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Exam 2 with Multiple Choice Questions - Investments | FINC 314, Exams of Investment Theory

Material Type: Exam; Professor: Harris; Class: Investments; Subject: Finance; University: University of Delaware; Term: Fall 2006;

Typology: Exams

2009/2010

Uploaded on 11/01/2010

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Sample Exam #2
1. Multiple Choice Choose the best answer for each of the following questions.
1. Consider the four risky securities described below. Which of these securities would be the
best to combine with a Treasury Bill that pays a risk-free rate of 7.0%?
a) Security A: E(R)=10% σ=14.0%
b) Security B: E(R)=15% σ=19.0%
c) Security C: E(R)=21% σ=19.0%
d) Security D: E(R)=18% σ=14.0%
2. Given the two security choices described below, which security would be selected by a risk-
averse investor?
Security A is a risk-free security with a return equal to 8.0%.
Security B is a risky security that pays -4% or +20% with equal probability.
a) Security A would be selected by a risk-averse investor
b) Security B would be selected by a risk-averse investor
c) A risk-averse investor would be indifferent between Security A and Security B
d) The answer cannot be determined without knowing the investor’s exact risk-
aversion level and utility function.
3. For each individual investor, the optimal combination of a risky security and a risk-free
security is determined by:
a) The point of minimum variance on the Efficient Frontier.
b) The point of tangency between the Capital Allocation Line and the Efficient
Frontier.
c) The point of tangency between the Efficient Frontier and the investor’s
indifference curves.
d) The point of tangency between the Capital Allocation Line and the investor’s
indifference curves.
4. Other things equal, diversification is most effective when:
a) Security returns are uncorrelated.
b) Security returns are positively correlated.
c) Security returns are negatively correlated.
d) Security returns are high.
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Sample Exam #

  1. Multiple Choice Choose the best answer for each of the following questions.
  2. Consider the four risky securities described below. Which of these securities would be the best to combine with a Treasury Bill that pays a risk-free rate of 7.0%?

a) Security A : E(R)=10% σ=14.0% b) Security B : E(R)=15% σ=19.0% c) Security C : E(R)=21% σ=19.0% d) Security D : E(R)=18% σ=14.0%

  1. Given the two security choices described below, which security would be selected by a risk- averse investor?

Security A is a risk-free security with a return equal to 8.0%. Security B is a risky security that pays -4% or +20% with equal probability.

a) Security A would be selected by a risk-averse investor b) Security B would be selected by a risk-averse investor c) A risk-averse investor would be indifferent between Security A and Security B d) The answer cannot be determined without knowing the investor’s exact risk- aversion level and utility function.

  1. For each individual investor, the optimal combination of a risky security and a risk-free security is determined by:

a) The point of minimum variance on the Efficient Frontier. b) The point of tangency between the Capital Allocation Line and the Efficient Frontier. c) The point of tangency between the Efficient Frontier and the investor’s indifference curves. d) The point of tangency between the Capital Allocation Line and the investor’s indifference curves.

  1. Other things equal, diversification is most effective when:

a) Security returns are uncorrelated. b) Security returns are positively correlated. c) Security returns are negatively correlated. d) Security returns are high.

  1. Consider the two risky securities described below. If the correlation between these securities

is ρ = -1, what weights in securities X and Y would give you a perfect hedge (or zero risk)?

Security X : E(R (^) X)=6.0% σX=8.0% Security Y : E(RY)=12.0% σY=24.0%

a) 50% in Security X and 50% in Security Y b) 75% in Security X and 25% in Security Y c) 25% in Security X and 75% in Security Y d) None of the above.

  1. The reward-to-variability ratio is given by:

a) the alpha of a security. b) the slope of an investor’s indifference curve. c) the slope of the capital allocation line (CAL). d) the covariance of the market returns with stock returns.

  1. Which of the following was not a significant factor in the Arbitrage Pricing Theory (APT) tests by Chen, Roll and Ross?

a) Unexpected inflation. b) Bond risk premiums. c) Market returns. d) Industrial production.

  1. One of your co-workers informs you that they have developed a foolproof strategy for making risk-adjusted abnormal profits in the stock market. The strategy involves looking up trades by corporate insiders on the internet and buying any stocks that are being purchased by the CEO of the company. This type of trading strategy would violate which form(s) of the efficient markets hypothesis?

a) Strong only b) Semi-Strong only c) Semi-Strong and Strong d) Weak and Semi-Strong

Answers to Sample Exam #

1-d 2-a 3-d 4-c 5-b 6-c 7-c 8-c

Short Problems:

A. Here are the plots:

Capital Market Line

0

2

4

6

8

10

12

14

16

18

20

0 5 10 15 20 25 30 35 Standard Deviation

F

F

Z

X

M

Y

CML

Security Market Line

4

6

8

10

12

14

16

18

20

0

2

0 0.2 0.4 0.6 0.8 1 1.2 1. Beta

F

Z

M, X

Y

B. βM = 1.0 (always)

βF = 0.0 (always)

βX = (E(R)-Rf )/( E(RM)-Rf ) = (16% - 5%)/(16%-5%) = 1. [note: this must equal 1.0, since E(R)=E(RM)]

βY = (6% - 5%)/(16%-5%) = 0.

βZ = (19% - 5%)/(16%-5%) = 1.

C. Portfolio betas are just the weighted average of the individual betas.

Here, βP = 0.75*(1.0) + 0.25(0.0909) = 0.

  1. See notes from class for the Security Market Line, CAPM and Treynor measure, etc.

  2. The Weekend (or Monday) Effect refers to the fact that returns on Mondays are unusually low on Mondays. This regularity has caused some to question the efficiency of the market. Purely random returns would predict no pattern like this at regular intervals. Whether this pattern represents inefficiency (in the sense that an investor may be able to profit from this knowledge) or some other quirk in the market is still not resolved. The debate on market efficiency continues.

Essays

1-- I wanted some discussion of multifactor models and CAPM including, but not limited to: -- CAPM relies on investor preferences or multivariate normal returns (APT simply utilizes a no arbitrage argument). --CAPM assumes only one source of risk (variance) while multifactor models don't. --CAPM relies on many assumptions (see notes). Some of these overlap with APT (like no transaction costs) but many others do not. --CAPM holds that the one factor affecting returns is the market. Obviously, multifactor models allow for more than one factor, but not necessarily the market. --Multifactor models allow for more than one factor, but don't specify how many or what the factors are. CAPM states the factor is the market.

2--Covariance and correlation both refer to how two sets of data (here, stock returns) vary with each other. Covariance is a raw measure that is difficult to interpret whereas correlations are standardized measures of covariance that lie between -1 and +1, making comparisons across pairs of data easier.

3--Arbitrage, in terms of cash flows and returns, is simply the guarantee of future positive cash flows without having to invest any money up front. In the simplest terms, arbitrage occurs when cash flows at T=0 are zero and future cash flows are all positive.

4--Assuming away the possibility of fraud, stealing on the job and other job-related mistakes, BESTOne’s manager may still have been fired for poor performance in the fund itself. We need to know the performance of the funds on a risk-adjusted basis. Given these facts, it could be that BESTOne’s manager is in high risk stocks which had even higher returns than the 14% that