CFA 43: Portfolio Management II

The line depicting the risk and return of portfolio combinations of a risk-free asset and any risky asset is the:

security market line.

capital allocation line.

security characteristic line.

B is correct. The capital allocation line, CAL, is a combination of the risk-free asset and a risky asset (or a portfolio of risky assets). The combination of the risk-free asset and the market portfolio is a special case of the CAL, which is the capital market line, CML.
The portfolio of a risk-free asset and a risky asset has a better risk-return tradeoff than investing in only one asset type because the correlation between the risk-free asset and the risky asset is equal to:

−1.0.

0.0.

1.0.

B is correct. A portfolio of the risk-free asset and a risky asset or a portfolio of risky assets can result in a better risk-return tradeoff than an investment in only one type of an asset, because the risk-free asset has zero correlation with the risky asset.
With respect to capital market theory, an investor’s optimal portfolio is the combination of a risk-free asset and a risky asset with the highest:

expected return.

indifference curve.

capital allocation line slope.

B is correct. Investors will have different optimal portfolios depending on their indifference curves. The optimal portfolio for each investor is the one with highest utility; that is, where the CAL is tangent to the individual investor’s highest possible indifference curve.
Highly risk-averse investors will most likely invest the majority of their wealth in:

risky assets.

risk-free assets.

the optimal risky portfolio.

B is correct. Although the optimal risky portfolio is the market portfolio, highly risk-averse investors choose to invest most of their wealth in the risk-free asset.
The capital market line, CML, is the graph of the risk and return of portfolio combinations consisting of the risk-free asset and:

any risky portfolio.

the market portfolio.

the leveraged portfolio.

B is correct. Although the capital allocation line includes all possible combinations of the risk-free asset and any risky portfolio, the capital market line is a special case of the capital allocation line, which uses the market portfolio as the optimal risky portfolio.
Which of the following statements most accurately defines the market portfolio in capital market theory? The market portfolio consists of all:

risky assets.

tradable assets.

investable assets.

A is correct. The market includes all risky assets, or anything that has value; however, not all assets are tradable, and not all tradable assets are investable.
With respect to capital market theory, the optimal risky portfolio:

is the market portfolio.

has the highest expected return.

has the lowest expected variance.

A is correct. The optimal risky portfolio is the market portfolio. Capital market theory assumes that investors have homogeneous expectations, which means that all investors analyze securities in the same way and are rational. That is, investors use the same probability distributions, use the same inputs for future cash flows, and arrive at the same valuations. Because their valuations of all assets are identical, all investors will invest in the same optimal risky portfolio (i.e., the market portfolio).
Relative to portfolios on the CML, any portfolio that plots above the CML is considered:

inferior.

inefficient.

unachievable.

C is correct. Theoretically, any point above the CML is not achievable and any point below the CML is dominated by and inferior to any point on the CML.
A portfolio on the capital market line with returns greater than the returns on the market portfolio represents a(n):

lending portfolio.

borrowing portfolio.

unachievable portfolio.

B is correct. As one moves further to the right of point M on the capital market line, an increasing amount of borrowed money is being invested in the market portfolio. This means that there is negative investment in the risk-free asset, which is referred to as a leveraged position in the risky portfolio.
With respect to the capital market line, a portfolio on the CML with returns less than the returns on the market portfolio represents a(n):

lending portfolio.

borrowing portfolio.

unachievable portfolio

A is correct. The combinations of the risk-free asset and the market portfolio on the CML where returns are less than the returns on the market portfolio are termed ‘lending’ portfolios.
Which of the following types of risk is most likely avoided by forming a diversified portfolio?

Total risk.

Systematic risk.

Nonsystematic risk.

C is correct. Investors are capable of avoiding nonsystematic risk by forming a portfolio of assets that are not highly correlated with one another, thereby reducing total risk and being exposed only to systematic risk.
Which of the following events is most likely an example of nonsystematic risk?

A decline in interest rates.

The resignation of chief executive officer.

An increase in the value of the U.S. dollar.

B is correct. Nonsystematic risk is specific to a firm, whereas systematic risk affects the entire economy.
With respect to the pricing of risk in capital market theory, which of the following statements is most accurate?

All risk is priced.

Systematic risk is priced.

Nonsystematic risk is priced.

B is correct. Only systematic risk is priced. Investors do not receive any return for accepting nonsystematic or diversifiable risk.
The sum of an asset’s systematic variance and its nonsystematic variance of returns is equal to the asset’s:

beta.

total risk.

total variance.

C is correct. The sum of systematic variance and nonsystematic variance equals the total variance of the asset. References to total risk as the sum of systematic risk and nonsystematic risk refer to variance, not to risk.
With respect to return-generating models, the intercept term of the market model is the asset’s estimated:

beta.

alpha.

variance.

B is correct. In the market model, Ri=αi+βiRm+ei , the intercept, αi, and slope coefficient, βi, are estimated using historical security and market returns.
With respect to return-generating models, the slope term of the market model is an estimate of the asset’s:

total risk.

systematic risk.

nonsystematic risk.

B is correct. In the market model, Ri=αi+βiRm+ei , the slope coefficient, βi, is an estimate of the asset’s systematic or market risk.
With respect to return-generating models, which of the following statements is most accurate? Return-generating models are used to directly estimate the:

expected return of a security.

weights of securities in a portfolio.

parameters of the capital market line.

A is correct. In the market model, Ri=αi+βiRm+ei , the intercept, αi, and slope coefficient, βi, are estimated using historical security and market returns. These parameter estimates then are used to predict firm-specific returns that a security may earn in a future period.
An analyst gathers the following information:

Security Expected
Annual Return (%) Expected
Standard Deviation (%) Correlation between Security and the Market
Security 1 11 25 0.6
Security 2 11 20 0.7
Security 3 14 20 0.8
Market 10 15 1.0

Which security has the highest total risk?

Security 1.

Security 2.

Security 3

A is correct. Security 1 has the highest total variance; 0.0625=0.252 compared to Security 2 and Security 3 with a total variance of 0.0400.
An analyst gathers the following information:

Security Expected
Annual Return (%) Expected
Standard Deviation (%) Correlation between Security and the Market
Security 1 11 25 0.6
Security 2 11 20 0.7
Security 3 14 20 0.8
Market 10 15 1.0

Which security has the highest beta measure?

Security 1.

Security 2.

Security 3.

C is correct. Security 3 has the highest beta value; 1.07=ρ3,mσ3σm=(0.80)(20%)15% compared to Security 1 and Security 2 with beta values of 1.00 and 0.93, respectively.
An analyst gathers the following information:

Security Expected
Annual Return (%) Expected
Standard Deviation (%) Correlation between Security and the Market
Security 1 11 25 0.6
Security 2 11 20 0.7
Security 3 14 20 0.8
Market 10 15 1.0

Which security has the least amount of market risk?

Security 1.

Security 2.

Security 3.

B is correct. Security 2 has the lowest beta value; .93=ρ2,mσ2σm=(0.70)(20%)15% compared to Security 1 and 3 with beta values of 1.00 and 1.07, respectively.
With respect to capital market theory, the average beta of all assets in the market is:

less than 1.0.

equal to 1.0.

greater than 1.0.

B is correct. The average beta of all assets in the market, by definition, is equal to 1.0.
The slope of the security characteristic line is an asset’s:

beta.

excess return.

risk premium.

A is correct. The security characteristic line is a plot of the excess return of the security on the excess return of the market. In such a graph, Jensen’s alpha is the intercept and the beta is the slope.
The graph of the capital asset pricing model is the:

capital market line.

security market line.

security characteristic line.

B is correct. The security market line (SML) is a graphical representation of the capital asset pricing model, with beta risk on the x-axis and expected return on the y-axis.
With respect to capital market theory, correctly priced individual assets can be plotted on the:

capital market line.

security market line.

capital allocation line.

B is correct. The security market line applies to any security, efficient or not. The CAL and the CML use the total risk of the asset (or portfolio of assets) rather than its systematic risk, which is the only risk that is priced.
With respect to the capital asset pricing model, the primary determinant of expected return of an individual asset is the:

asset’s beta.

market risk premium.

asset’s standard deviation.

A is correct. The CAPM shows that the primary determinant of expected return for an individual asset is its beta, or how well the asset correlates with the market.
With respect to the capital asset pricing model, which of the following values of beta for an asset is most likely to have an expected return for the asset that is less than the risk-free rate?

−0.5

0.0

0.5

A is correct. If an asset’s beta is negative, the required return will be less than the risk-free rate in the CAPM. When combined with a positive market return, the asset reduces the risk of the overall portfolio, which makes the asset very valuable. Insurance is an example of a negative beta asset.
With respect to the capital asset pricing model, the market risk premium is:

less than the excess market return.

equal to the excess market return.

greater than the excess market return.

B is correct. In the CAPM, the market risk premium is the difference between the return on the market and the risk-free rate, which is the same as the return in excess of the market return.
An analyst gathers the following information:

Security Expected
Standard Deviation (%) Beta
Security 1 25 1.50
Security 2 15 1.40
Security 3 20 1.60

With respect to the capital asset pricing model, if the expected market risk premium is 6% and the risk-free rate is 3%, the expected return for Security 1 is closest to:

9.0%.

12.0%.

13.5%.

B is correct. The expected return of Security 1, using the CAPM, is 12.0% = 3% + 1.5(6%); E(Ri)=Rf+βi[E(Rm)−Rf] .
An analyst gathers the following information:

Security Expected
Standard Deviation (%) Beta
Security 1 25 1.50
Security 2 15 1.40
Security 3 20 1.60

With respect to the capital asset pricing model, if expected return for Security 2 is equal to 11.4% and the risk-free rate is 3%, the expected return for the market is closest to:

8.4%.

9.0%.

10.3%.

B is correct. The expected risk premium for Security 2 is 8.4%, (11.4% − 3%), indicates that the expected market risk premium is 6%; therefore, since the risk-free rate is 3% the expected rate of return for the market is 9%. That is, using the CAPM, E(Ri)=Rf+βi[E(Rm)−Rf] , 11.4% = 3% + 1.4(X%), where X% = (11.4% − 3%)/1.4 = 6.0% = market risk premium.
An analyst gathers the following information:

Security Expected
Standard Deviation (%) Beta
Security 1 25 1.50
Security 2 15 1.40
Security 3 20 1.60

With respect to the capital asset pricing model, if the expected market risk premium is 6% the security with the highest expected return is:

Security 1.

Security 2.

Security 3.

C is correct. Security 3 has the highest beta; thus, regardless of the value for the risk-free rate, Security 3 will have the highest expected return:

E(Ri)=Rf+βi[E(Rm)−Rf]

An analyst gathers the following information:

Security Expected
Standard Deviation (%) Beta
Security 1 25 1.50
Security 2 15 1.40
Security 3 20 1.60

With respect to the capital asset pricing model, a decline in the expected market return will have the greatest impact on the expected return of:

Security 1.

Security 2.

Security 3.

C is correct. Security 3 has the highest beta; thus, regardless of the risk-free rate the expected return of Security 3 will be most sensitive to a change in the expected market return.
Which of the following performance measures is consistent with the CAPM?

M-squared.

Sharpe ratio.

Jensen’s alpha.

C is correct. Jensen’s alpha adjusts for systematic risk, and M-squared and the Sharpe Ratio adjust for total risk.
Which of the following performance measures does not require the measure to be compared to another value?

Sharpe ratio.

Treynor ratio.

Jensen’s alpha.

C is correct. The sign of Jensen’s alpha indicates whether or not the portfolio has outperformed the market. If alpha is positive, the portfolio has outperformed the market; if alpha is negative, the portfolio has underperformed the market.
Which of the following performance measures is most appropriate for an investor who is not fully diversified?

M-squared.

Treynor ratio.

Jensen’s alpha.

A is the correct. M-squared adjusts for risk using standard deviation (i.e., total risk).
Analysts who have estimated returns of an asset to be greater than the expected returns generated by the capital asset pricing model should consider the asset to be:

overvalued.

undervalued.

properly valued.

B is correct. If the estimated return of an asset is above the SML (the expected return), the asset has a lower level of risk relative to the amount of expected return and would be a good choice for investment (i.e., undervalued).
With respect to capital market theory, which of the following statements best describes the effect of the homogeneity assumption? Because all investors have the same economic expectations of future cash flows for all assets, investors will invest in:

the same optimal risky portfolio.

the Standard and Poor’s 500 Index.

assets with the same amount of risk.

A is correct. The homogeneity assumption refers to all investors having the same economic expectation of future cash flows. If all investors have the same expectations, then all investors should invest in the same optimal risky portfolio, therefore implying the existence of only one optimal portfolio (i.e., the market portfolio).
With respect to capital market theory, which of the following statements best describes the effect of the homogeneity assumption? Because all investors have the same economic expectations of future cash flows for all assets, investors will invest in:

the same optimal risky portfolio.

the Standard and Poor’s 500 Index.

assets with the same amount of risk.

B is correct. The homogeneous expectations assumption means that all investors analyze securities in the same way and are rational. That is, they use the same probability distributions, use the same inputs for future cash flows, and arrive at the same valuations. Because their valuation of all assets is identical, they will generate the same optimal risky portfolio, which is the market portfolio.
The intercept of the best fit line formed by plotting the excess returns of a manager’s portfolio on the excess returns of the market is best described as Jensen’s:

beta.

ratio.

alpha.

C is correct. This is because of the plot of the excess return of the security on the excess return of the market. In such a graph, Jensen’s alpha is the intercept and the beta is the slope.
Portfolio managers who are maximizing risk-adjusted returns will seek to invest more in securities with:

lower values of Jensen’s alpha.

values of Jensen’s alpha equal to 0.

higher values of Jensen’s alpha.

C is correct. Since managers are concerned with maximizing risk-adjusted returns, securities with a higher value of Jensen’s alpha, αi, should have a higher weight.
Portfolio managers, who are maximizing risk-adjusted returns, will seek to invest less in securities with:

lower values for nonsystematic variance.

values of nonsystematic variance equal to 0.

higher values for nonsystematic variance.

C is correct. Since managers are concerned with maximizing risk-adjusted returns, securities with greater nonsystematic risk should be given less weight in the portfolio.