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1. Here are some characteristics of two securities:

Security 1 E(R1) = .10 σ 2 1 = .0025

Security 2 E(R2) = .16 σ 2 2 = .0064

Answer the following questions:

(a) Suppose the investor can only hold a single stock.

(i) Which security should she choose if she wants to maximize expected returns only?

(ii) Which security should she choose if she wants to minimize risk only?

(b) Suppose the correlation of returns is -1.0, what fraction of the investor’s net worth should be held in security 1 and in security 2 in order to produce a zero risk portfolio?

(c) What is the expected return on the portfolio in (c)? How does this compare with the riskless return on Treasury Bills of 10%? Would an investor who is risk averse and likes high expected return want to invest in Treasury Bills?

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Hubert Koch
Hubert KochLv2
22 Dec 2018

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1. The diversification effect of a portfolio of two stocks: . A. increases as the correlation between the stocks declines. B. increases as the correlation between the stocks rises. C. decreases as the correlation between the stocks rises. D. Both A and C. E. None of the above. 2. Irene Adler is considering investing in the common stock of Holmes and Watson. The following data are available for the two securities. . ................... Expected Return ..... Standard Deviation Holmes .............. 0.12 ......................... 0.08 Watson ............. 0.19 .......................... 0.25 . If she invests 60% of her funds Holmes and 40% in Watson, and if the correlation of returns between these two securities is 0.45, what is the portfolio’s expected return and standard deviation? . A. 14.8% and 12.89% B. 13.6% and 11.03% C. 14.6% and 13.94% D. 14.4% and 11.03% E. 13.21% and 10.08% 3. What does a security bring to the risk of a well diversified portfolio? . A. It brings its standard deviation of possible returns. B. It brings its covariance with the other securities in the portfolio. C. It brings its total risk. D. It brings its unsystematic risk. 4. Diversification can effectively reduce risk. Once a portfolio is diversified, the type of risk remaining is: . A. individual security risk. B. riskless security risk. C. unsystematic risk D. systematic risk 5. Efficient portfolios are those, which offer: . A. Highest expected return for a given level of risk B. Highest risk for a given level of expected return C. The maximum risk and expected return D. All of the above

Choose the correct answer:

The beta of an efficient portfolio: a. must be 1 since an efficient portfolio is perfectly positively correlated with the market portfolio.

b. is proportional to 1, depending on the proportion invested in the market portfolio.

c. is equivalent to the portfolio's standard deviation, since standard deviation is the measure of risk for an efficient portfolio.

d. is always less than 1.

Security A has a greater level of systematic risk than security B. The expected equilibrium return for A must be greater than that for B because:

a. B's price will fall as investors realize that B offers lower returns.

b. if it is not, then A's price will fall and B's price will rise as investors sell A and buy B.

c. the Security Market Line is negatively sloped.

d. the standard deviation of A's return is greater than B's.

In case of a simple CAPM being used to estimate a time series data:

a. the mean of a residual risk should be equal to zero.

b. the regression coefficient should be equal to zero.

c. the difference between the market return and the riskfree rate of return should be equal to zero.

d. the beta of the portfolio should be equal to zero.

In a CAPM framework, prohibiting short sales:

a. will prohibit investors from holding the market portfolio in equilibrium.

b. will make the security market line steeper.

c. will encourage investors to hold more riskless assets.

d. will not change the equilibrium.

Stock 1: E(R) = 10%, SD = 10% ; Stock 2: E(R) = 20%, SD = 30% ; The correlation between Stock 1 & 2 = 0.5. The risk-free return of 5% is avaliable in T-bills.

A investor invested all of his $10,000 net worth in Stock 1.

(a) Is there any portfolio that can be formed with Stock 1, 2 and risk-free security that can make the investor better off? What is it? Assume that no short-selling of stocks is allowed. And also explain why the portfolio is better than investing Stock 1 alone.

(b) Based on the answer in (a), The investor is advised to invest in that portfolio but he asks if the investment in this portfolio can be guaranteed and will not regret with the portfolio one year from now. Can the advisor assure the investor that there will be no regrets and it is guaranteed? Why or why not? Explain in words.

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