Question 1

Which one of the following statements is correct concerning asset allocation?
A) Because there is an ideal mix, all investors should use the same asset allocation for their portfolios.
B) The minimum variance portfolio will have a 50/50 asset allocation between stocks and bonds.
C) Asset allocation affects the expected return but not the risk level of a portfolio.
D) There is an ideal asset allocation between stocks and bonds given a specified level of risk.
E) Asset allocation should play a minor role in portfolio construction.

Accepted Answer

Asset allocation refers to the distribution of investments across different asset classes such as stocks, bonds, and cash. There is no one-size-fits-all approach to asset allocation as it should be tailored to an investor's individual risk tolerance, financial goals, and investment timeframe. Therefore, there is an ideal asset allocation between stocks and bonds given a specified level of risk. The allocation will vary depending on an investor's goals and risk tolerance. The minimum variance portfolio is not necessarily a 50/50 asset allocation between stocks and bonds, as it is a portfolio with the lowest overall portfolio risk.

Question 2

Which one of the following correlation coefficients must apply to two assets if the equally weighted portfolio of those assets creates a minimum variance portfolio that has a standard deviation of zero?
A) -1.0
B) -0.5
C) 0.0
D) 0.5
E) 1.0

Accepted Answer

A correlation coefficient of -1.0 indicates perfect negative correlation, allowing for complete risk elimination in an equally weighted portfolio, resulting in a standard deviation of zero.

Question 3

Which one of the following distinguishes a minimum variance portfolio?
A) lowest risk portfolio of any possible portfolio given the same securities but in differing proportions
B) lowest risk portfolio possible given any specified expected rate of return
C) the zero risk portfolio created by maximizing the asset allocation mix
D) any portfolio with an expected standard deviation of 9 percent or less
E) any portfolio created with securities that are evenly weighted in respect to the asset allocation mix

Accepted Answer

A minimum variance portfolio is the portfolio with the lowest risk possible given any combination of securities, regardless of the expected rate of return. It is the portfolio that optimizes the trade-off between risk and return and has the lowest standard deviation of any possible portfolio given the same securities but in differing proportions.

Question 4

If two assets have a zero correlation,their returns will:
A) always move in the same direction by the same amount.
B) always move in the same direction but not necessarily by the same amount.
C) move randomly and independently of each other.
D) always move in opposite directions but not necessarily by the same amount.
E) always move in opposite directions by the same amount.

Accepted Answer

A correlation of zero indicates that the two assets have no linear relationship with each other. Therefore, their returns will move randomly and independently of each other.

Question 5

You own a portfolio comprised of 4 stocks and the economy has 3 possible states.Assume you invest your portfolio in a manner that results in an expected rate of return of 7.5 percent,regardless of the economic state.Given this,what must be value of the portfolio's variance be?
A) negative, but not -1
B) -1.0
C) 0.0
D) 1.0
E) positive, but not +1

Accepted Answer

Since the expected rate of return is the same across all economic states, the portfolio's variance must be zero. This indicates that there is no variability in the portfolio's returns and that the returns are the same in all economic states.

Question 6

Which one of the following statements is correct?
A) A portfolio variance is a weighted average of the variances of the individual securities which comprise the portfolio.
B) A portfolio variance is dependent upon the portfolio's asset allocation.
C) A portfolio variance is unaffected by the correlations between the individual securities held in the portfolio.
D) The portfolio variance must be greater than the lowest variance of any of the securities held in the portfolio.
E) The portfolio variance must be less than the lowest variance of any of the securities held in the portfolio.

Accepted Answer

A portfolio's variance is dependent upon the portfolio's asset allocation, as it takes into account not only the variances of the individual securities but also their correlations with each other. Therefore, option A is incorrect as it suggests that the portfolio variance is solely a weighted average of the variances of the individual securities. Option C is also incorrect as correlations between the securities will affect the portfolio variance. Option D is incorrect as the portfolio variance can be lower than the variance of any individual security if the securities have negative correlation with each other. Option E is also incorrect as it contradicts option D.

Question 7

Which one of the following correlation relationships has the potential to completely eliminate risk?
A) perfectly positive
B) positive
C) negative
D) perfectly negative
E) uncorrelated

Accepted Answer

A perfect negative correlation means that the two variables move in opposite directions. Therefore, if one variable experiences a loss, the other variable will experience a gain. This diversification completely eliminates risk.

Question 8

You are graphing the portfolio expected return against the portfolio standard deviation for a portfolio consisting of two securities.Which one of the following statements is correct regarding this graph?
A) Risk-taking investors should select the minimum variance portfolio.
B) Risk-averse investors should select the portfolio with the lowest rate of return.
C) Some portfolios will be efficient while others will not.
D) The minimum variance portfolio will have the lowest portfolio expected return of any of the possible portfolios.
E) All possible portfolios will graph as efficient portfolios.

Accepted Answer

The graph is a representation of the efficient frontier, which shows the possible combinations of portfolio standard deviation and return that could be achieved with a given set of securities. Some portfolios will be efficient (i.e. they offer the highest expected return for a given level of risk) while others will not. The minimum variance portfolio will have the lowest portfolio standard deviation of any of the possible portfolios, but this does not necessarily mean it will have the lowest expected return. Risk-taking investors could opt for portfolios with higher expected returns, while risk-averse investors may select a portfolio with a lower expected return if it also has lower volatility. Therefore, the optimal portfolio choice will depend on an investor's risk tolerance and return objectives.

Question 9

Which one of the following is eliminated,or at least greatly reduced,by increasing the number of individual securities held in a portfolio?
A) number of economic states
B) various expected returns caused by changing economic states
C) market risk
D) diversifiable risk
E) non-diversifiable risk

Accepted Answer

Diversifiable risk, also known as unsystematic or idiosyncratic risk, is the risk that is specific to an individual security or company and can be reduced through diversification. By increasing the number of individual securities held in a portfolio, the impact of any one security's performance is diluted, thus reducing the overall diversifiable risk. Increasing the number of securities held in a portfolio does not necessarily eliminate or greatly reduce other types of risk such as market risk, non-diversifiable risk, various expected returns caused by changing economic states, or the number of economic states.

Question 10

Which one of the following correlation coefficients can provide the greatest diversification benefit?
A) -1.0
B) -0.5
C) 0.0
D) 0.5
E) 1.0

Accepted Answer

A correlation coefficient of -1.0 indicates a perfect negative correlation, which means that the returns of the two assets move in opposite directions. This provides the greatest diversification benefit because it reduces the overall risk of the portfolio.

Question 11

Non-diversifiable risk:
A) can be cut almost in half by simply investing in 10 stocks provided each stock is in a different industry.
B) can almost be eliminated by investing in 35 diverse securities.
C) remains constant regardless of the number of securities held in a portfolio.
D) has little, if any, impact on the actual realized returns for a diversified portfolio.
E) should be ignored by investors.

Accepted Answer

Non-diversifiable risk, also known as systematic risk, is inherent in the market and cannot be eliminated by diversifying a portfolio. It is caused by factors such as changes in interest rates, inflation, and political instability, and affects all securities in the market. Therefore, the level of non-diversifiable risk remains constant regardless of the number of securities held in a portfolio.

Question 12

A portfolio comprised of which one of the following is most apt to be the minimum variance portfolio?
A) 100 percent stocks
B) 100 percent bonds
C) 50/50 mix of stocks and bonds
D) 30 percent stocks and 70 percent bonds
E) 30 percent bonds and 70 percent stocks

Accepted Answer

A minimum variance portfolio aims to achieve the lowest possible risk for a given level of expected return. Typically, a higher allocation to bonds, which are generally less volatile than stocks, will result in a lower overall portfolio variance. Therefore, a 30 percent stocks and 70 percent bonds allocation is most likely to be the minimum variance portfolio among the given options.

Question 13

Which one of the following statements about efficient portfolios is correct?
A) Any efficient portfolio will lie below the minimum variance portfolio when the expected portfolio return is plotted against the portfolio standard deviation.
B) An efficient portfolio will have the lowest standard deviation of any portfolio consisting of the same two securities.
C) There are multiple efficient portfolios that can be constructed using the same two securities.
D) Any portfolio mix consisting of only two securities will be an efficient portfolio.
E) There is only one efficient portfolio that can be constructed using two securities.

Accepted Answer

The efficient frontier represents all portfolios that offer the highest expected return for a given level of risk, or the lowest risk for a given level of expected return. There can be multiple efficient portfolios on this frontier for a given set of assets. Therefore, statement A and B are incorrect. Statement D is also incorrect, as not all combinations of two securities will result in an efficient portfolio. Statement E is also incorrect as there can be multiple efficient portfolios.

Question 14

Where does the minimum variance portfolio lie in respect to the investment opportunity set?
A) lowest point
B) highest point
C) most leftward point
D) most rightward point
E) exact center

Accepted Answer

The minimum variance portfolio lies at the most leftward point on the efficient frontier of the investment opportunity set. This point represents the portfolio with the lowest level of risk (variance).

Question 15

To reduce risk as much as possible,you should combine assets which have one of the following correlation relationships?
A) strong positive
B) slightly positive
C) slightly negative
D) strongly negative
E) zero

Accepted Answer

Combining assets with a strong negative correlation (i.e. when one asset goes up, the other goes down) is the best way to reduce risk. This is because if one asset performs poorly, the other asset is likely to perform well, offsetting any losses.

Question 16

How will the returns on two assets react if those returns have a perfect positive correlation?
I.move in the same direction
II.move in opposite directions
III.move by the same amount
IV.move by either equal or unequal amounts
A) I and III only
B) I and IV only
C) II and III only
D) II and IV only
E) III only

Accepted Answer

If the returns of two assets have a perfect positive correlation, it means they move in the same direction. Therefore, choice I is correct. Additionally, if they have a perfect positive correlation, their returns will move by either equal or unequal amounts. Therefore, choice IV is also correct. Choice II is incorrect because assets with perfect positive correlation do not move in opposite directions. Choice III is incorrect because their returns do not necessarily move by the same amount.

Question 17

Assume the returns on Stock X were positive in January,February,April,July,and November.The other months the returns on Stock X were negative.The returns on Stock Y were positive in January,April,May,July,August,and October and negative the remaining months.Which one of the following correlation coefficients best describes the relationship between Stock X and Stock Y?
A) -1.0
B) -0.5
C) 0.0
D) 0.5
E) 1.0

Accepted Answer

The answer of Assume the returns on Stock X were...

Question 18

You currently have a portfolio comprised of 70 percent stocks and 30 percent bonds.Which one of the following must be true if you change the asset allocation?
A) The expected return will remain constant.
B) The revised portfolio will be perfectly negatively correlated with the initial portfolio.
C) The two portfolios could have significantly different standard deviations.
D) The portfolio variance will be unaffected.
E) The portfolio variance will most likely decrease in value.

Accepted Answer

Changing the asset allocation will result in different standard deviations for the portfolios because stocks and bonds have different levels of risk. Therefore, the choice that must be true is C. The expected return may or may not remain constant depending on the specific stocks and bonds in the portfolio, so A cannot be the answer. B is not true because a perfectly negative correlation is unlikely and would result in a more extreme change in the portfolio's risk and return. D and E are not necessarily true because the impact on the portfolio variance depends on how the new allocation affects the correlation and volatility of the assets.

Question 19

As the number of individual stocks in a portfolio increases,the portfolio standard deviation:
A) increases at a constant rate.
B) remains unchanged.
C) decreases at a constant rate.
D) decreases at a diminishing rate.
E) decreases at an increasing rate.

Accepted Answer

The portfolio standard deviation will decrease at a diminishing rate as more stocks are added to the portfolio. In other words, as the number of stocks in the portfolio increases, the benefits of diversification will decrease, but the reduction in risk will continue nonetheless. This is because there is always some level of correlation between stocks and by using more stocks in our portfolio we can essentially achieve a lower risk with less resources.

Question 20

What is the correlation coefficient of two assets that are uncorrelated?
A) -100
B) -1
C) 0
D) 1
E) 100

Accepted Answer

The correlation coefficient is a measure of the linear relationship between two variables. When two assets are uncorrelated, there is no linear relationship between them, and the correlation coefficient is equal to 0. Therefore, the best choice is C. The other choices indicate perfect negative or positive correlation, which are not applicable to uncorrelated assets.

Quiz 11: Diversification and Risky Asset Allocation

Which one of the following statements is correct concerning asset allocation?

Which one of the following correlation coefficients must apply to two assets if the equally weighted portfolio of those assets creates a minimum variance portfolio that has a standard deviation of zero?

Which one of the following distinguishes a minimum variance portfolio?

If two assets have a zero correlation,their returns will:

You own a portfolio comprised of 4 stocks and the economy has 3 possible states.Assume you invest your portfolio in a manner that results in an expected rate of return of 7.5 percent,regardless of the economic state.Given this,what must be value of the portfolio's variance be?

Which one of the following statements is correct?

Which one of the following correlation relationships has the potential to completely eliminate risk?

You are graphing the portfolio expected return against the portfolio standard deviation for a portfolio consisting of two securities.Which one of the following statements is correct regarding this graph?

Which one of the following is eliminated,or at least greatly reduced,by increasing the number of individual securities held in a portfolio?

Which one of the following correlation coefficients can provide the greatest diversification benefit?

Non-diversifiable risk:

A portfolio comprised of which one of the following is most apt to be the minimum variance portfolio?

Which one of the following statements about efficient portfolios is correct?

Where does the minimum variance portfolio lie in respect to the investment opportunity set?

To reduce risk as much as possible,you should combine assets which have one of the following correlation relationships?

How will the returns on two assets react if those returns have a perfect positive correlation? I.move in the same direction II.move in opposite directions III.move by the same amount IV.move by either equal or unequal amounts

You currently have a portfolio comprised of 70 percent stocks and 30 percent bonds.Which one of the following must be true if you change the asset allocation?

As the number of individual stocks in a portfolio increases,the portfolio standard deviation:

What is the correlation coefficient of two assets that are uncorrelated?