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Multiple Choice Questions
1. Risk that can be eliminated through diversification is called ______ risk.
A. unique
B. firm-specific
C. diversifiable
D. all of these options
Answer: D. all of these options
2. The _______ decision should take precedence over the _____ decision.
A. asset allocation; stock selection
B. bond selection; mutual fund selection
C. stock selection; asset allocation
D. stock selection; mutual fund selection
Answer: A. asset allocation; stock selection
3. Many current and retired Enron Corp. employees had their 401k retirement accounts wiped
out when Enron collapsed because ________.
A. they had to pay huge fines for obstruction of justice
B. their 401k accounts were held outside the company
C. their 401k accounts were not well diversified
D. none of these options
Answer: C. their 401k accounts were not well diversified
4. Based on the outcomes in the following table, choose which of the statements below is
(are) correct?

I. The covariance of security A and security B is zero.
II. The correlation coefficient between securities A and C is negative.
III. The correlation coefficient between securities B and C is positive.
A. I only
B. I and II only
C. II and III only
D. I, II, and III
Answer: B. I and II only
5. 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.
Answer: A. asset A
6. Adding additional risky assets to the investment opportunity set will generally move the
efficient frontier _____ and to the ______.
A. up; right
B. up; left
C. down; right

D. down; left
Answer: B. up; left
7. An investor's degree of risk aversion will determine his or her ______.
A. optimal risky portfolio
B. risk-free rate
C. optimal mix of the risk-free asset and risky asset
D. capital allocation line
Answer: C. optimal mix of the risk-free asset and risky asset
8. The ________ is equal to the square root of the systematic variance divided by the total
variance.
A. covariance
B. correlation coefficient
C. standard deviation
D. reward-to-variability ratio
Answer: B. correlation coefficient
9. Which of the following statistics cannot be negative?
A. Covariance
B. Variance
C. E(r)
D. Correlation coefficient
Answer: B. Variance
10. Asset A has an expected return of 20% and a standard deviation of 25%. The risk-free rate
is 10%. What is the reward-to-variability ratio?
A. .40
B. .50
C. .75
D. .80
Answer: A. .40
20% - 10%/25% = .40
11. The correlation coefficient between two assets equals _________.
A. their covariance divided by the product of their variances
B. the product of their variances divided by their covariance
C. the sum of their expected returns divided by their covariance
D. their covariance divided by the product of their standard deviations
Answer: D. their covariance divided by the product of their standard deviations
12. Diversification is most effective when security returns are _________.
A. high
B. negatively correlated
C. positively correlated
D. uncorrelated
Answer: B. negatively correlated
13. The expected rate of return of a portfolio of risky securities is _________.
A. the sum of the securities' covariances
B. the sum of the securities' variances
C. the weighted sum of the securities' expected returns
D. the weighted sum of the securities' variances

Answer: C. the weighted sum of the securities' expected returns
14. Beta is a measure of security responsiveness to _________.
A. firm-specific risk
B. diversifiable risk
C. market risk
D. unique risk
Answer: C. market risk
15. The risk that can be diversified away is __________.
A. beta
B. firm-specific risk
C. market risk
D. systematic risk
Answer: B. firm-specific risk
16. Approximately how many securities does it take to diversify almost all of the unique risk
from a portfolio?
A. 2
B. 6
C. 8
D. 20
Answer: D. 20
17. Consider an investment opportunity set formed with two securities that are perfectly
negatively correlated. The global minimum-variance portfolio has a standard deviation that is
always _________.
A. equal to the sum of the securities' standard deviations
B. equal to -1
C. equal to 0
D. greater than 0
Answer: C. equal to 0
18. Market risk is also called __________ and _________.
A. systematic risk; diversifiable risk
B. systematic risk; nondiversifiable risk
C. unique risk; nondiversifiable risk
D. unique risk; diversifiable risk
Answer: B. systematic risk; nondiversifiable risk
19. Firm-specific risk is also called __________ and __________.
A. systematic risk; diversifiable risk
B. systematic risk; nondiversifiable risk
C. unique risk; nondiversifiable risk
D. unique risk; diversifiable risk
Answer: D. unique risk; diversifiable risk
20. Which one of the following stock return statistics fluctuates the most over time?
A. Covariance of returns
B. Variance of returns
C. Average return
D. Correlation coefficient
Answer: C. Average return

21. Harry Markowitz is best known for his Nobel Prize-winning work on _____________.
A. strategies for active securities trading
B. techniques used to identify efficient portfolios of risky assets
C. techniques used to measure the systematic risk of securities
D. techniques used in valuing securities options
Answer: B. techniques used to identify efficient portfolios of risky assets
22. Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means
that ______.
A. the returns on the stock and bond portfolios tend to move inversely
B. the returns on the stock and bond portfolios tend to vary independently of each other
C. the returns on the stock and bond portfolios tend to move together
D. the covariance of the stock and bond portfolios will be positive
Answer: B. the returns on the stock and bond portfolios tend to vary independently of each
other
23. You put half of your money in a stock portfolio that has an expected return of 14% and a
standard deviation of 24%. You put the rest of your money in a risky bond portfolio that has
an expected return of 6% and a standard deviation of 12%. The stock and bond portfolios
have a correlation of .55. The standard deviation of the resulting portfolio will be
________________.
A. more than 18% but less than 24%
B. equal to 18%
C. more than 12% but less than 18%
D. equal to 12%
Answer: C. more than 12% but less than 18%
σ2p = .02592 = (.52)(.242) + (.52)(.122) + 2(.5)(.5)(.24)(.12).55 = .02592; σ = 16.1%
24. On a standard expected return versus standard deviation graph, investors will prefer
portfolios that lie to the _____________ of the current investment opportunity set.
A. left and above
B. left and below
C. right and above
D. right and below
Answer: A. left and above
25. The term complete portfolio refers to a portfolio consisting of _________________.
A. the risk-free asset combined with at least one risky asset
B. the market portfolio combined with the minimum-variance portfolio
C. securities from domestic markets combined with securities from foreign markets
D. common stocks combined with bonds
Answer: A. the risk-free asset combined with at least one risky asset
26. Rational risk-averse investors will always prefer portfolios _____________.
A. located on the efficient frontier to those located on the capital market line
B. located on the capital market line to those located on the efficient frontier
C. at or near the minimum-variance point on the efficient frontier
D. that are risk-free to all other asset choices
Answer: B. located on the capital market line to those located on the efficient frontier
27. The optimal risky portfolio can be identified by finding:
I. The minimum-variance point on the efficient frontier

II. The maximum-return point on the efficient frontier and the minimum-variance point on the
efficient frontier
III. The tangency point of the capital market line and the efficient frontier
IV. The line with the steepest slope that connects the risk-free rate to the efficient frontier
A. I and II only
B. II and III only
C. III and IV only
D. I and IV only
Answer: C. III and IV only
28. The _________ reward-to-variability ratio is found on the ________ capital market line.
A. lowest; steepest
B. highest; flattest
C. highest; steepest
D. lowest; flattest
Answer: C. highest; steepest
29. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of
return of 24%, while stock B has a standard deviation of return of 18%. Stock A comprises
60% of the portfolio, while stock B comprises 40% of the portfolio. If the variance of return
on the portfolio is .0380, the correlation coefficient between the returns on A and B is
_________.
A. .583
B. .225
C. .327
D. .128
Answer: A. .583
.0380 = (.62)(.242) + (.42)(.182) + 2(.6)(.4)(.24)(.18) ρ; ρ = .583
30. The standard deviation of return on investment A is .10, while the standard deviation of
return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation
coefficient between the returns on A and B is _________.
A. .12
B. .36
C. .60
D. .77
Answer: C. .60
Correlation =
31. 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 _________.
A. 23%
B. 19.76%
C. 18.45%
D. 17.67%
Answer: B. 19.76%

σ2p = (.402)(.352) + (.602)(.15)2 + (2)(.4)(.6)(.35)(.15)(.45)
σ2p = .039046
σp = 19.76%
32. The standard deviation of return on investment A is .10, while the standard deviation of
return on investment B is .04. If the correlation coefficient between the returns on A and B is .50, the covariance of returns on A and B is _________.
A. -.0447
B. -.0020
C. .0020
D. .0447
Answer: B. -.0020
Convariance = .50(.10)(.04) = -.0020
33. 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%
Answer: C. 40%

34. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an
expected return of 18% and a standard deviation of return of 20%. Stock B has an expected
return of 14% and a standard deviation of return of 5%. The correlation coefficient between
the returns of A and B is .50. The risk-free rate of return is 10%. The proportion of the
optimal risky portfolio that should be invested in stock A is _________.
A. 0%
B. 40%
C. 60%
D. 100%
Answer: A. 0%

Since the numerator equals zero, WA = 0 without any further calculations.
35. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an
expected return of 18% and a standard deviation of return of 20%. Stock B has an expected
return of 14% and a standard deviation of return of 5%. The correlation coefficient between
the returns of A and B is .50. The risk-free rate of return is 10%. The expected return on the
optimal risky portfolio is _________.
A. 14%
B. 15.6%

C. 16.4%
D. 18%
Answer: A. 14%

Wa = 0
E(rp) = 1(.14) = .1400
Since WA = 0 and WB = 1, the risky portfolio's expected return is the same as asset B's
expected return.
36. An investor can design a risky portfolio based on two stocks, A and B. Stock A has an
expected return of 18% and a standard deviation of return of 20%. Stock B has an expected
return of 14% and a standard deviation of return of 5%. The correlation coefficient between
the returns of A and B is .50. The risk-free rate of return is 10%. The standard deviation of
return on the optimal risky portfolio is _________.
A. 0%
B. 5%
C. 7%
D. 20%
Answer: B. 5%

Wa = 0
Since WA = 0 and WB = 1, the risky portfolio's standard deviation is the same as asset B's
standard deviation.
37. 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 _________.
A. 29%
B. 44%
C. 56%
D. 71%
Answer: D. 71%

WB = 71%
38. 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.)

A. 14%
B. 16%
C. 18%
D. 19%
Answer: B. 16%

WB = 71% and WA = 29%
E[rp] = (.29)(.21) + (.71)(.14) = 16.03%
39. 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 standard deviation of the
returns on the optimal risky portfolio is _________.
A. 25.5%
B. 22.3%
C. 21.4%
D. 20.7%
Answer: C. 21.4%

WB = 71% and WA = 29%
σ2rp = (.292)(.392) + (.712)(.202) + 2(.29)(.71)(.39)(.20).4
σ2rp = .045804
σrp = 21.4%
40. An investor can design a risky portfolio based on two stocks, A and B. The standard
deviation of return on stock A is 24%, while the standard deviation on stock B is 14%. The
correlation coefficient between the returns on A and B is .35. The expected return on stock A
is 25%, while on stock B it is 11%. The proportion of the minimum-variance portfolio that
would be invested in stock B is approximately _________.
A. 45%
B. 67%
C. 85%
D. 92%
Answer: C. 85%

41. An investor can design a risky portfolio based on two stocks, A and B. The standard
deviation of return on stock A is 20%, while the standard deviation on stock B is 15%. The
correlation coefficient between the returns on A and B is 0%. The expected return on the
minimum-variance portfolio is approximately _________.

A. 10%
B. 13.6%
C. 15%
D. 19.41%
Answer: B. 13.6%

42. An investor can design a risky portfolio based on two stocks, A and B. The standard
deviation of return on stock A is 20%, while the standard deviation on stock B is 15%. The
correlation coefficient between the returns on A and B is 0%. The standard deviation of return
on the minimum-variance portfolio is _________.
A. 0%
B. 6%
C. 12%
D. 17%
Answer: C. 12%

43. A measure of the riskiness of an asset held in isolation is ____________.
A. beta
B. standard deviation
C. covariance
D. alpha
Answer: B. standard deviation
44. 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?
A. 7%
B. 8.5%
C. 8.8%
D. 9.25%
Answer: C. 8.8%
6% + (1.5%)(1.2) + 1% = 8.8%
45. The part of a stock's return that is systematic is a function of which of the following
variables?
I. Volatility in excess returns of the stock market
II. The sensitivity of the stock's returns to changes in the stock market
III. The variance in the stock's returns that is unrelated to the overall stock market
A. I only
B. I and II only
C. II and III only
D. I, II, and III

Answer: B. I and II only
46. Stock A has a beta of 1.2, and stock B has a beta of 1. The returns of stock A are ______
sensitive to changes in the market than are the returns of stock B.
A. 20% more
B. slightly more
C. 20% less
D. slightly less
Answer: A. 20% more
47. Which risk can be partially or fully diversified away as additional securities are added to a
portfolio?
I. Total risk
II. Systematic risk
III. Firm-specific risk
A. I only
B. I and II only
C. I, II, and III
D. I and III
Answer: D. I and III
48. According to Tobin's separation property, portfolio choice can be separated into two
independent tasks consisting of __________ and __________.
A. identifying all investor imposed constraints; identifying the set of securities that conform
to the investor's constraints and offer the best risk-return trade-offs
B. identifying the investor's degree of risk aversion; choosing securities from industry groups
that are consistent with the investor's risk profile
C. identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and
the optimal risky portfolio based on the investor's degree of risk aversion
D. choosing which risky assets an investor prefers according to the investor's risk-aversion
level; minimizing the CAL by lending at the risk-free rate
Answer: C. identifying the optimal risky portfolio; constructing a complete portfolio from Tbills and the optimal risky portfolio based on the investor's degree of risk aversion
49. You are constructing a scatter plot of excess returns for stock A versus the market index.
If the correlation coefficient between stock A and the index is -1, you will find that the points
of the scatter diagram ___________ and the line of best fit has a ______________.
A. all fall on the line of best fit; positive slope
B. all fall on the line of best fit; negative slope
C. are widely scattered around the line; positive slope
D. are widely scattered around the line; negative slope
Answer: B. all fall on the line of best fit; negative slope
50. The term excess return refers to ______________.
A. returns earned illegally by means of insider trading
B. the difference between the rate of return earned and the risk-free rate
C. the difference between the rate of return earned on a particular security and the rate of
return earned on other securities of equivalent risk
D. the portion of the return on a security that represents tax liability and therefore cannot be
reinvested
Answer: B. the difference between the rate of return earned and the risk-free rate

51. You are recalculating the risk of ACE stock in relation to the market index, and you find
that the ratio of the systematic variance to the total variance has risen. You must also find that
the ____________.
A. covariance between ACE and the market has fallen
B. correlation coefficient between ACE and the market has fallen
C. correlation coefficient between ACE and the market has risen
D. unsystematic risk of ACE has risen
Answer: C. correlation coefficient between ACE and the market has risen
52. A stock has a correlation with the market of .45. The standard deviation of the market is
21%, and the standard deviation of the stock is 35%. What is the stock's beta?
A. 1
B. .75
C. .60
D. .55
Answer: B. .75

53. The values of beta coefficients of securities are __________.
A. always positive
B. always negative
C. always between positive 1 and negative 1
D. usually positive but are not restricted in any particular way
Answer: D. usually positive but are not restricted in any particular way
54. A security's beta coefficient will be negative if ____________.
A. its returns are negatively correlated with market-index returns
B. its returns are positively correlated with market-index returns
C. its stock price has historically been very stable
D. market demand for the firm's shares is very low
Answer: A. its returns are negatively correlated with market-index returns
55. The market value weighted-average beta of firms included in the market index will always
be _____________.
A. 0
B. between 0 and 1
C. 1
D. none of these options (There is no particular rule concerning the average beta of firms
included in the market index.)
Answer: C. 1
56. Diversification can reduce or eliminate __________ risk.
A. all
B. systematic
C. nonsystematic
D. only an insignificant
Answer: C. nonsystematic
57. To construct a riskless portfolio using two risky stocks, one would need to find two stocks
with a correlation coefficient of ________.

A. 1
B. .5
C. 0
D. -1
Answer: D. -1
58. Some diversification benefits can be achieved by combining securities in a portfolio as
long as the correlation between the securities is _____________.
A. 1
B. less than 1
C. between 0 and 1
D. less than or equal to 0
Answer: B. less than 1
59. If an investor does not diversify his portfolio and instead puts all of his money in one
stock, the appropriate measure of security risk for that investor is the ________.
A. stock's standard deviation
B. variance of the market
C. stock's beta
D. covariance with the market index
Answer: A. stock's standard deviation
60. Which of the following provides the best example of a systematic-risk event?
A. A strike by union workers hurts a firm's quarterly earnings.
B. Mad Cow disease in Montana hurts local ranchers and buyers of beef.
C. The Federal Reserve increases interest rates 50 basis points.
D. A senior executive at a firm embezzles $10 million and escapes to South America.
Answer: C. The Federal Reserve increases interest rates 50 basis points.
61. 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.
A. I only
B. II only
C. II and III only
D. I, II, and III
Answer: C. II and III only
62. You find that the annual Sharpe ratio for stock A returns is equal to 1.8. For a 3-year
holding period, the Sharpe ratio would equal _______.
A. 1.8
B. 2.48
C. 3.12
D. 5.49
Answer: C. 3.12
The Sharpe ration grows at a rate of s1√Tso the 3-year Sharpe ration would be 1.8 × √3 =
√3.12.
63.

The beta of this stock is ________.
A. .12
B. .35
C. 1.32
D. 4.05
Answer: C. 1.32
Beta equals slope coefficient = 1.32
64.

This stock has greater systematic risk than a stock with a beta of ___.
A. .50
B. 1.5
C. 2
D. 3
Answer: A. .50
.50 (W12σ12 + W22σ22)
79. What is the standard deviation of a portfolio of two stocks given the following data: Stock
A has a standard deviation of 18%. Stock B has a standard deviation of 14%. The portfolio
contains 40% of stock A, and the correlation coefficient between the two stocks is -.23.
A. 9.7%
B. 12.2%
C. 14%
D. 15.6%
Answer: A. 9.7%

80. What is the standard deviation of a portfolio of two stocks given the following data: Stock
A has a standard deviation of 30%. Stock B has a standard deviation of 18%. The portfolio
contains 60% of stock A, and the correlation coefficient between the two stocks is -1.
A. 0%
B. 10.8%
C. 18%
D. 24%
Answer: B. 10.8%

81. The expected return of a portfolio is 8.9%, and the risk-free rate is 3.5%. If the portfolio
standard deviation is 12%, what is the reward-to-variability ratio of the portfolio?

A. 0
B. .45
C. .74
D. 1.35
Answer: B. .45
Reward-to-variability ratio = (.089 - .035)/.12 = .45
82. 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?
A. 25%
B. 50%
C. 62%
D. 73%
Answer: D. 73%
E[rp] = (.60)(1) + (.40)(-.5) = .40
σ2rp = (.60)(1 - .40)2 + (.40)(-.5 - .40)2 = .54
σrp = .73
83. A project has a 50% chance of doubling your investment in 1 year and a 50% chance of
losing half your money. What is the expected return on this investment project?
A. 0%
B. 25%
C. 50%
D. 75%
Answer: B. 25%
E[rp] = (.5)(100) + (.5)(-50) = 25%
84. The figures below show plots of monthly excess returns for two stocks plotted against
excess returns for a market index.

Which stock is likely to further reduce risk for an investor currently holding her portfolio in a
well-diversified portfolio of common stock?
A. Stock A
B. Stock B
C. There is no difference between A or B.
D. The answer cannot be determined from the information given.
Answer: A. Stock A
85. 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?
A. Stock A is riskier.
B. Stock B is riskier.
C. Both stocks are equally risky.
D. The answer cannot be determined from the information given.
Answer: A. Stock A is riskier.

Test Bank for Essentials of Investments
Zvi Bodie, Alex Kane, Alan Marcus
9780078034695, 9789389957877, 9781264140251, 9781260316148, 9780073382401, 9780078034695, 9781260013924, 9780077835422

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