at the risk-free rate and investing in the portfolio of all risky
assets provides for attainable portfolios that dominate risky assets below the CAL.

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11. B is correct. The CAL represents the set of all feasible investments. Each investor’s
indifference curve determines the optimal combination of the risk-free asset and
the portfolio of all risky assets, which must lie on the CAL.

12. A is correct. The asset’s returns are not used to calculate the portfolio’s variance
[only the assets’ weights, standard deviations (or variances), and covariances (or
correlations) are used].

13. C is correct.

14. A is correct.

15. C is correct. A portfolio standard deviation of 14.40% is the weighted average, which
is possible only if the correlation between the securities is equal to 1.0.

16. B is correct. A portfolio standard deviation of 14.40% is the weighted average, which
is possible only if the correlation between the securities is equal to 1.0. If the
correlation coefficient is equal to 1.0, then the covariance must equal 0.0240,
calculated as: Cov(R1,R2) = ρ12σ1σ2 = (1.0)(20%)(12%) = 2.40% = 0.0240.

17. C is correct.

18. A is correct.

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19. B is correct.

20. C is correct. An equally weighted portfolio of Asset 2 and Asset 3 will have the lowest
portfolio standard deviation, because for each outcome, the portfolio has the same
expected return (they are perfectly negatively correlated).

21. A is correct. An equally weighted portfolio of Asset 1 and Asset 2 has the highest
level of volatility of the three pairs. All three pairs have the same expected return;
however, the portfolio of Asset 1 and Asset 2 provides the least amount of risk
reduction.

22. B is correct. The contribution of each individual asset’s variance (or standard
deviation) to the portfolio’s volatility decreases as the number of assets in the equally
weighted portfolio increases. The contribution of the co-movement measures
between the assets increases (i.e., covariance and correlation) as the number of
assets in the equally weighted portfolio increases.

23. C is correct. The co-movement measures between the assets increases (i.e.,
covariance and correlation) as the number of assets in the equally weighted portfolio
increases. The contribution of each individual asset’s variance (or standard deviation)
to the portfolio’s volatility decreases as the number of assets in the equally weighted
portfolio increases.

24. A is correct. Higher correlations will produce less diversification benefits provided
that the other components of the portfolio standard deviation do not change (i.e.,
the weights and standard deviations of the individual assets).

25. C is correct. The efficient frontier does not account for the risk-free rate. The
efficient frontier is the set of all attainable risky assets with the highest expected
return for a given level of risk or the lowest amount of risk for a given level of return.

26. C is correct. The global minimum-variance portfolio is the portfolio on the minimum-
variance frontier with the lowest standard deviation. Although the portfolio is
attainable, when the risk-free asset is considered, the global minimum-variance
portfolio is not the optimal risky portfolio.

27. B is correct. The Markowitz efficient frontier has higher rates of return for a given
level of risk. With respect to the minimum-variance portfolio, the Markowitz
efficient frontier is the set of portfolios above the global minimum-variance portfolio
that dominates the portfolios below the global minimum-variance portfolio.

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28. A is correct. The use of leverage and the combination of a risk-free asset and the
optimal risky asset will dominate the efficient frontier of risky assets (the
Markowitz efficient frontier).

29. B is correct. The CAL dominates the efficient frontier at all points except for the
optimal risky portfolio. The ability of the investor to purchase additional amounts of
the optimal risky portfolio by borrowing (i.e., buying on margin) at the risk-free rate
makes higher rates of return for levels of risk greater than the optimal risky asset
possible.

30. C is correct. Each individual investor’s optimal mix of the risk-free asset and the
optimal risky asset is determined by the investor’s risk preference.

31. A is correct. An investor may achieve diversification by combining two assets that
are not perfectly correlated. This diversification increases as the correlation
decreases.

32. A is correct. Both options have the same expected return of $50. Option A, however,
has a higher risk (standard deviation) than Option B. Therefore, John Smith’s risk
preference is that of risk seeking.

33. C is correct. Investor B has a higher risk aversion coefficient, thus a lower risk
tolerance and a lower expected return on the capital allocation line.

34. C is correct. The formula for portfolio risk shows that portfolio risk decreases as
the correlation decreases.

35. B is correct. The global minimum-variance portfolio is the left-most point on the
minimum-variance frontier among all portfolios of risky assets. Portfolios A and C
have the same standard deviation, but Portfolio A dominates Portfolio C because of
a higher return.

36. A is correct. The CAPM requires that there are no restrictions on short selling (which
is an assumption underlying frictionless markets) and that the amount invested in an
asset can be as much or as little as the investor wants (that is, investments are
infinitely divisible). The CAPM also assumes that all investors analyze securities in
the same way using the same inputs for future cash flows and the same probability
distributions; that is, it assumes that investors have homogenous expectations.

37. A is correct. The covariance is calculated from the standard deviations of the two
assets and their correlation. The portfolio weights are not relevant.

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38. C is correct. The standard deviation of a two-asset portfolio is calculated as follows:

39. B is correct. The standard deviation of a two-asset portfolio is given by the square
root of the portfolio’s variance:

40. B is correct. Utility has two terms: the expected return and a negative term based
on the portfolio risk weighted by risk aversion. For an identical portfolio, the investor
with a higher risk aversion (A) would calculate a lower utility (U). U = E (r) − 0.5A𝜎 ! .

41. A is correct. The optimal portfolio is identified as the point at which the capital
allocation line (CAL) is tangential to the investor’s indifference curve. As investor
risk aversion increases, the optimal portfolio slides down the CAL to a point of lower
expected risk and lower expected return.

42. A is correct. The optimal risky portfolio lies at the point of tangency between the
capital allocation line and the efficient frontier of risky assets.

43. B is correct.

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