Deck 5: The Theory of Portfolio Allocation

Question 1

Suppose that when your wealth increases from $100,000 to $200,000, your holdings of savings deposits increase from $10,000 to $12,000. Your wealth elasticity of demand for savings deposits then is

A)less than 1 and savings deposits are a necessity asset.
B)greater than 1 and savings deposits are a necessity asset.
C)less than 1 and savings deposits are a luxury asset.
D)greater than 1 and savings deposits are a luxury asset.

Answer 1

less than 1 and savings deposits are a necessity asset.

Question 2

Comparing U.S. household portfolios in 2006 with U.S. household portfolios in 1950, which of the following statements is true?

A)Pension reserves were a larger fraction of U.S. household portfolios in 2006, but U.S. government securities were a smaller fraction.
B)Life insurance reserves were a larger fraction of U.S. household portfolios, but pension reserves were a smaller fraction.
C)Money market mutual funds were a smaller fraction of U.S. household portfolios, but U.S. government securities were a larger fraction.
D)U.S. government securities were a smaller fraction of U.S. household portfolios, but life insurance reserves were a larger fraction.

Answer 2

Pension reserves were a larger fraction of U.S. household portfolios in 2006, but U.S. government securities were a smaller fraction.

Question 3

Which of the following was NOT a major store of U.S. household wealth in 1950?

A)Mutual funds
B)Equities
C)Bank accounts
D)U.S. government securities

Answer 3

Mutual funds

Question 4

An asset in a portfolio always represents

A)a medium of exchange.
B)a unit of account.
C)a store of value.
D)the same thing as a liability.

Question 5

A portfolio is a

A)brokerage house specializing in the trading of common stock.
B)brokerage house specializing in the trading of corporate bonds.
C)measure of the risk involved with a holding a particular asset.
D)collection of assets.

Question 6

Luxury assets are assets

A)with wealth elasticities of less than 1.
B)held by savers for investment.
C)used by savers to conduct regular transactions.
D)not subject to federal income tax.

Question 7

Which of the following assets made up the largest fraction of the portfolios of U.S. households in 2006?

A)Pension reserves
B)Equities
C)Mortgages
D)U.S. government securities

Question 8

Suppose that when your wealth increases from $100,000 to $200,000 , your holdings of U.S. Treasury securities increases from $2000 to $5000. Your wealth elasticity of demand for U.S. government securities then is

A)less than 1 and U.S. government securities are a luxury asset.
B)greater than 1 and U.S. government securities are a necessity asset.
C)less than 1 and U.S. government securities are a necessity asset.
D)greater than 1 and U.S. government securities are a luxury asset.

Question 9

Which of the following assets made up the largest fraction of the portfolios of U.S. households in 1950?

A)Pension reserves
B)Equities
C)Mortgages
D)U.S. government securities

Question 10

Which of the following is NOT a determinant of asset demand?

A)The saver's wealth
B)The saver's income
C)Expectations of the return on the asset
D)The liquidity of the asset

Question 11

As wealth decreases, which of the following is likely to account for a larger fraction of a saver's portfolio?

A)Corporate stock
B)Corporate bonds
C)U.S. government securities
D)Checking account balance

Question 12

Necessity assets are assets

A)used by savers to conduct regular transactions.
B)with wealth elasticities of greater than 1.
C)held by savers for investment.
D)not subject to federal income tax.

Question 13

The theory of portfolio allocation describes

A)why savers behave as they do when selecting one asset rather than another.
B)the relationship among interest rates on bonds of different maturities.
C)why firms sometimes raise funds by issuing equities and sometimes by issuing debt.
D)the reasons why assets differ in their degree of liquidity.

Question 14

Economists believe that as a saver's wealth increases, the saver will generally

A)increase his or her holdings of all assets proportionately.
B)increase the fraction of wealth held as cash.
C)increase the fraction of wealth held as common stock.
D)decrease the fraction held as corporate bonds.

Question 15

As wealth increases, which of the following is likely to account for a smaller fraction of a saver's portfolio?

A)Corporate stock
B)Corporate bonds
C)Cash
D)U.S. government securities

Question 16

Necessity assets are assets

A)with wealth elasticities of less than 1.
B)with wealth elasticities of greater than 1.
C)held by savers for investment.
D)not subject to federal income tax.

Question 17

The theory of portfolio allocation

A)predicts how savers allocate their assets.
B)explains the relative liquidity of different assets.
C)explains the relative riskiness of different assets.
D)predicts the inflation rate.

Question 18

Luxury assets

A)have wealth elasticities of less than 1.
B)generally have low fixed costs of ownership.
C)generally have high transactions costs of acquisition.
D)have returns that are taxed at a higher rate than the returns on necessity assets.

Question 19

Suppose that when your wealth increases from $100,000 to $200,000, your holdings of stock mutual funds increases from $20,000 to $50,000. Your wealth elasticity of demand for stock mutual funds then is

A)less than 1 and stock mutual funds are a necessity asset.
B)greater than 1 and stock mutual funds are a luxury asset.
C)less than 1 and stock mutual funds are a luxury asset.
D)greater than 1 and stock mutual funds are a necessity asset.

Question 20

The wealth elasticity of demand describes the percentage change in

A)the quantity demanded of an asset for a given percentage change in the price of the asset.
B)the amount of wealth possessed for a given percentage change in the age of the saver.
C)the quantity of an asset demanded for a given percentage change in wealth.
D)wealth for a given percentage change in the amount of any one asset added to the saver's portfolio.

Question 21

Suppose that Steve's Book Supplies has a return of 15% one-third of the time and a return of 0% two-thirds of the time. Your expected return from investing in Acme Widget would be

A)2.5%.
B)5.0%.
C)7.5%.
D)10.0%.

Question 22

According to many economists, the equity premium

A)is mainly attributable to tax considerations.
B)reflects investors' fears of future inflation.
C)is probably zero.
D)is too large to be explained by risk considerations alone.

Question 23

Assets with greater liquidity

A)also typically have greater returns.
B)are generally tax-free.
C)help savers smooth spending over time.
D)are generally available only through brokers.

Question 24

As wealth increases, savers choose

A)more necessity assets and fewer luxury assets.
B)more luxury assets and fewer necessity assets.
C)more of both luxury assets and necessity assets.
D)fewer of both luxury assets and necessity assets.

Question 25

The expected real return to savers equals

A)expected inflation less the nominal return.
B)expected inflation plus the nominal return.
C)the nominal return minus expected inflation.
D)the nominal return divided by expected inflation.

Question 26

Suppose that the number of buyers and sellers of municipal bonds decreases substantially. The result should be a(an)

A)decline in municipal bond yields.
B)increase in municipal bond yields.
C)decline in U.S. Treasury bond yields.
D)increase in the tax rate on municipal bond yields.

Question 27

Rank the following assets from least liquid to most liquid: U.S. Treasury bills; corporate bonds issued by Jimmy's Motorcycle Emporium; municipal bonds issued by the city of Orlando.

A)Orlando, Jimmy's, U.S. Treasury
B)Jimmy's, Orlando, U.S. Treasury
C)Jimmy's, U.S. Treasury, Orlando
D)Orlando, U.S. Treasury, Jimmy's

Question 28

In making investment decisions, savers evaluate

A)the variability of the expected return as well as the size of the return.
B)the size of the expected return, but not the variability of the return.
C)the variability of the expected return, but not the size of the return.
D)neither the size nor the variability of the expected return.

Question 29

Which of the following is an example of a tax-exempt bond?

A)A bond issued by Microsoft
B)A U.S. Treasury note
C)A bond issued by the state of Ohio
D)No bonds issued in the United States are exempt from taxation.

Question 30

The main reason that savers must assess the impact of inflation on returns is

A)an increase in inflation will lower the nominal return on an asset.
B)changes in the value of money will affect the real value of returns.
C)inflation has a larger impact on the returns on luxury assets than on the returns on necessity assets.
D)real after-tax returns generally rise during periods of inflation.

Question 31

Interest from U.S. Treasury securities is

A)not subject to taxation.
B)taxed at the federal level, but not at the state and local levels.
C)taxed at the state and local levels, but not at the federal level.
D)taxed at the local, state, and federal levels.

Question 32

In general, a young saver should choose a financial portfolio based on

A)maximizing expected return with only limited concern for variability.
B)minimizing variability with only limited concern for expected return.
C)equal concern for expected return and variability.
D)maximizing the number of tax-free securities included.

Question 33

The obligations of state and local governments

A)are taxed at the federal level, but not at the state and local levels.
B)are taxed at the state and local levels, but not at the federal level.
C)are taxed at the state, local, and federal levels.
D)are called municipal bonds.

Question 34

The "equity premium" refers to

A)the exemption of stock dividends from federal income tax.
B)the gap between the return on stocks and the return on bonds.
C)the premium investors are willing to pay for Internet stocks.
D)the low mortgage rates available to borrowers who make large down payments when purchasing a home.

Question 35

Savers generally compare

A)the nominal rates of return on assets.
B)the real rates of return on assets.
C)the real after-tax rates of return on assets.
D)the nominal after-tax rates of return on assets.

Question 36

In general, an older saver should choose a financial portfolio based on

A)selecting safe assets to earn an expected real return of about zero.
B)maximizing expected return with only limited concern for variability
C)equal concern for expected return and variability.
D)avoiding tax-free securities.

Question 37

Liquidity is

A)the ease with which an asset can be converted into cash.
B)desirable, but reduces the value of assets held to smooth spending.
C)desirable, but reduces the value of assets held for precautionary purposes.
D)greater for common stock than for checkable deposits in commercial banks.

Question 38

Securities issued by state and local governments generally are

A)not subject to taxation.
B)taxed at the federal level, but not at the state and local levels.
C)taxed at the state and local levels, but not at the federal level.
D)taxed at the local, state, and federal levels.

Question 39

Suppose that information is made public that Mammoth Computer is having severe financial difficulties. The effect will be to

A)increase the yield on Mammoth's long-term bonds.
B)increase the yield on rival Orange Computer's long-term bonds.
C)lower the yield on Mammoth's long-term bonds.
D)increase the yield on both Mammoth's long-term bonds and rival Orange Computer's long-term bonds.

Question 40

Comparing the range of the one-year returns on stocks to the range of the twenty-year returns over the period from 1926 to 2005 reveals that

A)the range has been about the same.
B)the range has been narrower for one-year returns.
C)the range has been narrower for twenty-year returns.
D)there has been no consistent relationship between the ranges for one-year returns and twenty-year returns.

Question 41

Suppose that the number of buyers and sellers of municipal bonds increases substantially. The result should be a(an)

A)increase in the prices of municipal bonds.
B)decrease in the prices of municipal bonds.
C)increase in U.S. Treasury bond yields.
D)decrease in the tax rate on municipal bond yields.

Question 42

If General Auto and Crystal Auto have returns that are perfectly positively correlated, then adding Crystal Auto to a portfolio that already contains General Auto will

A)reduce the risk in the portfolio.
B)increase the risk in the portfolio.
C)neither increase nor decrease the risk in the portfolio.
D)reduce the risk in the portfolio only for risk-averse savers.

Question 43

Diversification can eliminate

A)all risk in a portfolio.
B)the idiosyncratic risk in a portfolio.
C)the market risk in a portfolio.
D)risk only if the saver is risk neutral.

Question 44

One of the important hindrances to savers placing their funds in foreign financial assets is

A)the costliness of gathering information about foreign financial assets.
B)the higher tax rates levied by the U.S. government on earnings from such assets.
C)the reluctance of many European countries to allow foreign investment in their financial assets.
D)the difficulty in reading company reports written in a foreign language.

Question 45

Suppose that you own $10,000 worth of stock in General Motors. Adding stock in which of the following companies would be least likely to reduce the risk in your portfolio?

A)Google
B)Wal-Mart
C)Ford
D)General Electric

Question 46

Diversification refers to

A)choosing assets so as to maximize expected return.
B)choosing assets so as to minimize tax liability.
C)choosing assets so as to maximize liquidity.
D)allocating savings among different assets.

Question 47

Why do CDs have higher interest rates than savings accounts?

A)CDs are much riskier investments than savings accounts.
B)Interest on CDs is taxable while interest on savings accounts is not.
C)CDs provide better hedges against inflation than do savings accounts.
D)CDs are not as liquid as savings accounts.

Question 48

Which of the following assets has the highest information costs?

A)A U.S. Treasury bond
B)A bond issued by the city of Smallplace, South Dakota
C)A bond issued by General Motors
D)A share of stock issued by General Motors

Question 49

A risk-neutral saver

A)can eliminate the market risk in his or her portfolio through diversification.
B)gains nothing from diversification.
C)benefits from diversification more than does the risk-averse saver.
D)actually increases the risk in his or her portfolio by diversification.

Question 50

If the returns on two assets are perfectly positively correlated, adding the second asset to your portfolio when you already own the first

A)reduces the risk in the portfolio.
B)increases the risk in the portfolio.
C)has no effect on the risk in the portfolio.
D)reduces the risk in the portfolio only if you are risk averse.

Question 51

The average investor must weigh the benefits of liquidity against

A)the high taxes generally levied on liquid assets.
B)the lower returns on liquid assets.
C)the high transactions costs involved in disposing of liquid assets.
D)the greater variability in the nominal returns on liquid assets.

Question 52

Which of the following assets has the lowest information costs?

A)A U.S. Treasury bond
B)A bond issued by the city of Smallplace, South Dakota
C)A bond issued by General Motors
D)A share of stock issued by General Motors

Question 53

If the returns to Mammoth Computer and Stupendous Chemicals are independent (have zero correlation), adding Stupendous Chemicals to a portfolio already containing Mammoth Computer

A)reduces the overall portfolio risk.
B)does not affect the overall portfolio risk.
C)increases the overall portfolio risk.
D)affects the overall portfolio risk only if the saver is risk averse.

Question 54

Acme Gold Mining, Inc. discovers a huge vein of gold in the mountains of Iowa. This is an example of

A)the high returns that can be expected from investing in companies that mine minerals.
B)idiosyncratic risk.
C)market risk.
D)systematic risk.

Question 55

Unsystematic risk is another name for

A)liquidity.
B)market risk.
C)idiosyncratic risk.
D)diversification.

Question 56

Which of the following economists has NOT won a Nobel Prize in economics for research on the benefits of diversification?

A)James Tobin
B)Harry Markowitz
C)Milton Friedman
D)William Sharpe

Question 57

A small company that issues bonds for the first time may have to offer them at a high yield because the bonds will

A)not be as liquid as many other corporate bonds.
B)be less risky than many other corporate bonds.
C)be less costly to gather information on than other corporate bonds.
D)be subject to a lower tax rate than other corporate bonds.

Question 58

Market risk

A)can be eliminated through diversification.
B)represents the risk generated through chance events affecting a single company.
C)cannot be eliminated through diversification.
D)is another name for idiosyncratic risk.

Question 59

The main reason for diversifying a portfolio is

A)to take advantage of the fact that returns on assets are imperfectly correlated.
B)to take advantage of the favorable tax treatments diversified portfolios receive from the federal government.
C)that diversified portfolios have greater liquidity than undiversified portfolios.
D)that diversified portfolios have lower information costs than undiversified portfolios.

Question 60

The theory of portfolio selection leads to the conclusion that

A)there is one best asset for each investor.
B)there is one best asset for all investors.
C)savers should allocate their savings among many different assets.
D)savers should concentrate their savings in as few assets as possible.

Question 61

Suppose you hold a portfolio consisting of a single stock. About how many more stocks would you need to add to your portfolio in order to reduce its average annual variability to about the level of average annual variability you would experience if you held a portfolio consisting of every stock listed on the New York Stock Exchange?

A)1
B)20
C)1000
D)10,000

Question 62

A portfolio consisting of every stock traded on the New York Stock Exchange would have

A)diversified away all risk.
B)diversified away idiosyncratic risk.
C)diversified away market risk.
D)much more risk than a portfolio containing only a few stocks.

Question 63

Households save through life insurance reserves, at least in part, because

A)life insurance reserves are very liquid.
B)the transactions costs of saving in this way are very low.
C)life insurance reserves receive favorable tax treatment.
D)life expectancy in the United States has been declining.

Question 64

A portfolio that includes all the stocks listed on the New York Stock Exchange would

A)have a higher expected return than the expected return on any individual stock.
B)face no idiosyncratic risk, only systematic risk.
C)face no systematic risk, only idiosyncratic risk.
D)face neither systematic nor idiosyncratic risk.

Question 65

Mutual funds arose to

A)reduce the transactions costs small savers incur when diversifying.
B)take advantage of the tax breaks the federal government grants for diversified portfolios.
C)provide home buyers with an inexpensive source of mortgage funds.
D)provide personal financial advice to small savers.

Question 66

TIAA-CREF is the pension plan for college professors. Professors can direct their contributions entirely to the TIAA part of the plan which offers a guaranteed, but generally relatively low, return or entirely to the CREF part of the plan, which invests in the stock market, or they can divide their contributions between the two parts of the plan. Funds invested in the CREF part of the plan will on average earn a higher rate of return than funds invested in the TIAA part of the plan, but the return is not guaranteed and in some years the value of funds invested in the CREF part of the plan will decline. How would you expect each of the following professors to divide his or her contributions between the TIAA and CREF parts of the plan: (a) a 28-year-old professor just beginning her career; (b) a 58-year-old professor who is about 10 years from retirement; and (c) a 68-year-old professor on the verge of retirement?

Question 67

An investor makes the following remark: "I don't understand the junk bond market. Junk bonds have become more liquid. This should have made them more desirable and increased the demand for them. The increased demand should have driven their yields up, but in fact their yields have gone down. I guess investors just don't value liquidity." Do you agree with the investor's reasoning?

Question 68

According to the capital asset pricing model, the expected return on asset j, , equals

A) - × (
-
).
B) - + (
-
).
C) + - (
-
).
D) + × (
-
).

Question 69

As a saver's wealth increases, explain whether each of the following is likely to become a smaller or a larger fraction of her portfolio.
(a) Corporate bonds
(b) Corporate stock
(c) Cash
(d) Checking account balance

Question 70

About what percentage of the financial assets of U.S. households are in stock mutual funds?

A)1%
B)2%
C)14%
D)50%

Question 71

Suppose the expected return on the market portfolio is 10%, the risk-free rate is 2%, and the beta for an asset is 2. According to CAPM what is the expected return on the asset?

Question 72

The variable beta

A)measures the degree of liquidity in a portfolio.
B)is the responsiveness of a stock's expected return to changes in the value of the complete market portfolio.
C)measures the degree of idiosyncratic risk in the complete market portfolio.
D)is always less for an individual portfolio than for the complete market portfolio.

Question 73

Investors are less willing to hold an asset with a high beta because

A)such assets tend to be illiquid.
B)systematic risk cannot be diversified away.
C)idiosyncratic risk cannot be diversified away.
D)such assets tend to have lower expected returns.

Question 74

If, on average, a 1% increase in the market portfolio leads to an increase of 2% in the value of an asset, then the asset's beta equals

A)0.5.
B)1.
C)2.
D)Not enough information has been given to determine the asset's beta.