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Exam 6: Efficient Diversification

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Question 1

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Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of return of 16% and a standard deviation of return of 20%. B has an expected rate of return of 10% and a standard deviation of return of 30%. The weight of security B in the minimum-variance portfolio is ________.

A) 10%
B) 20%
C) 40%
D) 60%

E) B) and C)
F) None of the above

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Question 2

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Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has an expected return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would prefer a portfolio using the risk-free asset and ________.

A) asset A
B) asset B
C) no risky asset
D) The answer cannot be determined from the data given.

E) A) and C)
F) All of the above

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Question 3

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The term complete portfolio refers to a portfolio consisting of ________.

A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 35%, while stock B has a standard deviation of return of 15%. The correlation coefficient between the returns on A and B is .45. Stock A comprises 40% of the portfolio, while stock B comprises 60% of the portfolio. The standard deviation of the return on this portfolio is ________.

Rational risk-averse investors will always prefer portfolios ________.

The market value weighted-average beta of firms included in the market index will always be ________.

Semitool Corp. has an expected excess return of 6% for next year. However, for every unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it turns out that the economy and the stock market do better than expected by 1.5% and Semitool's products experience more rapid growth than anticipated, pushing up the stock price by another 1%. Based on this information, what was Semitool's actual excess return?

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The expected return on the optimal risky portfolio is approximately ________. (Hint: Find weights first.)

Investing in two assets with a correlation coefficient of -.5 will reduce what kind of risk?

The risk that can be diversified away is ________.

You run a regression for a stock's return on a market index and find the following Excel output: The beta of this stock is ________.

A project has a 60% chance of doubling your investment in 1 year and a 40% chance of losing half your money. What is the standard deviation of this investment?

The efficient frontier represents a set of portfolios that

On a standard expected return versus standard deviation graph, investors will prefer portfolios that lie to the ________ the current investment opportunity set.

Lear Corp. has an expected excess return of 8% next year. Assume Lear's beta is 1.43. If the economy booms and the stock market beats expectations by 5%, what was Lear's actual excess return?

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is .4. The risk-free rate of return is 5%. The proportion of the optimal risky portfolio that should be invested in stock B is approximately ________.

You are considering adding a new security to your portfolio. 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

The ________ decision should take precedence over the ________ decision.

Which of the following statements is (are) true regarding time diversification? I. The standard deviation of the average annual rate of return over several years will be smaller than the 1-year standard deviation. II. For a longer time horizon, uncertainty compounds over a greater number of years. III. Time diversification does not reduce risk.

The figures below show plots of monthly excess returns for two stocks plotted against excess returns for a market index. Which stock is riskier to a nondiversified investor who puts all his money in only one of these stocks?