Portfolio Theory

Tutorial 4
Part 1

1. Which statement about portfolio diversification is correct?

A) Proper diversification can reduce systematic risk.
B) Proper diversification can reduce market risk.
C) As more securities are added to the portfolio, total risk typically is expected to fall at a
decreasing rate.
D) As more securities are added to the portfolio, total risk typically is expected to fall at an
increasing rate.
E) None of the above.

2. The variance of a portfolio of risky securities is the:

A) weighted sum of the securities’ variances.
B) sum of the securities’ variances.
C) the weighted sum of the securities’ variances and covariances.
D) the sum of the securities’ covariances.
E) the weighted sum of the securities’ covariances

**midterm & finals

Remember the formula p2= WDWDCOV(rD,rD) + WEWECOV(rE,rE) + 2WDWECOV(rD,rE)

3. When computing the expected return on a portfolio of stocks, the portfolio weights are
based on the:
A) Number of shares owned in each stock.
B) Price per share of each stock.
C) Original amount invested in each stock.
D) Market value of the total shares held in each stock.
E) None of the above.

Remember formula E(rp) = WDE(rD) + WEE(rE)

4. An efficient set of portfolio is:

A) The complete opportunity set.
B) The portion of the opportunity set below the minimum variance portfolio.
C) Only the minimum variance portfolio.
D) The dominant portion of the opportunity set.
E) Only the maximum return portfolio.

5. The portfolio with the lowest possible risk is:

A) The efficient frontier.
B) The minimum variance portfolio.
C) The upper tail of the efficient set.
D) The tangency portfolio.
E) None of the above.

6. When a stock portfolio is very well diversified, the variance of the portfolio:
A) Will be the arithmetic average of the variances of the individual securities in the
portfolio.
 B) May be less than the variance of the least risky stock in the portfolio.
C) Must be equal to or greater than the variance of the least risky stock in the portfolio.
D) Will be a weighted average of the variances of the individual securities in the
portfolio.
E) None of the above.

7. The slope of the Capital Allocation Line is the:

A) Market Risk Premium.
B) Sharpe Ratio.
C) Beta Coefficient.
D) Risk free Interest Rate.
E) None of the above.

8. Which of the following is NOT true?

A) The Capital Allocation Line extends from the riskfree rate to touch risky portfolio.
B) The intercept of the Capital Allocation Line is the riskfree rate.
C) The slope of the Capital Allocation Line is the steepest if it touches the market
portfolio.
D) The Sharpe Ratio for the market portfolio is the highest.
E) All of the above are true.

9. Reduction in risk is only possible when:

A) Two assets covariate perfectly together.
B) Two assets are perfectly correlated.
C) The number of assets is increased.
D) The market risk is less than 1.
E) None of the above

10. If the correlation between two stocks is +1, then a portfolio combining these two stocks
will have a variance that is:
A) Less than the weighted average of the two individual variances.
B) Greater than the weighted average of the two individual variances.
C) Equal to the weighted average of the two individual variances.
D) Less than or equal to average variance of the two weighted variances, depending on
other information.
E) None of the above.

11. A portfolio is effectively diversified when the portfolio’s

A) Beta’s decreases.
B) Rate of Return increases.
C) Standard Deviation decreases.
D) Market risk is diversified away.
E) None of the above.

If SD until 0, it is effectively diversified

 12. Stock A has an expected return of 20%, and stock B has an expected return of 4%.
However, the risk of stock A as measured by its standard deviation is 2 times that of
Stock B. If the two stocks are combined equally in a portfolio, what would be the
portfolio’s expected return?
A) 4%
B) 12%
C) 20%
D) Greater than 20%
E) Need more information to answer.

= 0.5(0.2) + 0.5(0.04)
= 0.12
**

13. If the standard deviation of Stock B is 2 times that of Stock A, and the correlation between
them is -1 (negative one), the minimum variance portfolio would constitute:
A) 100% Stock A
B) 100% Stock B
C) 50% Stock A and 50% Stock B
D) 33% Stock A and 67% Stock B
E) 67% Stock A and 33% Stock B

Bcs A is two times less risky, in order to make it 0.

**

14. Given the following:

Stock A standard deviation is 0.22

Stock B standard deviation is 0.34

If stock A and stock B have perfect positive correlation, which portfolio composition represents
the minimum variance portfolio?

A) 100% Stock A
B) 100% Stock B
C) 50% Stock A and 50% Stock B
D) 25% Stock A and 75% Stock B
E) 75% Stock A and 25% Stock B

**

15. The variance of Stock A is 0.004, the variance of the market is 0.007 and the covariance
between the two is 0.0036. What is the correlation coefficient?
A) 0.9285
B) 0.8542
C) 0.5010
D) 0.4913
E) None of the above
**
 16. Which one of the following is a correct statement concerning risk premium?
A) The greater the volatility of returns. The greater the risk premium.
B) The lower the volatility of returns, the greater the risk premium.
C) The lower the average rate of return, the greater the risk premium.
D) The risk premium is not correlated to the average rate of return.
E) The risk premium is not affected by the volatility of returns.

Risk Premium Formula

17. The efficient set of portfolios is determined by:

A) the principle of dominance, where one portfolio dominates another at the same level of
risk or return.
B) the principle of diversification, where investable funds are placed in various asset
classes.
C) the principle of correlation, where the stocks in the portfolio have positive covariance.
D) the principle of covariance, where the stocks in the portfolio have positive correlation.
E) None of the above.

18. According to Portfolio Theory, which of the following has the highest return?
A) Stock Selling and Scrip Borrowing
B) Margin Borrowing to purchase the market portfolio
C) Purchase of Option
D) Writing Options
E) Difficult to say

19. Which of the following portfolios can NOT lie on the efficient frontier as described by
Markowitz?

Portfolio Expected Return (%) Standard Deviation (%)

A) 15 36
B) 14 15
C) 6 9
D) 12 22
E) All the above lies on the efficient frontier.
**
Can draw

20. Stock A, B and C have the same expected return and standard deviation. The following
table shows the correlations between the returns of these stocks:

Stock A Stock B Stock C

Stock A '+1
Stock B '+0.7 '+1
Stock C ‘+0.1 '-0.6 '+1

The portfolio that has the lowest risk is:

A) Equally invested in A and B
B) Equally invested in A and C
C) Equally invested in B and C
D) Totally invested in B
E) The information provided is insufficient to answer the question.

Nearest to - 1.
Portfolio Theory
Tutorial 4
Part 2

1. The parameters of the opportunity set are:

E(rS) = 19%, σS = 22%, E(rB) = 10%, σB = 10%, ρ = -0.10

a) What is the covariance between that stock and that bond?
b) What is the minimum-variance portfolio weightage for i) stock and ii)bond?
c) What is the mean of this portfolio?
d) What is the standard deviation of this portfolio?
e) Draw this Portfolio A's expected return as a function of investment proportions.

2. In the process of assets allocation, the following information is compiled.

Expected Standard Deviation

Return

Market 30% 28%

Stock 30% 30%
Bond 10% 10%

Correlation between Stock and Bond is 0.20.

Riskfree Rate (Rf)Treasury Bill (T-Bill) is 5%.

a) What is the Covariance between that stock and that bond?

b) What is weightage for stock in the Minimum Variance Portfolio?

c) What is the expected return of this Minimum Variance Portfolio?

d) What is the Standard Deviation of this Minimum Variance Portfolio?

e) What is the Sharpe Ratio of this Minimum Variance Portfolio?

f) Draw this Minimum Variance Portfolio and Capital Allocation Line on a Return-Risk
 Chart.

g) What is the Sharpe Ratio for the Market Portfolio?

h) Draw the Market Portfolio and the Capital Market Line on a Return-Risk Chart.

i) Would a rational investor prefer to invest in the Minimum Variance Portfolio or the Market
Portfolio? Explain your answer well.