Study Session 18 Sample Questions Portfolio Management .

1 2003www.modlin.orgStudy Session 18Sample QuestionsPortfolio ManagementCapital Market Theory: Basic Concepts1A. The Investment Setting1.Assume that the nominal return on U.S. government T-bills was 10%during 20X2, when the rate of inflation was 6%. The real risk-free rate ofreturn on these T-bills was:A.B.C.D.10%6%3.77%0%AnswerC.Calculating the real risk-free rate of return (1 Nominal Risk Free Rate of Return ) -1(1 Rate of Inflation) RRFR [(1 (0.10)/1 0.06)] – 1 0.0377 3.77%ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, Capital Market Theory: Basic Concepts, LOS:1.A, bStudy Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

2 20032.www.modlin.orgThe relationship between risk and return is such that:A.B.C.D.investors increase their required rates of return asincreasesinvestors decrease their required rates of return asincreasesinvestors increase their required rates of return asdecreasesinvestors decrease their required rates of return asdecreasesperceived riskperceived riskperceived riskperceived riskAnswerA.The relationship between risk and returnThe relationship between risk and return is such that investors increasetheir required rates of return as perceived risk increases.ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, Capital Market Theory: Basic Concepts, LOS:1.A, d3.If a firm increases its financial risk by selling a large bond issue thatincreases its financial leverage:A.B.C.D.investors will perceive its common stock as lessstock will move up the SMLinvestors will perceive its common stock as riskierwill move down the SMLinvestors will perceive its common stock as riskierwill move up the SMLinvestors will perceive its common stock as lessstock will move down the SMLStudy Session 18 Sample Questionsrisky and theand the stockand the stockrisky and theCapital Market Theory: Basic Concepts

3 2003www.modlin.orgAnswerC.Financial leverageIf a firm increases its financial risk by selling a large bond issue thatincreases its financial leverage, investors will perceive its common stockas riskier and the stock will move up the SML.ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, Capital Market Theory: Basic Concepts, LOS:1.A, fB.The Asset Allocation Decision1.When individuals believe they have sufficient income and assets tocover their expenses while maintaining a reserve for uncertainties, theyare most likely in the phase of the investment life dingAnswerA.The gifting phase of the investment life cycleWhen individuals believe they have sufficient income and assets tocover their expenses while maintaining a reserve for uncertainties, theyare in the gifting phase of the investment life cycle.Study Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

4 2003www.modlin.orgReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, The Asset Allocation Decision, LOS: 1.B, a2.When setting investor objectives in the investment policy statement,expressing goals only in terms of returns can:A.B.C.D.lead to inappropriate investment practices by the portfoliomanager, such as the use of low-risk investment strategiesdistort the expected outcomelead to inappropriate investment practices by the portfoliomanager, such as the use of high-risk investment strategieslead to a misleading outcomeAnswerC.Setting investor objectives in the investment policy statementWhen setting investor objectives in the investment policy statement,expressing goals only in terms of returns can lead to inappropriateinvestment practices by the portfolio manager, such as the use of highrisk investment strategies.ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, The Asset Allocation Decision, LOS: 1.B, c3.Asset allocation is important in determining overall investmentperformance because it:A.B.C.D.helps determine the expected return of the portfoliodetermines most of the portfolio’s returns over timehelps determine the standard deviation of the portfoliohelps determine the covariance of the portfolioStudy Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

5 2003www.modlin.orgAnswerB.Asset allocationAsset allocation is important in determining overall investmentperformance because it determines most of the portfolio’s returns overtime.ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, The Asset Allocation Decision, LOS: 1.B, eC.Selecting Investments in a Global Market1.Which statement is FALSE regarding the trading of securities and bondsin the U.S. and other markets?I.II.III.A.B.C.D.Prior to 1970, the securities traded in the U.S. stock and bondmarkets comprised about 65% of all the securities available inworld capital marketsBy 1998, U.S. bonds and equities accounted for 42.3% of the totalsecurities market versus 47.3% for nondollar bonds and stocksIf you consider only the stock and bond market, the U.S.proportion of this combined market is 47% in 1998I onlyII onlyIII onlyNone of the aboveAnswerD.Study Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

6 2003www.modlin.orgComparison of the relative size of the U.S. market with other globalstock and bond marketsThe relative size of the U.S. market with other global stock and bondmarkets is as follows: Prior to 1970, the securities traded in the U.S. stock and bondmarkets comprised about 65% of all the securities available inworld capital marketsBy 1998, U.S. bonds and equities accounted for 42.3% of the totalsecurities market versus 47.3% for non-dollar bonds and stocksIf you consider only the stock and bond market, the U.S.proportion of this combined market is 47% in 1998ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, Selecting Investments in a Global Market, LOS:1.C, b2.An analysis of domestic returns for the U.S. bond markets ranks fourthout of six countries. When the impact of exchange rates is considered,the U.S. is the lowest out of six. This means that the:A.B.C.D.exchange rate effect for a U.S. investor who invested in foreignbonds was always negative (i.e. the U.S. dollar was weak)exchange rate effect for a U.S. investor who invested in foreignbonds was always positive (i.e. the U.S. dollar was strong)exchange rate effect for a U.S. investor who invested in foreignbonds was always positive (i.e. the U.S. dollar was weak)exchange rate effect for a U.S. investor who invested in foreignbonds was always negative (i.e. the U.S. dollar was strong)AnswerC.Study Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

7 2003www.modlin.orgDomestic returns for the U.S. bond marketsAn analysis of domestic returns for the U.S. bond markets ranks fourthout of six countries. When the impact of exchange rates is considered,the U.S. is the lowest out of six. This means that the exchange rateeffect for a U.S. investor who invested in foreign bonds was alwayspositive (i.e. the U.S. dollar was weak).ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, Selecting Investments in a Global Market, LOS:1.C, d3.Adding a security that has a low correlation to an existing portfolio will:A.B.C.D.lower the overall variability of the portfolioincrease the overall variability of the portfoliomake the portfolio more riskyensure the portfolio achieves a good rate of returnAnswerA.Variability of portfoliosAdding a security that has a low correlation to an existing portfolio willlower the overall variability of the portfolio.ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, Selecting Investments in a Global Market, LOS:1.C, dStudy Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

8 2003www.modlin.orgD.An Introduction to Portfolio Management1.Consider the following information:The possible rate of return for a portfolio for an investment is shownbelow.Probability0.250.250.250.25Possible rate of return0.090.110.130.16The expected rate of return for the investment is as ing Expected rate of returnExpected rate of return (Probability x Possible rate of return) (0.25 x 0.09 0.25 x 0.11 0.25 x 0.13 0.25 x 0.16) 0.0225 0.0275 0.0325 0.04 0.1225 12.25%ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, An Introduction to Portfolio Management, LOS:1.D, bStudy Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

9 20032.www.modlin.orgConsider the information below relating to the monthly rates of return fortwo companies X and Y over a period of 4 months:DateMonth 1Month 2Month 3Month 4XRate of return %YRate of Return %-4.765.3412.09-2.98-4.757.656.989.65The covariance per month between the two companies is equal to:A.B.C.D.17.952.424.8871.78AnswerA.Calculating covarianceStep 1First you need to calculate the expected rate of return for the 4 months:X : [5.34 12.09 – 4.76 – 2.98] / 4 2.42Y : [7.65 6.98 9.65 – 4.75] / 4 4.88Study Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

10 2003www.modlin.orgStep 2Now, we use the table below to compute the covariance as follows:DateReturn(1)Return(2)Month 1Month 2Month 3Month urn Expected(3)-7.182.929.67-5.40Return –Expected(4)-9.632.772.104.77(3) x (4)69.148.0920.31-25.7671.78Step 3Covariance per month 71.78/4 17.95ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, An Introduction to Portfolio Management, LOS:1.D, b3.Consider the following information relating to two assets:E (R1) 0.3E (R2) 0.3E ( θ 1) 0.2E ( θ 2) 0.2The weights of each asset in the portfolio are:W1 0.5W2 0.5The correlation coefficient is r1, 2 1.00Study Session 18 Sample QuestionsCapital Market Theory: Basic Concepts

11 2003www.modlin.orgThe covariance of the portfolio is equal to:A.B.C.D.0.21.00.060.04AnswerD.Calculating covariance in a two asset portfolioCovi, j rij σ σi jCov1, 2 1.00 x 0.2 x 0.2 0.04ReferenceInvestment Analysis and Portfolio Management, 6th edition, Frank K.Reilly and Keith C. Brown (Dryden, 2000)Study Session 18 2003, An Introduction to Portfolio Management, LOS:1.D, hE.An Introduction to Asset Pricing Models1.The market portfolio is:A.B.C.D.a completely diversified portfolio, which means that most of therisk unique to individual assets in the portfolio is diversified awaya portfolio in which both systematic and unsystematic risk hasbeen diversified awaythe portfolio that all investors invest their funds ina completely diversified portfolio, which means that all the riskunique to individual assets in the portfolio is diversified awayStudy Session 18 Sample QuestionsCapital Market Theory: Basic Concepts