Portfolio Management Concepts PDF

An analyst gathers the following data about the returns for two stocks. Stock A, Stock B: E(R): 0.04, 0.09 σ^2: 0.0025, 0.0064 Cov(A,B) = 0.001 The correlation between the returns of Stock A and Stock B is closest to: A. 0.25. B. 0.50. C. 0.63. ANSWER: A Over long periods of time, compar...

An analyst gathers the following data about the returns for two stocks. Stock A, Stock B: E(R): 0.04, 0.09 σ^2: 0.0025, 0.0064 Cov(A,B) = 0.001 The correlation between the returns of Stock A and Stock B is closest to: A. 0.25. B. 0.50. C. 0.63. ANSWER: A Over long periods of time, compared to fixed income securities, equities have tended to exhibit: A. higher average annual returns and lower standard deviation of returns. B. higher average annual returns and higher standard deviation of returns. C. lower average annual returns and higher standard deviation of returns. ANSWER: B Historically, which of the following asset classes has exhibited the smallest standard deviation of monthly returns? A. Large-capitalization stocks. B. Long-term corporate bonds. C. Treasury bills. ANSWER: C Over the long term, the annual returns and standard deviations of returns for major asset classes have shown: A. a negative relationship. B. a positive relationship. C. no clear relationship. ANSWER: B A line that represents the possible portfolios that combine a risky asset and a risk free asset is most accurately described as a: A. capital allocation line. B. capital market line. C. characteristic line. ANSWER: A Which of the following statements about the efficient frontier is least accurate? A. Investors will want to invest in the portfolio on the efficient frontier that offers the highest rate of return. B. Portfolios falling on the efficient frontier are fully diversified. C. The efficient frontier shows the relationship that exists between expected return and total risk in the absence of a risk-free asset. ANSWER: A The optimal portfolio in the Markowitz framework occurs when an investor achieves the diversified portfolio with the: A. lowest risk. B. highest utility. C. highest return. ANSWER: B Which of the following statements about the optimal portfolio is NOT correct? The optimal portfolio: A. lies at the point of tangency between the efficient frontier and the indifference curve with the highest possible utility. B. may be different for different investors. C. is the portfolio that gives the investor the maximum level of return. ANSWER: C The basic premise of the risk-return trade-off suggests that risk-averse individuals purchasing investments with higher non-diversifiable risk should expect to earn: A. higher rates of return. B. rates of return equal to the market. C. lower rates of return. ANSWER: A Investors who are less risk averse will have what type of indifference curves for risk and expected return? A. Inverted. B. Flatter. C. Steeper. ANSWER: B Smith has more steeply sloped risk-return indifference curves than Jones. Assuming these investors have the same expectations, which of the following best describes their risk preferences and the characteristics of their optimal portfolios? Smith is: A. more risk averse than Jones and will choose an optimal portfolio with a higher expected return. B. more risk averse than Jones and will choose an optimal portfolio with a lower expected return. C. less risk averse than Jones and will choose an optimal portfolio with a lower expected return. ANSWER: B The particular portfolio on the efficient frontier that best suits an individual investor is determined by: A. the individual's asset allocation plan. B. the current market risk-free rate as compared to the current market return rate. C. the individual's utility curve. ANSWER: C According to Markowitz, an investor's optimal portfolio is determined where the: A. investor's lowest utility curve is tangent to the efficient frontier. B. investor's utility curve meets the efficient frontier. C. investor's highest utility curve is tangent to the efficient frontier. ANSWER: C Becky Scott and Sid Fiona have the same expectations about the risk and return of the market portfolio; however, Scott selects a portfolio with 30% T-bills and 70% invested in the market portfolio, while Fiona holds a leveraged portfolio, having borrowed to invest 130% of his portfolio equity value in the market portfolio. Regarding their preferences between risk and return and their indifference curves, it is most likely that: A. Scott is willing to take on more risk to increase her expected portfolio return than Fiona is. B. Scott is risk averse but Fiona is not. C. Fiona’s indifference curves are atter than Scott’s. ANSWER: C Three portfolios have the following expected returns and risk: Portfolio, Expected return, Standard deviation: Jones, 4%, 4%. Kelly, 5%, 5%. Lewis, 6%, 5%. A risk-averse investor choosing from these portfolios could rationally select: A. Jones or Lewis, but not Kelly. B. Lewis, but not Kelly or Jones. C. Jones, but not Kelly or Lewis. ANSWER: A Risk aversion means that an individual will choose the less risky of two assets: A. even if it has a lower expected return. B. if they have the same expected return. C. in all cases. ANSWER: B The graph below combines the efficient frontier with the indifference curves for two different investors, X and Y. *I can't put the image, but I will do my best to describe it* X-axis: Standard deviation of returns; Y-axis: Expected Return Efficient frontier curve looks like a sqrt(x) curve - steep, then smooths out. Investor X indifference curve is steep, above the indifference curve, and touches around the steep part. Investor Y indifference curve is shallow, above the indifference curve, and touches around the smooth part. Which of the following statements about the above graph is least accurate? A. The efficient frontier line represents the portfolios that provide the highest return at each risk level. B. Investor X is less risk-averse than Investor Y. C. Investor X's expected return is likely to be less than that of Investor Y. ANSWER: B A stock has an expected return of 4% with a standard deviation of returns of 6%. A bond has an expected return of 4% with a standard deviation of 7%. An investor who prefers to invest in the stock rather than the bond is best described as: A. risk averse. B. risk neutral. C. risk seeking. ANSWER: A An investor has a two-stock portfolio (Stocks A and B) with the following characteristics: σA = 55% σB = 85% CovarianceA,B = 0.09 WA = 70% WB = 30% The variance of the portfolio is closest to: A. 0.54. B. 0.39. C. 0.25. ANSWER: C Using the following correlation matrix, which two stocks would combine to make the lowest-risk portfolio? (Assume the stocks have equal risk and returns.) Stock, A, B, C: A, +1, -, -. B, -0.2, +1, -. C, +0.6, -0.1, +1. A. C and B. B. A and B. C. A and C. ANSWER: B If the standard deviation of returns for stock A is 0.40 and for stock B is 0.30 and the covariance between the returns of the two stocks is 0.007 what is the correlation between stocks A and B? A. 17.14300. B. 0.05830. C. 0.00084. ANSWER: B Two assets are perfectly positively correlated. If 30% of an investor's funds were put in the asset with a standard deviation of 0.3 and 70% were invested in an asset with a standard deviation of 0.4, what is the standard deviation of the portfolio? A. 0.370. B. 0.151. C. 0.426. ANSWER: A Which of the following statements regarding the covariance of rates of return is least accurate? A. If the covariance is negative, the rates of return on two investments will always move in different directions relative to their means. B. Covariance is positive if two variables tend to both be above their mean values in the same time periods. C. Covariance is not a very useful measure of the strength of the relationship between rates of return. ANSWER: A Betsy Minor is considering the diversification benefits of a two stock portfolio. The expected return of stock A is 14 percent with a standard deviation of 18 percent and the expected return of stock B is 18 percent with a standard deviation of 24 percent. Minor intends to invest 40 percent of her money in stock A, and 60 percent in stock B. The correlation coefficient between the two stocks is 0.6. What is the variance and standard deviation of the two stock portfolio? A. Variance = 0.02206; Standard Deviation = 14.85%. B. Variance = 0.03836; Standard Deviation = 19.59%. C. Variance = 0.04666; Standard Deviation = 21.60%. ANSWER: B If the standard deviation of stock A is 10.6%, the standard deviation of stock B is 14.6%, and the covariance between the two is 0.015476, what is the correlation coefficient? A. +1. B. 0. C. 0.0002. ANSWER: A What is the variance of a two-stock portfolio if 15% is invested in stock A (variance of 0.0071) and 85% in stock B (variance of 0.0008) and the correlation coefficient between the stocks is 0.04? A. 0.0007. B. 0.0020. C. 0.0026. ANSWER: A The correlation coefficient between stocks A and B is 0.75. The standard deviation of stock A's returns is 16% and the standard deviation of stock B's returns is 22%. What is the covariance between stock A and B? A. 0.3750. B. 0.0352. C. 0.0264. ANSWER: C Calculating the variance of a two-asset portfolio least likely requires inputs for each asset's: A. beta. B. standard deviation. C. weight in the portfolio. ANSWER: A The covariance of the market's returns with the stock's returns is 0.008. The standard deviation of the market's returns is 0.1 and the standard deviation of the stock's returns is 0.2. What is the correlation coefficient between the stock and market returns? A. 0.00016. B. 0.40. C. 0.91. ANSWER: B An analyst gathered the following data for Stock A and Stock B: Time Period, Stock A Returns, Stock B Returns: 1, 10%, 15%. 2, 6%, 9%. 3, 8%, 12%. What is the covariance for this portfolio? A. 3. B. 12. C. 6. ANSWER: C An investor's portfolio currently has an expected return of 11% with a variance of 0.0081. She is considering replacing 20% of the portfolio with a security that has an expected return of 12% and a standard deviation of 0.07. If the covariance between the returns on the existing portfolio and the returns on the added security is 0.0058, the variance of returns on the new portfolio will be closest to: A. 0.00545. B. 0.00724. C. 0.00984. ANSWER: B An investor calculates the following statistics on her two-stock (A and B) portfolio. σA = 20% σB = 15% rA,B = 0.32 WA = 70% WB = 30% The portfolio's standard deviation is closest to: A. 0.1832. B. 0.0256. C. 0.1600. ANSWER: C If the standard deviation of asset A is 12.2%, the standard deviation of asset B is 8.9%, and the correlation coefficient is 0.20, what is the covariance between A and B? A. 0.0001. B. 0.0022. C. 0.0031. ANSWER: B A bond analyst is looking at historical returns for two bonds, Bond 1 and Bond 2. Bond 2's returns are much more volatile than Bond 1. The variance of returns for Bond 1 is 0.012 and the variance of returns of Bond 2 is 0.308. The correlation between the returns of the two bonds is 0.79, and the covariance is 0.048. If the variance of Bond 1 increases to 0.026 while the variance of Bond 2 decreases to 0.188 and the covariance remains the same, the correlation between the two bonds will: A. decrease. B. increase. C. remain the same. ANSWER: A If two stocks have positive covariance: A. their rates of return tend to change in the same direction. B. they are likely to be in the same industry. C. they exhibit a strong correlation of returns. ANSWER: A An investment advisor is considering a portfolio that is 60% invested in a broad-based stock index fund with the remainder invested in a taxable bond fund. The stock index fund has an expected return of 7% and variance of 0.04, while the bond fund has an expected return of 3% and a variance of 0.0081. If the covariance of returns between the bond and index funds is 0.0108, the standard deviation of returns for the overall portfolio is closest to: A. 14.45%. B. 12.56%. C. 1.58%. ANSWER: A If the standard deviation of returns for stock X is 0.60 and for stock Y is 0.40 and the covariance between the returns of the two stocks is 0.009, the correlation between stocks X and Y is closest to: A. 26.6670. B. 0.0020. C. 0.0375. ANSWER: C A portfolio manager invests 40% of a portfolio in Asset X, which has an expected standard deviation of returns of 15%, and the remainder in Asset Y, which has an expected standard deviation of returns of 25%. If the covariance of returns between assets X and Y is 0.0158, the expected standard deviation of portfolio returns is closest to: A. 2.7%. B. 16.3%. C. 18.4%. ANSWER: C If the standard deviation of stock X is 7.2%, the standard deviation of stock Y is 5.4%, and the covariance between the two is –0.0031, their correlation coefficient is closest to: A. -0.64. B. -0.80. C. -0.19. ANSWER: B Stock 1 has a standard deviation of 10. Stock 2 also has a standard deviation of 10. If the correlation coefficient between these stocks is –1, what is the covariance between these two stocks? A. –100.00. B. 1.00. C. 0.00. ANSWER: A Assets A (with a variance of 0.25) and B (with a variance of 0.40) are perfectly positively correlated. If an investor creates a portfolio using only these two assets with 40% invested in A, the portfolio standard deviation is closest to: A. 0.5795. B. 0.3742. C. 0.3400. ANSWER: A In the Markowitz framework, risk is defined as the: A. variance of returns. B. probability of a loss. C. beta of an investment. ANSWER: A Which of the following portfolios falls below the Markowitz efficient frontier? Portfolio, Expected Return, Expected Standard Deviation: A, 12.1%, 8.5%. B, 14.2%, 8.7%. C, 15.1%, 8.7%. A. Portfolio C. B. Portfolio B. C. Portfolio A. ANSWER: B Which of the following statements about the efficient frontier is least accurate? A. A portfolio that plots above efficient frontier is not attainable, while a portfolio that plots below the efficient frontier is inefficient. B. The efficient frontier is the set of portfolios with the greatest expected return for a given level of risk. C. The slope of the efficient frontier increases steadily as risk increases. ANSWER: C The efficient frontier is best described as the set of attainable portfolios that gives investors: A. the highest diversification ratio for any given level of expected return. B. the lowest risk for any given level of risk tolerance. C. the highest expected return for any given level of risk. ANSWER: C Stock A has a standard deviation of 0.5 and Stock B has a standard deviation of 0.3. Stock A and Stock B are perfectly positively correlated. According to Markowitz portfolio theory how much should be invested in each stock to minimize the portfolio's standard deviation? A. 100% in Stock B. B. 30% in Stock A and 70% in Stock B. C. 50% in Stock A and 50% in Stock B. ANSWER: A Which of the following inputs is least likely required for the Markowitz efficient frontier? The: A. covariation between all securities. B. level of risk aversion in the market. C. expected return of all securities. ANSWER: B Which of the following statements best describes an investment that is not on the efficient frontier? A. The portfolio has a very high return. B. There is a portfolio that has a lower return for the same risk. C. There is a portfolio that has a lower risk for the same return. ANSWER: C Adding a stock to a portfolio will reduce the risk of the portfolio if the correlation coefficient is less than which of the following? A. +1.00. B. +0.50. C. 0.00. ANSWER: A An investor has identified the following possible portfolios. Which portfolio cannot be on the efficient frontier? Portfolio, Expected Return, Standard Deviation: V, 18%, 35%. W, 12%, 16%. X, 10%, 10%. Y, 14%, 20%. Z, 13%, 24%. A. Y. B. X. C. Z. ANSWER: C Which one of the following portfolios does not lie on the efficient frontier? Portfolio, Expected Return, Standard Deviation: A, 7, 5. B, 9, 12. C, 11, 10. D, 15, 15. A. A. B. C. C. B. ANSWER: C Which of the following possible portfolios is least likely to lie on the efficient frontier? Portfolio, Expected Return, Standard Deviation: X, 9%, 12%. Y, 11%, 10%. Z, 13%, 15%. A. Portfolio X. B. Portfolio Z. C. Portfolio Y. ANSWER: A Which of the following portfolios falls below the Markowitz efficient frontier? Portfolio, Expected Return, Expected Standard Deviation: A, 7%, 14%. B, 9%, 26%. C, 15%, 30%. D, 12%, 22%. A. B. B. C. C. D. ANSWER: A Which of the following statements about portfolio theory is least accurate? A. Assuming that the correlation coefficient is less than one, the risk of the portfolio will always be less than the simple weighted average of individual stock risks. B. For a two-stock portfolio, the lowest risk occurs when the correlation coefficient is close to negative one. C. When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will not decrease the overall portfolio standard deviation. ANSWER: C Which one of the following statements about correlation is NOT correct? A. If the correlation coefficient were -1, a zero variance portfolio could be constructed. B. If the correlation coefficient were 0, a zero variance portfolio could be constructed. C. Potential benefits from diversification arise when correlation is less than +1. ANSWER: B A portfolio manager adds a new stock that has the same standard deviation of returns as the existing portfolio but has a correlation coefficient with the existing portfolio that is less than +1. Adding this stock will have what effect on the standard deviation of the revised portfolio's returns? The standard deviation will: A. decrease only if the correlation is negative. B. decrease. C. increase. ANSWER: B As the correlation between the returns of two assets becomes lower, the risk reduction potential becomes: A. smaller. B. decreased by the same level. C. greater. ANSWER: C There are benefits to diversification as long as: A. there must be perfect negative correlation between the assets. B. there is perfect positive correlation between the assets. C. the correlation coefficient between the assets is less than 1. ANSWER: C On a graph of risk, measured by standard deviation and expected return, the efficient frontier represents: A. all portfolios plotted in the northeast quadrant that maximize return. B. the set of portfolios that dominate all others as to risk and return. C. the group of portfolios that have extreme values and therefore are “efficient” in their allocation. ANSWER: B Kendra Jackson, CFA, is given the following information on two stocks, Rockaway and Bridgeport. Covariance between the two stocks = 0.0325 Standard Deviation of Rockaway's returns = 0.25 Standard Deviation of Bridgeport's returns = 0.13 Assuming that Jackson must construct a portfolio using only these two stocks, which of the following combinations will result in the minimum variance portfolio? A. 100% in Bridgeport. B. 50% in Bridgeport, 50% in Rockaway. C. 80% in Bridgeport, 20% in Rockaway. ANSWER: A Stock A has a standard deviation of 4.1% and Stock B has a standard deviation of 5.8%. If the stocks are perfectly positively correlated, which portfolio weights minimize the portfolio's standard deviation? Stock A, Stock B: A. 0%, 100% B. 100%, 0% C. 63%, 37% ANSWER: B Which one of the following portfolios cannot lie on the efficient frontier? Portfolio, Expected Return, Standard Deviation: A, 20%, 35%. B, 11%, 13%. C, 8%, 10%. D, 8%, 9%. A. Portfolio D. B. Portfolio A. C. Portfolio C. ANSWER: C In a two-asset portfolio, reducing the correlation between the two assets moves the efficient frontier in which direction? A. The efficient frontier is stable unless return expectations change. If expectations change, the efficient frontier will extend to the upper right with little or no change in risk. B. The efficient frontier is stable unless the asset’s expected volatility changes. This depends on each asset’s standard deviation. C. The frontier extends to the left, or northwest quadrant representing a reduction in risk while maintaining or enhancing portfolio returns. ANSWER: C A portfolio currently holds Randy Co. and the portfolio manager is thinking of adding either XYZ Co. or Branton Co. to the portfolio. All three stocks offer the same expected return and total risk. The covariance of returns between Randy Co. and XYZ is +0.5 and the covariance between Randy Co. and Branton Co. is -0.5. The portfolio's risk would decrease: A. more if she bought Branton Co. B. more if she bought XYZ Co. C. most if she put half your money in XYZ Co. and half in Branton Co. ANSWER: A According to the CAPM, a rational investor would be least likely to choose as his optimal portfolio: A. a 130% allocation to the market portfolio. B. the global minimum variance portfolio. C. a 100% allocation to the risk-free asset. ANSWER: B Of the six attainable portfolios listed, which portfolios are not on the efficient frontier? Portfolio, Expected Return, Standard Deviation: A, 26%, 28%. B, 23%, 34%. C, 14%, 23%. D, 18%, 14%. E, 11%, 8%. F, 18%, 16%. A. A, B, and C. B. B, C, and F. C. C, D, and E. ANSWER: B What is the risk measure associated with the CML? A. Beta. B. Market risk. C. Standard deviation. ANSWER: C A plot of the expected returns and standard deviations of each possible portfolio that combines a risky asset and a risk-free asset will be: A. a curve that approaches an upper limit. B. a straight line. C. convex to the origin. ANSWER: B The correlation of returns on the risk-free asset with returns on a portfolio of risky assets is: A. negative. B. positive. C. zero. ANSWER: C In the context of the capital market line (CML), which of the following statements is CORRECT? A. Firm-specific risk can be reduced through diversification. B. Market risk can be reduced through diversification. C. The two classes of risk are market risk and systematic risk. ANSWER: A The slope of the characteristic line is used to estimate: A. a risk premium. B. risk aversion. C. beta. ANSWER: C Which of the following statements about systematic and unsystematic risk is most accurate? A. As an investor increases the number of stocks in a portfolio, the systematic risk will remain constant. B. The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms. C. Total risk equals market risk plus firm-specific risk. ANSWER: C Which of the following is the risk that disappears in the portfolio construction process? A. Unsystematic risk. B. Interest rate risk. C. Systematic risk. ANSWER: A According to capital market theory, which of the following represents the risky portfolio that should be held by all investors who desire to hold risky assets? A. Any point on the efficient frontier and to the right of the point of tangency between the CML and the efficient frontier. B. Any point on the efficient frontier and to the left of the point of tangency between the CML and the efficient frontier. C. The point of tangency between the capital market line (CML) and the efficient frontier. ANSWER: C Which of the following statements about risk is NOT correct? A. The market portfolio has only systematic risk. B. Total risk = systematic risk - unsystematic risk. C. Unsystematic risk is diversifiable risk. ANSWER: B Bruce Johansen, CFA, is fully invested in the market portfolio. Johansen desires to increase the expected return from his portfolio. According to capital market theory, Johansen can meet his return objective by: A. owning the risky market portfolio and lending at the risk-free rate. B. allocating a higher proportion of the portfolio to higher risk assets. C. borrowing at the risk-free rate to invest in the risky market portfolio. ANSWER: C Given the following data, what is the correlation coefficient between the two stocks and the Beta of stock A? standard deviation of returns of Stock A is 10.04% standard deviation of returns of Stock B is 2.05% standard deviation of the market is 3.01% covariance between the two stocks is 0.00109 covariance between the market and stock A is 0.002 Correlation Coefficient, Beta (stock A): A. 0.5296, 0.06 B. 0.5296, 2.20 C. 0.6556, 2.20 ANSWER: B In the context of the CML, the market portfolio includes: A. 12-18 stocks needed to provide maximum diversification. B. all existing risky assets. C. the risk-free asset. ANSWER: B The expected rate of return is twice the 12% expected rate of return from the market. What is the beta if the risk-free rate is 6%? A. 2. B. 3. C. 4. ANSWER: B In extending the 3-factor model of Fama and French, the additional factor suggested by Carhart that is often used is: A. price momentum. B. GDP growth. C. market-to-book value. ANSWER: A Which of the following is least likely considered a source of systematic risk for bonds? A. Default risk. B. Purchasing power risk. C. Market risk. ANSWER: A Based on Capital Market Theory, an investor should choose the: A. market portfolio on the Capital Market Line. B. portfolio that maximizes his utility on the Capital Market Line. C. portfolio with the highest return on the Capital Market Line. ANSWER: B In Fama and French's multifactor model, the expected return on a stock is explained by: A. excess return on the market portfolio, book-to-market ratio, and price momentum. B. firm size, book-to-market ratio, and excess return on the market portfolio. C. firm size, book-to-market ratio, and price momentum. ANSWER: B Which type of risk is positively related to expected excess returns according to the CAPM? A. Systematic. B. Diversifiable. C. Unique. ANSWER: A A portfolio manager is constructing a new equity portfolio consisting of a large number of randomly chosen domestic stocks. As the number of stocks in the portfolio increases, what happens to the expected levels of systematic and unsystematic risk? Systematic risk, Unsystematic risk: A. Increases, Remains the same B. Decreases, Increases C. Remains the same, Decreases ANSWER: C In equilibrium, investors should only expect to be compensated for bearing systematic risk because: C. systematic risk is specific to the securities the investor selects. A. individual securities in equilibrium only have systematic risk. B. nonsystematic risk can be eliminated by diversification. ANSWER: B Which of the following is the vertical axis intercept for the Capital Market Line (CML)? A. Expected return on the market. C. Risk-free rate. B. Expected return on the portfolio. ANSWER: C Which of the following terms refer to the same type of risk? B. Systematic risk and firm-specific risk. A. Undiversifiable risk and unsystematic risk. C. Total risk and the variance of returns. ANSWER: C Which of the following is the most accurate description of the market portfolio in Capital Market Theory? The market portfolio consists of all: A. equity securities in existence. B. risky and risk-free assets in existence. C. risky assets in existence. ANSWER: C The market model of the expected return on a risky security is best described as a(n): A. single-factor model. B. arbitrage-based model. C. two-factor model. ANSWER: A When a risk-free asset is combined with a portfolio of risky assets, which of the following is least accurate? A. The standard deviation of the return for the newly created portfolio is the standard deviation of the returns of the risky asset portfolio multiplied by its portfolio weight. B. The expected return for the newly created portfolio is the weighted average of the return on the risk-free asset and the expected return on the risky asset portfolio. C. The variance of the resulting portfolio is a weighted average of the returns variances of the risk-free asset and of the portfolio of risky assets. ANSWER: C The slope of the capital market line (CML) is a measure of the level of: A. excess return per unit of risk. B. expected return over the level of inflation. C. risk over the level of excess return. ANSWER: A Beta is a measure of: B. company-specific risk. C. systematic risk. A. total risk. ANSWER: C Portfolios on the capital market line: B. each contain different risky assets. A. include some positive allocation to the risk-free asset. C. are perfectly positively correlated with each other. ANSWER: C An analyst has developed the following data for two companies, PNS Manufacturing (PNS) and InCharge Travel (InCharge). PNS has an expected return of 15% and a standard deviation of 18%. InCharge has an expected return of 11% and a standard deviation of 17%. PNS's correlation with the market is 75%, while InCharge's correlation with the market is 85%. If the market standard deviation is 22%, which of the following are the betas for PNS and InCharge? Beta of PNS, Beta of InCharge: B. 0.66, 0.61 C. 0.92, 1.10 A. 0.61, 0.66 ANSWER: A Which of the following statements about portfolio management is most accurate? C. The security market line (SML) measures systematic and unsystematic risk versus expected return; the CML measures total risk. A. As an investor diversifies away the unsystematic portion of risk, the correlation between his portfolio return and that of the market approaches negative one. B. Combining the capital market line (CML) (risk-free rate and efficient frontier) with an investor's indifference curve map separates out the decision to invest from the decision of what to invest in. ANSWER: B Portfolios that represent combinations of the risk-free asset and the market portfolio are plotted on the: A. capital market line. B. utility curve. C. capital asset pricing line. ANSWER: A The market portfolio in Capital Market Theory is determined by: C. the intersection of the efficient frontier and the investor's highest utility curve. A. a line tangent to the efficient frontier, drawn from any point on the expected return axis. B. a line tangent to the efficient frontier, drawn from the risk-free rate of return. ANSWER: B All portfolios that lie on the capital market line: A. contain at least some positive allocation to the risk-free asset. B. contain the same mix of risky assets unless only the risk-free asset is held. C. have some unsystematic risk unless only the risk-free asset is held. ANSWER: B James Franklin, CFA, has high risk tolerance and seeks high returns. Based on capital market theory, Franklin would most appropriately hold: A. a high-beta portfolio of risky assets financed in part by borrowing at the risk-free rate. B. a high risk biotech stock, as it will have high expected returns in equilibrium. C. the market portfolio as his only risky asset. ANSWER: C A portfolio to the right of the market portfolio on the capital market line (CML) is created by: A. holding both the risk-free asset and the market portfolio. B. holding more than 100% of the risky asset. C. fully diversifying. ANSWER: B A model that estimates expected excess return on a security based on the ratio of the firm's book value to its market value is best described as a: A. market model. B. multifactor model. C. single-factor model. ANSWER: C If a stock's beta is equal to 1.2, its standard deviation of returns is 28%, and the standard deviation of the returns on the market portfolio is 14%, the covariance of the stock's returns with the returns on the market portfolio is closest to: A. 0.168. B. 0.024. C. 0.600. ANSWER: B Beta is least accurately described as: A. the covariance of a security’s returns with the market return, divided by the variance of market returns. B. a measure of the sensitivity of a security’s return to the market return. C. a standardized measure of the total risk of a security. ANSWER: C For an investor to move further up the Capital Market Line than the market portfolio, the investor must: A. diversify the portfolio even more. B. reduce the portfolio's risk below that of the market. C. borrow and invest in the market portfolio. ANSWER: C An analyst has estimated the following: Correlation of Bahr Industries returns with market returns = 0.8 Variance of the market returns = 0.0441 Variance of Bahr returns = 0.0225 The beta of Bahr Industries stock is closest to: B. 0.77. C. 0.57. A. 0.67. ANSWER: C An equally weighted portfolio of a risky asset and a risk-free asset will exhibit: B. less than half the returns standard deviation of the risky asset. A. half the returns standard deviation of the risky asset. C. more than half the returns standard deviation of the risky asset. ANSWER: A If the standard deviation of the market's returns is 5.8%, the standard deviation of a stock's returns is 8.2%, and the covariance of the market's returns with the stock's returns is 0.003, what is the beta of the stock? A. 0.05. B. 0.89. C. 1.07. ANSWER: B The expected rate of return is 1.5 times the 16% expected rate of return from the market. What is the beta if the risk free rate is 8%? A. 2. B. 3. C. 4. ANSWER: A In the market model, beta measures the sensitivity of an asset's rate of return to the market's: B. excess return. C. risk-adjusted return. A. rate of return. ANSWER: A The expected rate of return is 2.5 times the 12% expected rate of return from the market. What is the beta if the risk-free rate is 6%? B. 3. C. 5. A. 4. ANSWER: A Consider the following graph of the Security Market Line (SML). The letters X, Y, and Z represent risky asset portfolios and an analyst's forecast for their returns over the next period. The SML crosses the y-axis at 0.07. *Picture Description* X is at 0.7, Y at 1.0, and Z at 1.3 (all values here are X-axis values). X is way above the SML, Y is below it, Z is just above it. The SML is linear and slants up from Rf on the y-axis. The expected market return is 13.0%. Using the graph above and the information provided, the analyst most likely believes that: A. Portfolio X's required return is greater than its forecast return. B. Portfolio Y is undervalued. C. the expected return for Portfolio Z is 14.8%. ANSWER: C A portfolio of options had a return of 22% with a standard deviation of 20%. If the risk-free rate is 7.5%, what is the Sharpe ratio for the portfolio? B. 0.725. C. 0.147. A. 0.568. ANSWER: B Given a beta of 1.25 and a risk-free rate of 6%, what is the expected rate of return assuming a 12% market return? B. 31%. C. 13.5%. A. 10%. ANSWER: C The stock of Mia Shoes is currently trading at \\$15 per share, and the stock of Video Systems is currently trading at \\$18 per share. An analyst expects the prices of both stocks to increase by \\$2 over the next year and neither company pays dividends. Mia Shoes has a beta of 0.9 and Video Systems has a beta of (-0.3). If the expected market return is 15% and the risk-free rate is 8%, which trading strategy does the CAPM indicate for these two stocks? Mia Shoes, Video Systems: A. Buy, Buy B. Buy, Sell C. Sell, Buy ANSWER: C The risk-free rate is 5% and the expected market return is 15%. A portfolio manager is estimating a return of 20% on a stock with a beta of 1.5. Based on the SML and the analyst's estimate, this stock is: A. undervalued. B. properly valued. C. overvalued. ANSWER: B An analyst estimated the following for three possible investments. Security, Current Price, Forecast Price in One Year, Annual Dividend, Beta: Alpha Inc., 25.00, 31.00, 2.00, 1.6. Lambda Inc., 10.00, 10.80, 0, 0.5. Omega Inc., 105.00, 110.00, 1.00, 1.2. Given an expected return on the market of 12% and a risk-free rate of 4%, which of the three securities is correctly priced based on the analyst's estimates? A. Omega. B. Lambda. C. Alpha. ANSWER: B Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-diversified portfolios with approximately equal market values. He expects Portfolio X to return 13% and Portfolio Y to return 14% over the upcoming year. Because of an unexpected need for cash, Smith is forced to sell at least one of the portfolios. He uses the security market line to determine whether his portfolios are undervalued or overvalued. Portfolio X's beta is 0.9 and Portfolio Y's beta is 1.1. The expected return on the market is 12% and the risk-free rate is 5%. Smith should sell: A. portfolio Y only. B. both portfolios X and Y because they are both overvalued. C. either portfolio X or Y because they are both properly valued. ANSWER: A An analyst collected the following data for three possible investments. Alpha Corporation has a beta of 1.6, Omega Company has a beta of 1.2, and Lambda, Inc. has a beta of 0.5. The expected return on the market is –3% and the risk-free rate is 4%. Assuming that capital markets are in equilibrium, which stock has the highest expected return? A. Omega. B. Alpha. C. Lambda. ANSWER: C Which of the following statements regarding the Sharpe ratio is most accurate? The Sharpe ratio measures: A. excess return per unit of risk. B. peakedness of a return distribution. C. total return per unit of risk. ANSWER: A A higher Sharpe ratio indicates: A. a higher excess return per unit of risk. B. a lower risk per unit of return. C. lower volatility of returns. ANSWER: A What is the expected rate of return on a stock that has a beta of 1.4 if the market risk premium is 9% and the risk-free rate is 4%? A. 13.0%. B. 16.6%. C. 11.0%. ANSWER: B An active manager will most likely short a security with an expected Jensen's alpha that is: A. negative. B. positive. C. zero. ANSWER: A Over a sample period, an investor gathers the following data about three mutual funds. Mutual Fund, Portfolio Return, Portfolio Standard Deviation, Portfolio Beta: P, 13%, 18%, 1.2. Q, 15%, 20%, 1.4. R, 18%, 24%, 1.8. The risk-free rate is 5%. Based solely on the Sharpe measure, an investor would prefer: A. Fund Q. B. Fund P. C. Fund R. ANSWER: C When the market is in equilibrium, all: A. assets plot on the CML. B. assets plot on the SML. C. investors hold the market portfolio. ANSWER: B Which is NOT an assumption of capital market theory? A. Investments are not divisible. C. There is no inflation. B. There are no taxes or transaction costs. ANSWER: A A portfolio's excess return per unit of systematic risk is known as its: A. Jensen’s alpha. B. Sharpe ratio. C. Treynor measure. ANSWER: C An investor's wealth is approximately 50% in bonds and broad-based equities and 50% in shares of a company she founded. Which of the following measures of risk-adjusted returns is least appropriate for this investor's portfolio? A. M-squared. B. Sharpe ratio. C. Jensen’s alpha. ANSWER: C Level I CFA candidate Adeline Bass is a member of an investment club. At the next meeting, she is to recommend whether or not the club should purchase the stocks of CS Industries and MG Consolidated. The risk-free rate is at 6% and the expected return on the market is 15%. Prior to the meeting, Bass gathers the following information on the two stocks: Statistic, CS Industries, MG Consolidated: Current Market Value, \\$25, \\$50. Expected Market Value in One Year, \\$30, \\$55. Expected Dividend, \\$1, \\$1. Beta, 1.2, 0.80. Bass should recommend that the club: A. purchase both stocks. C. purchase MG only. B. purchase CS only. ANSWER: B Which of the following statements regarding the Capital Asset Pricing Model is least accurate? A. It is useful for determining an appropriate discount rate. C. Its accuracy depends upon the accuracy of the beta estimates. B. It is when the security market line (SML) and capital market line (CML) converge. ANSWER: B Mason Snow, CFA, is considering two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a beta of 2.0). Snow uses a risk-free of 7% and estimates that the market risk premium is 4%. Based on capital market theory, Snow should conclude that: A. only Bahre is underpriced. B. neither security is underpriced. C. only Cubb is underpriced. ANSWER: B Which of the following statements about the security market line (SML) and capital market line (CML) is most accurate? A. The SML involves the concept of a risk-free asset, but the CML does not. B. The SML uses beta, but the CML uses standard deviation as the risk measure. C. Both the SML and CML can be used to explain a stock’s expected return. ANSWER: B What is the required rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the market risk premium is 12%? A. 13.2%. B. 15.4%. C. 20.4%. ANSWER: C The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return is 6%, what is the expected return of Stock A? A. 13.8%. B. 14.2%. C. 15.6%. ANSWER: A Which of the following is an assumption of the Capital Asset Pricing Model (CAPM)? A. No investor is large enough to influence market prices. B. There are no margin transactions or short sales. C. Investors with shorter time horizons exhibit greater risk aversion. ANSWER: A A stock has a beta of 1.55 and an expected return of 17.3%. If the risk-free rate is 8%, the expected market risk premium is: B. 14.0%. C. 6.0%. A. 12.0%. ANSWER: C One of the assumptions underlying the capital asset pricing model is that: B. only whole shares or whole bonds are available. A. there are no transactions costs or taxes. C. each investor has a unique time horizon. ANSWER: A An analyst determines that three stocks have the following characteristics: Stock, Beta, Estimated Return: X, 1.0, 10%. Y, 1.6, 16%. Z, 2.0, 16%. If the risk-free rate is 4% and the expected return on the market is 10%, which of the following statements is most accurate? A. Stock X is undervalued. B. Stock Y is overvalued. C. Stock Z is properly valued. ANSWER: C A stock that plots below the Security Market Line most likely: C. is below the efficient frontier. A. is overvalued. B. has a beta less than one. ANSWER: A Portfolios that plot on the security market line in equilibrium: B. must be well diversified. C. have only systematic (beta) risk. A. may be concentrated in only a few stocks. ANSWER: A Consider a stock selling for \\$23 that is expected to increase in price to \\$27 by the end of the year and pay a \\$0.50 dividend. If the risk-free rate is 4%, the expected return on the market is 8.5%, and the stock's beta is 1.9, what is the current valuation of the stock? The stock: C. is undervalued. A. is correctly valued. B. is overvalued. ANSWER: C Which of the following is NOT an assumption of capital market theory? C. All assets are infinitely divisible. A. The capital markets are in equilibrium. B. Investors can lend at the risk-free rate, but borrow at a higher rate. ANSWER: B The beta of stock D is -0.5. If the expected return of Stock D is 8%, and the risk-free rate of return is 5%, what is the expected return of the market? C. +3.5%. A. +3.0%. B. -1.0%. ANSWER: B When comparing portfolios that plot on the security market line (SML) to those that plot on the capital market line (CML), a financial analyst would most accurately state that portfolios that lie on the SML: C. have only systematic risk, while portfolios on the CML have both systematic and unsystematic risk. A. are not necessarily priced at their equilibrium values, while portfolios on the CML are priced at their equilibrium values. B. are not necessarily well diversified, while portfolios on the CML are well diversified. ANSWER: B Which of the following measures produces the same portfolio rankings as the Sharpe ratio but is stated in percentage terms? B. Treynor measure. C. M-squared. A. Jensen’s alpha. ANSWER: C Which of the following statements about the security market line (SML) is least accurate? A. Securities plotting above the SML are undervalued. B. The independent variable in the SML equation is the standard deviation of the market portfolio. C. The SML measures risk using the standardized covariance of the stock with the market. ANSWER: B If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on the stock according to the capital asset pricing model? C. 7.8%. A. 11.3%. B. 12.4%. ANSWER: A Which of the following is an assumption of capital market theory? All investors: A. have multiple-period time horizons. C. select portfolios that lie above the efficient frontier to optimize the risk-return relationship. B. see the same risk/return distribution for a given stock. ANSWER: B An investor believes Stock M will rise from a current price of \\$20 per share to a price of \\$26 per share over the next year. The company is not expected to pay a dividend. The following information pertains: RF = 8% ERM = 16% Beta = 1.7 Should the investor purchase the stock? C. Yes, because it is undervalued. A. No, because it is overvalued. B. No, because it is undervalued. ANSWER: C The expected market premium is 8%, with the risk-free rate at 7%. What is the expected rate of return on a stock with a beta of 1.3? B. 16.3%. A. 10.4%. C. 17.4%. ANSWER: C For a security with a beta of 1.10 when the risk-free rate is 5%, and the expected market risk premium is 5%, what is the expected rate of return on the security according to the CAPM? A. 5.5%. B. 10.5%. C. 15.5%. ANSWER: B According to the capital asset pricing model (CAPM): C. all investors who take on risk will hold the same risky-asset portfolio. A. a stock with high risk, measured as standard deviation of returns, will have high expected returns in equilibrium. B. an investor who is risk averse should hold at least some of the risk-free asset in his portfolio. ANSWER: C Given the following information, what is the required rate of return on Bin Co? inflation premium = 3% real risk-free rate = 2% Bin Co. beta = 1.3 market risk premium = 4% A. 7.6%. B. 16.7%. C. 10.2%. ANSWER: C In equilibrium, an inefficient portfolio will plot: A. on the CML and below the SML. B. below the CML and below the SML. C. below the CML and on the SML. ANSWER: C Which of the following is least likely an assumption underlying the capital asset pricing model? A. Investors are rational. B. Tax rates are constant over the investment horizon. C. All investors have the same expectations of return and risk for each security. ANSWER: B The following information is available for the stock of Park Street Holdings: The price today (P0) equals \\$45.00. The expected price in one year (P1) is \\$55.00. The stock's beta is 2.31. The firm typically pays no dividend. The 3-month Treasury bill is yielding 4.25%. The historical average S&P 500 return is 12.5%. Park Street Holdings stock is: A. undervalued by 3.7%. B. undervalued by 1.1%. C. overvalued by 1.1%. ANSWER: C An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by how much (expressed as percentage return). The analyst gathers the following information on the stock: Market standard deviation = 0.70 Covariance of Dover with the market = 0.85 Dover's current stock price (P0) = \\$35.00 The expected price in one year (P1) is \\$39.00 Expected annual dividend = \\$1.50 3-month Treasury bill yield = 4.50%. Historical average S&P 500 return = 12.0%. Dover Holdings stock is: A. undervalued by approximately 2.1%. B. overvalued by approximately 1.8%. C. undervalued by approximately 1.8%. ANSWER: B A stock's abnormal rate of return is defined as the: C. expected risk-adjusted rate of return minus the market rate of return. A. rate of return during abnormal price movements. B. actual rate of return less the expected risk-adjusted rate of return. ANSWER: B In the top-down approach to asset allocation, industry analysis should be conducted before company analysis because: A. the goal of the top-down approach is to identify those companies in non-cyclical industries with the lowest P/E ratios. B. most valuation models recommend the use of industry-wide average required returns, rather than individual returns. C. an industry's prospects within the global business environment are a major determinant of how well individual firms in the industry perform. ANSWER: C Identifying a benchmark for a client portfolio is most likely to be part of the: A. execution step. B. feedback step. C. planning step. ANSWER: C Which of the following would be assessed first in a top-down valuation approach? A. Fiscal policy. B. Industry return on equity (ROE). C. Industry risks. ANSWER: A In a defined contribution pension plan, investment risk is borne by the: A. employee. B. plan sponsor. C. fund manager. ANSWER: A In the Markowitz framework, an investor should most appropriately evaluate a potential investment based on its: A. effect on portfolio risk and return. B. expected return. C. intrinsic value compared to market value. ANSWER: A In a defined contribution pension plan, investment risk is borne by the: A. employee. B. employer. C. plan manager. ANSWER: A Which of the following is typically the first general step in the portfolio management process? A. Develop an investment strategy. B. Write a policy statement. C. Specify capital market expectations. ANSWER: B The top-down analysis approach is most likely to be employed in which step of the portfolio management process? A. The planning step. B. The execution step. C. The feedback step. ANSWER: B Promised payments to pension beneficiaries are a responsibility of the plan sponsor in: A. a defined benefit plan only. B. a defined contribution plan only. C. both a defined benefit plan and a defined contribution plan. ANSWER: A High risk tolerance, a long investment horizon, and low liquidity needs are most likely to characterize the investment needs of a(n): A. bank. B. defined benefit pension plan. C. insurance company. ANSWER: B The investment needs of a property and casualty insurance company are most likely different from the investment needs of a life insurance company with respect to: A. risk tolerance. B. liquidity needs. C. time horizon. ANSWER: C Endowments and foundations typically have investment needs that can be characterized as: A. long time horizon, high risk tolerance, and low liquidity needs. B. long time horizon, low risk tolerance, and high liquidity needs. C. short time horizon, low risk tolerance, and low liquidity needs. ANSWER: A Which of the following institutional investors is most likely to have low liquidity needs? B. Defined benefit pension plan. C. Bank. A. Property insurance company. ANSWER: B A. B. C. D. ANSWER: A. B. C. D. ANSWER: The execution step in the portfolio management process is most likely to include: A. asset allocation and security analysis. B. performance measurement and portfolio rebalancing. C. preparation of an investment policy statement. ANSWER: A The portfolio approach to investing is best described as evaluating each potential investment based on its: A. contribution to the investor’s overall risk and return. B. potential to generate excess return for the investor. C. fundamentals such as the financial performance of the security issuer. ANSWER: A Which of the following actions is best described as taking place in the execution step of the portfolio management process? A. Choosing a target asset allocation. B. Developing an investment policy statement. C. Rebalancing the portfolio. ANSWER: A The ratio of an equally weighted portfolio's standard deviation of return to the average standard deviation of the securities in the portfolio is known as the: A. diversification ratio. B. relative risk ratio. C. Sharpe ratio. ANSWER: A A pooled investment with a share price significantly different from its net asset value (NAV) per share is most likely a(n): A. closed-end fund. B. exchange-traded fund. C. open-end fund. ANSWER: A Open-end mutual funds differ from closed-end funds in that: A. open-end funds stand ready to redeem their shares, while closed-end funds do not. B. closed-end funds require active management, while open-end funds do not. C. open-end funds issue shares that are then traded in secondary markets, while closed-end funds do not. ANSWER: A A pooled investment fund buys all the shares of a publicly traded company. The fund reorganizes the company and replaces its management team. Three years later, the fund exits the investment through an initial public offering of the company's shares. This pooled investment fund is best described as a(n): A. event-driven fund. B. private equity fund. C. venture capital fund. ANSWER: B MAL Investments is an asset management company that consists of three subsidiaries: one that focuses on mid-cap value stocks, one that focuses on alternative assets, and one that focuses on long-term emerging market sovereign debt. MAL is most accurately described as a: A. full-service asset manager. B. multi-boutique firm. C. specialist asset manager. ANSWER: B Which of the following statements about active and passive asset management is most accurate? A. Compared to active management, passive management is more reliant on fundamental analysis. B. Active management has been gaining market share over time versus passive management. C. Passive management’s share of industry revenues is smaller than its share of assets under management. ANSWER: C Which of the following pooled investments is least likely to employ large amounts of leverage? A. Venture capital fund. B. Global macro hedge fund. C. Private equity buyout fund. ANSWER: A Which of the following pooled investment shares is least likely to trade at a price different from its NAV? A. Open-end mutual fund shares. B. Exchange-traded fund shares. C. Closed-end mutual fund shares. ANSWER: A A mutual fund that invests in short-term debt securities and maintains a net asset value of $1.00 per share is best described as a: A. balanced fund. B. bond mutual fund. C. money market fund. ANSWER: C Which of the following should least likely be included as a constraint in an investment policy statement (IPS)? A. Any unique needs or preferences an investor may have. B. Constraints put on investment activities by regulatory agencies. C. How funds are spent after being withdrawn from the portfolio. ANSWER: C An investment manager is most likely to be engaging in tactical asset allocation if she: A. increases the allocation to tax-free bonds because the investor’s effective tax rate has increased. B. allocates 5% to cash, 20% to fixed income, and 75% to equities based on the investor’s long time horizon and high risk tolerance. C. allocates more than the targeted 10% to emerging market bonds because the sector appears to be undervalued. ANSWER: C Brian Nebrik, CFA, meets with a new investment management client. They compose a statement that defines each of their responsibilities concerning this account and choose a benchmark index with which to evaluate the account's performance. Which of these items should be included in the client's Investment Policy Statement (IPS)? A. Only one of these items. B. Neither of these items. C. Both of these items. ANSWER: C A return objective is said to be relative if the objective is: A. stated in terms of probability. B. compared to a specific numerical outcome. C. based on a benchmark index or portfolio. ANSWER: C An investment manager has constructed an efficient frontier based on a client's investable asset classes. The strategic asset allocation for the client should be the asset allocation of one of these efficient portfolios, selected based on: A. the relative valuations of the investable asset classes. B. the client’s investment objectives and constraints. C. a risk budgeting process. ANSWER: B Which of the following is not necessarily included in an investment policy statement? A. Procedures to update the IPS when circumstances change. B. An investment strategy based on the investor’s objectives and constraints. C. A benchmark against which to judge performance. ANSWER: A A portfolio manager who believes equity securities are overvalued in the short term reduces the weight of equities in her portfolio to 35% from its longer-term target weight of 40%. This decision is best described as an example of: A. rebalancing. B. strategic asset allocation. C. tactical asset allocation. ANSWER: C An endowment is required by statute to pay out a minimum percentage of its asset value each period to its beneficiaries. This investment constraint is best classified as: A. legal and regulatory. B. liquidity. C. unique circumstances. ANSWER: A Categories of investment constraints in an investment policy statement least likely include: A. tax concerns. B. risk tolerance. C. liquidity needs. ANSWER: B Which of the following would least likely be considered a minimum requirement of an IPS? A(n): A. investment strategy based on client circumstances and constraints. B. benchmark portfolio. C. target return figure. ANSWER: C Which of the following factors is least likely to affect an investor's risk tolerance? A. Level of inflation in the economy. B. Level of insurance coverage. C. Number of dependent family members. ANSWER: A Which of the following is NOT a rationale for the importance of the policy statement in investing? It: A. helps investors understand the risks and costs of investing. B. identifies specific stocks the investor may wish to purchase. C. forces investors to understand their needs and constraints. ANSWER: B Based on a questionnaire about investment risk, an advisor concludes that an investor's risk tolerance is high, but based on an analysis of the client's income needs and time horizon, he concludes the investor's risk tolerance is low. The most appropriate action for the advisor is to: A. emphasize stocks over bonds. B. emphasize bonds over stocks. C. educate the client about investment risk and re-administer the questionnaire. ANSWER: B Which of the following statements about risk is NOT correct? Generally, greater: A. existing wealth allows for greater risk. B. insurance coverage allows for greater risk. C. spending needs allows for greater risk. ANSWER: C Which of the following portfolio constraints in the Investment Policy Statement of a local college's endowment most likely belongs in the "unique circumstances" category? The endowment is: B. exempt from taxes. C. subject to oversight by a regulatory authority. A. unwilling to invest in companies that sell weapons. ANSWER: A If an investor's ability to bear risk is low and willingness to bear risk is high, an investment manager should most appropriately consider the investor's overall financial risk tolerance to be: A. moderate. B. high. C. low. ANSWER: C When preparing a strategic asset allocation, how should asset classes be defined with respect to the correlations of returns among the securities in each asset class? A. Low correlation within asset classes and low correlation between asset classes. B. High correlation within asset classes and low correlation between asset classes. C. Low correlation within asset classes and high correlation between asset classes. ANSWER: B Which of the following statements about investment constraints is least accurate? A. Diversification e orts can increase tax liability. B. Investors concerned about time horizon are not likely to worry about liquidity. C. Unwillingness to invest in gambling stocks is a constraint. ANSWER: B Which of the following statements is NOT consistent with the assumption that individuals are risk averse with their investment portfolios? A. There is a positive relationship between expected returns and expected risk. B. Many individuals purchase lottery tickets. C. Higher betas are associated with higher expected returns. ANSWER: B Which of the following is least likely to be considered a constraint when preparing an investment policy statement? A. Liquidity needs. B. Risk tolerance. C. Tax concerns. ANSWER: B An individual investor specifies to her investment advisor that her portfolio must produce a minimum amount of cash each period. This investment constraint is best classified as: A. legal and regulatory. B. liquidity. C. unique circumstances. ANSWER: B All of the following affect an investor's risk tolerance EXCEPT: A. family situation. B. tax bracket. C. years of experience with investing in the markets. ANSWER: B While assessing an investor's risk tolerance, a financial adviser is least likely to ask which of the following questions? A. “How much insurance coverage do you have?” B. “Is your home life stable?” C. “What rate of investment return do you expect?” ANSWER: C Which of the following statements about risk and return is least accurate? A. Return objectives may be stated in absolute terms. B. Risk and return may be considered on a mutually exclusive basis. C. Specifying investment objectives only in terms of return may expose an investor to inappropriately high levels of risk. ANSWER: B A firm that invests the majority of a portfolio to track a benchmark index, and uses active investment strategies for the remaining portion, is said to be using: A. a core-satellite approach. B. risk budgeting. C. strategic asset allocation. ANSWER: A Davis Samuel, CFA, is meeting with one of his portfolio management clients, Joseph Pope, todiscuss Pope's investment constraints. Samuel has established that: Pope plans to retire from his job as a bond salesman in 17 years, after which this portfolio will be his primary source of income. Pope has sufficient cash available that he will not need this portfolio to generate cash outflows until he retires. Pope, as a registered securities representative, is required to have Samuel send a copy of his account statements to the compliance officer at Pope's employer. Pope opposes certain policies of the government of Lower Pannonia and does not wish to own any securities of companies that do business with its regime. To complete his assessment of Pope's investment constraints, Samuel still needs to inquire about Pope's: A. unique circumstances. B. liquidity needs. C. tax concerns. ANSWER: C Which of the following statements about the importance of risk and return in the investment objective is least accurate? A. Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. B. The return objective may be stated in dollar amounts even if the risk objective is stated in percentages. C. The investor’s risk tolerance is likely to determine what level of return will be feasible. ANSWER: A The major components of a typical investment policy statement (IPS) least likely include: A. duties and responsibilities of the investment manager. B. the investment manager’s compensation. C. investment objectives. ANSWER: B When developing the strategic asset allocation in an IPS, the correlations of returns: A. among asset classes should be relatively high. B. within an asset class should be relatively high. C. within an asset class should be relatively low. ANSWER: B When performing strategic asset allocation, properly defined and specified asset classes should: A. approximate the investor’s total investable universe as a group. B. each contain assets that have a broad range of risk and expected return. C. have high returns correlations with other asset classes. ANSWER: A Which of the following statements is most accurate about integrating ESG considerations into portfolio planning and construction? A. Integrating ESG considerations into portfolio planning and construction is likely to decrease portfolio returns. B. Investors who engage in active ownership to pursue their ESG considerations should vote their shares themselves rather than delegating share voting to an investment manager. C. A broad market index is an inappropriate benchmark for a portfolio that uses negative screening to address the investor’s ESG concerns. ANSWER: C Which of the following asset class specifications is most appropriate for asset allocation purposes? A. Consumer discretionary. B. Domestic bonds. C. Emerging markets. ANSWER: B Which of the following statements best describes the availability bias? An investor: A. only notices information that agrees with their perceptions or beliefs. B. associates new information with an easily recalled past event. C. bases a decision on how the information is presented. ANSWER: B Emotional biases are most likely to: A. stem from feelings or intuition. B. be mitigated rather than accommodated. C. be related to faulty reasoning. ANSWER: A Which of the following behavioral biases is most likely related to information processing? A. Loss aversion. B. Anchoring and adjustment. C. Status quo. ANSWER: B Steven Murphy has a tendency of overreacting to current events and trading too much based on news or anecdotes. Which of the following biases does Murphy most likely exhibit? A. Availability bias. B. Overconfidence bias. C. Loss-aversion bias. ANSWER: A Which of the following are considered emotional biases? A. Anchoring and adjustment bias. B. Confirmation, control, and availability biases. C. Status quo and endowment biases. ANSWER: C Sarah Kowalski bought a growth stock for $45 per share that subsequently fell by 35%, and she is reluctant to sell as she hopes the stock bounces back. Kowalski is most likely exhibiting: A. self-control bias. B. availability bias. C. loss-aversion bias. ANSWER: C Greg Brown receives new information regarding one of his stocks. This information appears to be reliable and conflicts with Brown's earlier forecast of what the stock should be trading for at this time. However, Brown does not revise his estimate of the stock's value. Brown is most likely exhibiting: A. hindsight bias. B. confirmation bias. C. conservatism bias. ANSWER: C Rex Newman treats wages differently from bonuses when determining his savings and investment goals. As a result, he invests any available after-tax wages in low-risk investments while investing his bonuses in high-risk alternatives. Newman is most likely exhibiting: A. mental accounting bias. B. framing bias. C. availability bias. ANSWER: A Which of the following most accurately describes cognitive errors? A. They are not related to conscious thought. B. They stem from feelings, impulses, or intuition. C. They are due primarily to faulty reasoning. ANSWER: C Compared to emotional biases, cognitive errors are more likely to be: A. related to intuition or impulses. B. difficult to overcome. C. mitigated by information. ANSWER: C Which of the following cognitive errors are best described as belief persistence biases? A. Mental accounting, framing, and availability biases. B. Illusion of control, confirmation, and anchoring and adjustment biases. C. Conservatism, representativeness, and hindsight biases. ANSWER: C Which of the following statements would most likely be classified as a cognitive error? The investor: A. has a tendency to place information into categories. B. acts defensively when asked why he made a poor investment decision. C. tends to take more risk rather than sell a stock at a loss. ANSWER: A Which of the following are considered biases due to cognitive errors? A. Loss aversion, self-control, and regret-aversion biases. B. Conservatism, hindsight, and framing biases. C. Representativeness, mental accounting, and overconfidence biases. ANSWER: B Harvey Woodman invests in modern art. Occasionally, he sells a piece from his collection, but the process is often difficult because he gets insulted when potential buyers offer what he believes to be too little. Which bias is Woodman most likely exhibiting? A. Mental accounting bias. B. Overconfidence bias. C. Endowment bias. ANSWER: C Evidence that investors hold portfolios that are less diversified than traditional finance would suggest may be best explained by: C. overconfidence. A. fear of regret. B. anchoring. ANSWER: C With respect to asset "bubbles": A. behavioral finance provides an overall explanation. B. hindsight bias can fuel overconfidence. C. anchoring may cause investors to mitigate bubbles by reducing their market exposure. ANSWER: B Risk governance is best described as: A. senior management’s oversight of the organization’s risk management. B. allocating an organization’s resources by considering their risk characteristics. C. determining an organization’s risk tolerance. ANSWER: A Operational risk is most accurately described as the risk that: A. human error or faulty processes will cause losses. B. extreme events are more likely than managers have assumed. C. the organization will run out of operating cash. ANSWER: A Measures of interest rate sensitivity least likely include: A. beta. B. duration. C. rho. ANSWER: A Which of the following risks is most accurately classified as a non-financial risk? C. Credit risk. A. Liquidity risk. B. Model risk. ANSWER: B Value-at-Risk (VaR) and Conditional VaR are best described as measures of: A. liquidity risk. B. model risk. C. tail risk. ANSWER: C Risk management within an organization should most appropriately consider: A. internal risks independently of external risks. B. financial risks independently of non-financial risks. C. interactions among different risks. ANSWER: C An objective of the risk management process is to: A. eliminate the risks faced by an organization. B. identify the risks faced by an organization. C. minimize the risks faced by an organization. ANSWER: B A portfolio manager uses a computer model to estimate the effect on a portfolio's value from both a 3% increase in interest rates and a 5% depreciation in the euro relative to the yen. The manager is most accurately described as engaging in: A. scenario analysis. B. risk shifting. C. stress testing. ANSWER: A Which of the following statements about an organization's risk tolerance is most accurate? A. An organization with low risk tolerance should take steps to reduce each of the risks it identifies. B. Risk tolerance is the degree to which an organization is able to bear the various risks that may arise from outside the organization. C. The financial strength of an organization is one of the factors it should consider when determining its risk tolerance. ANSWER: C Features of a risk management framework least likely include: A. monitoring the organization’s risk exposures. B. establishing risk governance policies and processes. C. disciplining managers who exceed their risk budgets. ANSWER: C Buying insurance is best described as a method for an organization to: A. prevent a risk. B. shift a risk. C. transfer a risk. ANSWER: C Examples of financial risks include: A. credit risk, market risk, and liquidity risk. B. market risk, liquidity risk, and tax risk. C. solvency risk, credit risk, and market risk. ANSWER: A