Quiz1d_2.doc

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Name: _____________________ ID number: _________________

FIN 406QUIZ. 1

October 3, 2002

Instructions: Circle the best answer for each question in the exam. There are 45questions and each question is worth 1 point. The exam is a closed book and closed notesexam.

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1. Why are derivatives potentially dangerous?a. They involve leverage b. They are used to hedgec. They are a tool for risk managementd. There are more than 1200 different derivatives on the market

2. Financial assets ___________ means by which individuals hold claims on realassets. Financial assets ________ directly to the productive capacity of theeconomy.a. are; contribute b. are; do not contributec. are not; contributed. are not; do not contribute

3. Asset allocation refers to the _______________.a. allocation of the investment portfolio across broad asset classes

b. analysis of the value of securitiesc. choice of specific assets within each asset classd. none of the above

4. _____________ portfolio management calls for holding diversified portfolioswithout spending effort or resources attempting to improve investment performance through security analysis.a. active b. idioticc. passived. none of the above

5. The most important feature of municipal bonds is their ____________.a. safety b. liquidityc. tax-exempt statusd. convertibility

6. ____________ is not a characteristic of a money market instrument.a. liquidity b. marketabilityc. low risk d. long maturity

7. Financial intermediaries exist because small investors cannot efficiently _____________.a. diversify their portfolios b. gather informationc. monitor their portfoliosd. all of the above

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8. When computing the bond equivalent yield in a leap year, you would use ________ days.a. 260 b. 360c. 365

d. 366

9. The bid price of a treasury bill is ______________.a. the price at which the dealer in treasury bills is willing to sell the bill b. the price at which the dealer in treasury bills is willing to buy the billc. greater than the ask price of the treasury bill expressed in dollar termsd. the price at which the investor can buy the treasury bill

10. In a futures contract, the long position is taken by the person who ____________.a. commits to delivering the commodity b. commits to purchasing the commodity

c. plays between second base and third based. uses his margin

11. A __________ gives its holder the right to buy an asset for a specified exercise price on or before a specified expiration date.a. call option b. futures contractc. put optiond. none of the above

12. A treasury bill has a face value of $10,000 and is selling for $9,800. If thetreasury bill matures in 80 days, its bank discount yield is ___________.a. 2.04% b. 9.46%c. 9.00%d. 9.66%

13. The bond equivalent yield on a treasury bill is 5%. The price of the bill is ______________ if it matures in 60 days and has a face value of $1,000.a. $950.00 b. $990.67c. $991.85d. none of the above

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14. If the market prices of the 30 stocks in the Dow Jones Industrial Average allchange by the same dollar amount on a given day (ignoring stock splits), whichstock will have the greatest impact on the average?a. the one with the highest price b. the one with the lowest price

c. all 30 stocks will have the same impactd. the answer cannot be determined by the information given

15. Which of the following are not characteristic of common stock ownership?a. residual claimant b. unlimited liabilityc. voting rightsd. all of the above are characteristics of stock ownership

16. Assume that you have just purchased some shares in an investment companyreporting $320 million in assets, $20 million in liabilities, and 200 million shares

outstanding. What is the net asset value of these shares?a. $10 b. $9.33c. $15d. $1.50

17. Sponsors of unit investment trusts earn a profit by ______________.a. deducting a quarterly management fee from fund assets b. deducting a percentage of any gains in asset valuec. selling shares in the trust at a premium to the cost of acquiring the

underlying assetsd. none of the above

18. Investors who wish to liquidate their holding in a closed-end fund may _______________.a. sell their shares back to the trustee at a discount b. sell their shares back to the trustee at net asset valuec. sell their shares on the open marketd. none of the above

19. ____________ is a false statement regarding open-end mutual funds.a. they offer investors a guaranteed rate of return b. they offer investors a well diversified portfolioc. they redeem their shares at their net asset valued. none of the above

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20. Mutual funds that vary the proportions of funds invested in particular marketsectors according to the fund manager’s forecast of the performance of thatmarket sector are called ______________.a. asset allocation funds b. balanced funds

c. index fundsd. income funds

21. Over the past two decades, actively managed funds have tended to ____________ index funds.a. outperform b. perform equivalently toc. underperformd. no consistent relationship between the performance of actively managed

funds and passively managed funds has been documented.

22. The stage an individual is in his/her life cycle will affect his/her _____________.a. return requirement b. risk tolerancec. both a. and b.d. neither a. nor b.

23. The ___________ average ignores compounding.a. geometric b. arithmeticc. both a and b aboved. none of the above

24. Of the alternatives available, _____________ typically have the lowest standarddeviation of returns.a. commercial paper b. corporate bondsc. stocksd. treasury bills

25. If you purchase a stock for $50, receive dividends of $2, and sell the stock at theend of the year for $50.5, what is your holding period return?a. 5% b. 10%c. 14%d. 18%

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26. The arithmetic average of 25%, 15%, and 20% is ________________.a. 15.7% b. 15%c. 17.2d. 20%

27. The geometric average of 10%, 20% and 25% is ____________.a. 14.9% b. 18.2%c. 19.7%d. 23%

28. The dollar weighted return is the same as the _______________.a. difference between cash inflows and outflows b. arithmetic average returnc. geometric average return

d. internal rate of return

29. Suppose you pay $9,700 for a Treasury bill maturing in three months. What is theeffective annual rate of return for this investment?a. 3.1% b. 13%c. 8.42%d. 10.66%

30. The reward/variability ratio is given by ________________.a. the slope of the capital allocation line b. the second derivative of the capital allocation linec. the point at which the second derivative of the investor’s indifference

curve reaches zero.d. none of the above.

31. If you require a real growth in the purchasing power of your investment of 8%,and you expect the rate of inflation over the next year to be 3%, what is the lowestnominal return that you would be satisfied with? (exact rate, not approximation)a. 3% b. 8%c. 11%d. 11.24%

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32. A Treasury bill pays a 6% rate of return. A risk averse investor _____________ invest in a risky portfolio that pays 12% with a probability of 40% or 2% with a probability of 60% because ___________________.a. might; she is rewarded a risk premium b. would not; because she is not rewarded any risk premium

c. would not; because the risk premium is smalld. cannot be determined

33. Consider a treasury bill with a rate of return of 5% and the following riskysecurities:

Expected Return VarianceA 0.15 0.0400B 0.10 0.0225C 0.12 0.1000D 0.20 0.0625

The investor must develop a complete portfolio by combining the risk-free asset

with one of the securities mentioned above. The security the investor wouldchoose as part of his complete portfolio would be _____________.a. security A b. security Bc. security Cd. security D

34. An investor invests 40% of his wealth in a risky asset with an expected rate of return of 15% and a variance of 4% and 60% in a treasury bill that pays 6%. The portfolio’s expected rate of return and standard deviation are _____________ and ______________.a. 8.0%; 12% b. 9.6%; 8%c. 9.6%; 10%d. 11.4%; 12%

35. Consider the following two investment alternatives. First, a risky portfolio that pays 15% rate of return with a probability of 60% or 5% with a probability of 40%. Second, a treasury bill that pays 4%. The risk premium on the riskyinvestment isa. 1% b. 5%c. 9%d. 7%

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36. You invest $100 in a complete portfolio. The complete portfolio is composed of arisky asset with an expected rate of return of 12% and a standard deviation of 15% and a treasury bill with a rate of return of 5%. ______ of your money should be invested in the risky asset to form a portfolio with an expected return of 8.5%.a. 28%

b. 86%c. 57%d. 50%

37. A portfolio is composed to two stocks, A and B. Stock A has a standard deviationof return of 25% while stock B has a standard deviation of return of 5%. Stock Acomprises 20% of the portfolio while stock B comprises 80% of the portfolio. If the variance of returns on the portfolio is 0.0050, the correlation coefficient between the returns on A and B is ____________.a. -0.225 b. -0.474

c. 0.474d. 0.225

38. The standard deviation of return on investment A is 0.1 while the standarddeviation of return on investment B is 0.05. If the covariance of returns on A andB is 0.0006, the correlation coefficient between the returns A and B is ____________.a. 0.12 b. 0.36c. 0.60d. 0.77

39. An investor can design a risky portfolio based on two stocks, A and B. Thestandard deviation of return on stock A is 20% while the standard deviation onstock stock B is 15%. The correlation coefficient between the return on A and B is0.The expected return on stock A is 20% while on stock B is 10%. The proportionof the minimum variance portfolio that would be invested in stock B is ________.a. 6% b. 50%c. 64%d. 100%

40. A portfolio is composed of two stocks, A and B. Stock A has a standard deviationof return of 5% while stock B has a standard deviation of return of 15%. Thecorrelation coefficient between the returns on A and B is –0.8. Stock A comprises40% of the portfolio while stock B comprises 60% of the portfolio. The varianceof return on the portfolio is ___________.a. 0.0056 b. 0.0067c. 0.0114d. 0.0103

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41. According to Tobin’s separation property, portfolio choice can be separated intotwo independent tasks consisting of ___________ and ___________.a. identifying all investor imposed constraints; identifying the set of

securities that conform to the investor’s constraints and offer the best risk-return tradeoff

b. identifying the investor’s degree of risk aversion; choosing securities fromindustry groups that are consistent with the investor’s risk profilec. identifying the optimal risky portfolio; constructing a complete portfolio

from the T-bills and the optimal risky portfolio based on the investor’sdegree of risk aversion

d. none of the above answers is correct.

42. The values of beta coefficients of securities are ___________.a. always positive b. always negativec. always between +1 and –1

d. usually positive, but not restricted in any particular way

43. Rational risk-averse investors will always prefer portfolios ____________.a. located on the efficient frontier to those located on the capital market line b. located on the capital market line to those located on the efficient frontier c. at or near the minimum variance point on the efficient frontier d. rational risk-averse investors prefer the risk-free asset to all other asset

classes

44. Risk that can’t be eliminated through diversification is called ____________ risk.a. firm-specific b. uniquec. both of the aboved. none of the above

45. The term excess returns refers to ______________.a. returns earned illegally by means of insider trading b. the difference between the rate of return earned and the risk-free ratec. the difference between the rate of return earned on a particular security

and the rate of return earned on other securities of equivalent risk d. the portion of the return on a security which represents tax liability and

therefore cannot be reinvested

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Answers to QUIZ. 1

(Since the correct answers are circled in red pen on your returned quizzes, only the work for computational questions are provided here.)

12. Bank discount yield = (face value – price)/face value x 360/80 = 9%

13. Bond equivalent yield = (face value – price)/price x 365/60

0.05 = (1000-P)/P x 365/60 solving for P yields $991.85

16. NAV = (assets-liabs)/shares outstanding = (320m-20m)/200m = $1.5

25. Return = (selling price +dividend)/purch price - 1 = (50.5+2)/50 - 1 = 5%

26. Arithmetric average = (0.25 + 0.15 + 0.20)/3 = 0.2 = 20%

27. Geometric average = ((1.1)(1.2)(1.25))1/3

29. Holding period return = (10,000-9,700)/9,700 = 0.0309278EAR = (1.0309278)4 - 1 = 0.1296 = 13%

31. (1 + nom rate) = (1+real rate)(1+inflation rate)= (1.08)(1.03) = 1.1124 so nominal rate = 11.24%

32. Expected return on the risky portfolio = (0.4)(0.12) + (0.6)(0.02) = 0.06 No point in investing in the risky portfolio since you can get the same rate of return from the risk free asset (there is no risk premium)

33. Calculate the slope of the CAL between the risk free asset and each of the riskysecurities. Slope of the CAL

= (Expected return on risky asset – risk free rate)/std dev of risky assetFor A: (0.15-0.05)/sqr root of 0.0400 = 0.5For B: = 0.33For C: = 0.22For D: = 0.6

Security D is best since it allows for a CAL with the highest slope.

34. Expected return on portfolio = (0.4)(0.15) + (0.6)(0.06) = 0.096Standard deviation = (0.4)(sqr root of 0.04) = 0.08

35. Expected return on risky portfolio = (0.6)(0.15)+(0.4)(0.05) = 0.11The risk premium = 0.11 – risk free rate = 0.11-0.04 = 0.07

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36. Expected return on portfolio = x(0.12) + (1-x)(0.05)We want the expected return to equal 0.085 so

0.085 = x(0.12) + (1-x)(0.05) solving for x yields 50%

37. using the equation for variance of returns on a portfolio:

0.0050 = (0.2)2

(0.25)2

+ (0.8)2

(0.05)2

+ 2(0.2)(0.8)(0.25)(0.05)(corr)solving for correlation yields 0.225

38. correlation coeff = covariance/(std dev of A x std dev of B)= 0.0006/(0.1*0.05) = 0.12

39. using the equation for solving the weight of asset B in the minimum variance portfolio

= (0.2)2 - (0.2)(0.15)(0)(0.15)2 + (0.2)2 - 2(0.2)(0.15)(0)

= 0.64 = 64%

40. using the equation for variance of returns on a portfolio= (0.4)2(0.05)2 + (0.6)2(0.15)2 + 2(0.4)(0.6)(0.05)(0.15)(-0.8)= 0.0004 + 0.0081 + (-0.00288) = 0.00562

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