MULTIPLE-CHOICE PROBLEMS MULTIPLE-CHOICE PROBLEMS

1.

Sylvia has a two assets in her portfolio, asset A and asset B. Asset A has a standard deviation of 40% and

asset B has a standard deviation of 20%. 50% of her portfolio is invested in asset A and 50% is invested

in asset B. The correlation for asset A and asset B is 0.90. What is the standard deviation of her

portfolio?

a. Greater than 30%.

b. Less than 30%.

c. Equal to 30%.

d. Not enough information to determine.

The correct answer is b.

It is not necessary to use the standard deviation of a two asset portfolio formula to answer this
question. Since

there is a 50/50 weighting for each asset, simply take a simple average of the standard deviations (0.40
+ 0.20)

÷ 2 = 0.30. Since the correlation is less than 1, the standard deviation for the portfolio will be less than
the

simple average. If correlation was equal to 1, then the standard deviation would be equal to 30%.

2.

Using the constant growth dividend valuation model, calculate the intrinsic value of a stock that pays a

dividend this year of $2.00 and is expected to grow at 6%. The beta for this stock is 1.5, the risk-free

rate of return is 3% and the market return is12%.

a. $20.19.

b. $28.75.
c. $35.33.

d. $48.27.

The correct answer is a.

Use the constant growth dividend model to solve for intrinsic value. The question does not provide the

required rate of return, however the capital asset pricing model can be used to solve for required rate of
return.

V = D1 ÷ (r - g)

V = 2 (1.06) ÷ (0.165 - 0.06)

V = 20.19

R = Rf + b(Rm - Rf )

R = 0.03 + 1.5(0.12 - 0.03)

R = 0.165

3.

Michael has an investment with the following annual returns for four years:

Year 1: 12%

Year 2: -5%

Year 3: 8%

Year 4: 18%

94

CHAPTER 9: INVESTMENTS
What is the arithmetic mean (AM) and what is the geometric mean (GM)?

a. AM = 8.25%, GM = 7.91%.

b. AM = 8.25%, GM = 10.64%.

c. AM = 10.75%, GM = 7.91%.

d. AM = 10.75%, GM = 10.64%.

The correct answer is a.

AM = (0.12 -0.05 + 0.08 + 0.18) ÷ 4 = 0.0825 = 8.25%

GM =

4 (1.12 ) × (0.95 ) × (1.08 ) × (1.18 ) –

1100

GM = (1.356)1/4 - 1 x 100

GM = 7.91%

4.

The type of risk which measures the extent to which a firm uses debt securities and other forms of debt

in its capital structure to finance is known as:

a. Business risk.

b. Systematic risk.
c. Default risk.

d. Financial risk.

The correct answer is d.

Financial risk has to do with the amount of leveraging or use of borrowed funds a firm utilizes to
structure its

investment and finance its assets.

5.

The type of risk which CANNOT be eliminated through diversification is:

a. Unsystematic Risk.

b. Company Specific Risk.

c. Systematic Risk.

d. Business Risk.

The correct answer is c.

Unsystematic risk, company specific risk and business risk can all be eliminated through diversification.

6.

Municipal bonds that are backed by the income from specific projects are known as:

a. Income bonds.

b. Revenue bonds.

c. General obligation bonds.

d. Debenture bonds.

The correct answer is b.

Revenue generated from the project, such as a toll to pay for the bridge, that is used to repay such
municipal

obligations are known as revenue bonds. The other municipal bonds, general obligation bonds, are
backed by

the taxing power of the issuing body.

MULTIPLE-CHOICE PROBLEMS 95
7.

Tom Taylor wants to accumulate wealth, but he has told his financial planner that he is risk-averse.

What should the financial planner advise Tom to do regarding his current asset investment choices,

considering his risk tolerance and his goal of accumulating wealth?

a. Invest in products which bring the highest return regardless of risk.

b. Invest in products producing high income because fixed income products are generally safe.

c. Put Tom’s assets in 100% cash equivalents because he is risk-averse.

d. Determine Tom’s true risk tolerance.

The correct answer is d.

Option c should be considered, but first a financial planner should determine a client’s true risk
tolerance

before taking any action. Therefore option d is the correct choice.

8.

A bond fund had the following yearly returns:

Year 1 at 14%

Year 2 at 7%

Year 3 at -3%

Year 4 at 18%

Year 5 at 9%

What is the standard deviation of the returns?

a. 6.04.
b. 7.13.

c. 7.97.

d. 8.43.

The correct answer is c.

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96

CHAPTER 9: INVESTMENTS
9.

If the risk/return performance of a stock lies above the Security Market Line, the stock is said to have a:

a. Positive correlation coefficient.

b. Positive alpha.

c. Positive expected return.

d. Positive covariance.

The correct answer is b.

Performance of a stock below the SML is a negative alpha. Again, the Jensen formula can be used for
this calculation.

10.

Bob Conrad’s investment portfolio consists of several types of stocks, bonds, and money market

instruments. The portfolio has an overall standard deviation of 12%, a beta of 1.06, and a total return

for the year of 11%. Bob is considering adding one of two alternative investments to his portfolio. Stock

A has a standard deviation of 13%, a beta of 0.87, and a correlation coefficient with the portfolio of 0.6.

Stock B has a standard deviation of 11%, a beta of 0.97, and a correlation coefficient of 0.95. Which

stock should Bob consider adding to his portfolio, and why?

a. Stock A because it has a lower correlation coefficient.

b. Stock A because it has a lower beta than that of the portfolio.

c. Stock B because it has a lower standard deviation than that of the portfolio.

d. Stock B because it has a higher correlation coefficient.

The correct answer is a.

In the process of adding new investments to a portfolio, the lowest correlation coefficient makes the
best addition.

Closest to negative one (-1) is always best.

11.

The Performance Fund had returns of 19% over the evaluation period and the benchmark portfolio

yielded a return of 17% over the same period. Over the evaluation period, the standard deviation of

returns from the Fund was 23% and the standard deviation of returns from the benchmark portfolio

was 21%. Assuming a risk-free rate of return of 8%, which one of the following is the calculation of the

Sharpe index of performance for the Performance Fund over the evaluation period?

a. 0.3913.

b. 0.4286.

c. 0.4783.

d. 0.5238.

The correct answer is c.

(0.19 - 0.08) ÷ 0.23 = 0.4783.

MULTIPLE-CHOICE PROBLEMS 97
12. Which of the following statements regarding investment risk is correct?

1. Beta is a measure of systematic, non-diversifiable risk.

2. Rational investors will form portfolios and eliminate systematic risk.

3. Rational investors will form portfolios and eliminate unsystematic risk.

4. Systematic risk is the relevant risk for a well-diversified portfolio.

5. Beta captures all the risk inherent in an individual security.

a. 1 and 5.

b. 2 and 5.

c. 1, 3 and 4.

d. 2, 3 and 4.

The correct answer is c.

Option 2 is false because systematic risk cannot be diversified away. Option 5 is false because beta
measures

systematic risk, and not all risk inherent (in this case diversifiable risk) is measured by beta.

13. Mutual fund XYZ has a beta of 1.5, a standard deviation of 12%, and a correlation to the S&P 500 of

0.80. How much return of fund XYZ is due to the S&P 500?

a. 20%.

b. 64%.

c. 80%.

d. 100%.

The correct answer is b.

Correlation is 0.80, therefore r-squared is 0.64. (R-squared = correlation coefficient squared). Therefore
64%

of the mutual fund’s return is due to the S&P 500. Remember, r-squared measures the percentage of
return
due to the market.

14. As a measure for risk, the Capital Market Line (CML) uses the:

a. Risk-free rate of return.

b. Beta of the market.

c. Standard deviation of the market.

d. Portfolio weighted beta.

The correct answer is c.

The CML (Capital Market Line) uses standard deviation, while the SML (Security Market Line) uses the
beta

as its “risk” measurement.

98 CHAPTER 9: INVESTMENTS
15. Given a mean of 13% and a deviation of 9%, what is the range for 99% of all possible results?

a. 1 standard deviation (68%) -4% to 22%.

b. 2 standard deviation (95%) -5% to 31%.

c. 3 standard deviation (99%) -14% to 40%.

d. None of the above.

The correct answer is c.

Standard Lowest Expected Highest Expected

Deviations Return Return

+/- 1 13 - 9 = 4% 13 + 9 = 22%

+/- 2 4 - 9 = <5%> 22 + 9 = 31%

+/- 3 <5> - 9 = <14%> 31 + 9 = 40%

16. Which index should Jan use as a benchmark when evaluating the performance of her XYZ mutual
fund?

Index 1 Index 2 Index 3 Index 4

Beta

r-squared

0.75

0.80

1.1

0.90

1.25

0.95

1.5

0.50
a. Index 1.

b. Index 2.

c. Index 3.

d. Index 4.

The correct answer is c.

Always select the index that explains “the most” of a funds return. 95% of the return, as measured by r-

squared, for fund XYZ is explained by Index 3.

17.

What is the return that a client should expect from a security that last year returned 11.7% with a

standard deviation of 0.146, a beta of 1.2, when the overall market return is expected to be 10.93%, and

U.S. Treasury is expected to earn 3.56%?

a. 11.7%.

b. 12.4%.

c. 13.3%.

d. 14.6%.

The correct answer is b.

Using the CAPM one can calculate this answer. Standard deviation and last years return are merely
distractors.

ER = Rf + B (Rm - Rf )

ER = 0.0356 + 1.2 (0.1093 - 0.0356)

ER = 0.0356 + 0.0884

ER = 0.1240 = 12.4%
MULTIPLE-CHOICE PROBLEMS 99
18.

19.

20.

An investor with a required rate of return of 12.5% is looking at a stock that currently pays a $3.75

dividend per share, has a dividend growth rate of 6%, and is selling in the market for $60.00 per share.

What would you recommend?

a. Buy; it meets the buyer’s return requirements and is underpriced.

b. Buy; it does not meet the buyer’s return requirements, but it is underpriced.

c. Do not buy; it does not meet the buyer’s return requirements and is overpriced.

d. Do not buy; it meets the buyer’s return requirements, but is overpriced.

The correct answer is a.

Use the constant growth dividend discount model to arrive at the correct solution for this problem.

Formula:

D1

V = ---------------

(rg–

)
($3.75 × 1.06)

V = -----------------------------------

(0.125 –

0.06)

$3.975

V = ---------------

--

0.065

V = $61.15

Therefore, the stock is undervalued since it is trading at $60.

The primary difference between open-end and closed-end investment companies is:

a. Closed end funds always sell at par value.

b. Open-end funds do not charge sales fees.

c. Closed-end funds guarantee the Net Asset Value (NAV) at the time of sale or purchase.
d. Closed-end funds sell only a limited number of shares.

The correct answer is d.

Closed-end funds offer a limited number of shares, while open-end funds continually create new shares
as new

monies are obtained. Closed-end funds offer no price guarantees and do not always sell at net asset
value.

Which of the following returns do mutual funds use when reporting a five-year historical return?

a. Time-Weighted Return.

b. Dollar-Weighted Return.

c. Arithmetic Mean.

d. Holding Period Return.

The correct answer is a.

Mutual funds use the security’s cash flow, which is a time-weighted return. An investor is concerned
about a

dollar-weighted return.

100 CHAPTER 9: INVESTMENTS

21.

Walt Drizzly stock is currently trading at $45 and pays a dividend of $3.50. Analysts project a dividend

growth rate of 5%. Your client, Toby Benjamin, requires a rate of 12% to meet his stated goal. Toby

wants to know if he should purchase stock in Walt Drizzly.

a. Yes, the stock is undervalued.

b. No, the stock is overvalued.

c. No, the required rate of return is higher than the projected growth rate.

d. Yes, the required rate is higher than the expected rate.

The correct answer is a.

The intrinsic value is: V = (D1 / r - g), therefore V = (3.50 x 1.05) / (0.12 - 0.05), V = $52.50 compared to
the

selling price of $45. Therefore the stock is undervalued.

22.

Match the investment characteristic(s) listed below which describe(s) a unit investment trust.

a. Passive management of the portfolios.

b. Self-liquidating investments usually holding bonds.

c. Both a and b.

d. Neither a nor b.

The correct answer is c.

Both statements are correct because a UIT typically holds municipal bonds until maturity. UITs can also
own

equities.
23.

Given the following diversified mutual fund performance data, which fund had the best risk-adjusted

performance if the risk-free rate of return is 5.7%?

• Fund A: Average rate of return = 7.82%, Standard deviation of annual return = 7.60% and Beta =

0.950

• Fund B: Average annual return = 12.87%, Standard deviation of annual return = 15.75% and Beta =

1.250

• Fund C: Average annual return = 10.34%, Standard deviation of annual return = 18.74% and Beta =

0.857

• Fund D: Average annual return = 7.50%, Standard deviation of annual return = 8.10% and Beta =

0.300

a. Fund B, because the annual return is highest.

b. Fund C, because the Sharpe ratio is lowest.

c. Fund D, because the Treynor ratio is highest.

d. Fund A, because the Treynor ratio is lowest.

The correct answer is c.

If a fund is diversified, use the Treynor model and the result there is arrived at by dividing the return by
the

beta. In this case, fund D has the highest risk adjusted rate of return. Treynor = [(rp - rf ) / (Bp)]. In this
case,

the result is (0.0750 - 0.57) ÷ 0.3000 = 0.06.

MULTIPLE-CHOICE PROBLEMS 101

24.

Match the investment characteristic(s) listed below which describe(s) closed-end investment companies.

a. Passive management of the portfolios.

b. Shares of the fund are normally traded in major secondary markets.

c. Both a and b.

d. Neither a nor b.

The correct answer is b.

Close-end funds are traded on the secondary markets but are not passively managed.

25.

In computing portfolio performance, the Sharpe index uses ______________, while the Treynor index

uses ________________ for the risk measure.

a. standard deviation; correlation coefficient.

b. beta; standard deviation.

c. standard deviation; beta.

d. standard deviation; coefficient of variation.

The correct answer is c.

Sharpe may be remembered as beginning with the letter “S” as does standard deviation. This mnemonic

device may be helpful.

26.

The following investment return will result in what dollar weighted return? An initial outlay of

$50,000, with three years of additional outflows of $10,000 each, and inflows as follows: $0 the first
year, $20,000 in years 2 and 3, and sale of the property at the end of year 3 for $75,000.

a. 27.64%.

b. 14.04%.

c. 18.32%.

d. 20.67%.

The correct answer is c.

CF0 = <50,000>

CF1 = 0 - 10,000 = <10,000>

CF2 = 20,000 - 10,000 = 10,000

CF3 = 20,000 - 10,000 + 75,000 = 85,000

IRR = ?

102 CHAPTER 9: INVESTMENTS

27.

Using the CAPM formula, what return should a client expect from a security that returned 10% with a

standard deviation of 6%, a beta of 1.5, when the overall market return has been 8%, and the risk-free

rare is around 2%?

a. 8%.

b. 9%.

c. 10%.

d. 11%.

The correct answer is d.

Using the CAPM, one can calculate this answer. Standard deviation and last years return are merely
distractors.

ER = Rf + B (Rm - Rf )

ER = 0.02 + 1.5 (0.08 -0.02)

ER = 0.02 + 0.09

ER = 0.11

28.

Match the investment characteristic(s) listed below which describe(s) an open-end investment
company.

a. Only passive management of the portfolios.

b. Shares of the fund are normally traded in major secondary markets.

c. Both a and b.

d. Neither a nor b.

The correct answer is d.

Option a is incorrect because open-end funds are both passively and actively managed. Option b is
incorrect
because open-end fund shares are traded directly with the fund, not on the secondary market.

29.

Which of the following is/are characteristics of a municipal bond unit investment trust?

1. Additional securities are not added to the trust.

2. Shares may be sold at a premium or discount to net asset value.

3. Shares are normally traded on the open market (exchanges.)

4. The portfolio is self-liquidating.

a. 1only.

b. 1 and 4.

c. 2 and 3.

d. 2 and 4.

The correct answer is b.

Unit investments do not make additions to investments once the trust has been structured. Shares are
not

bought or sold after structuring and the portfolio is self-liquidating.

MULTIPLE-CHOICE PROBLEMS 103

30.

A fixed income security whose price has fallen as a result of an increase in interest rates in the market

place is said to be subject to:

a. Interest rate risk.

b. Reinvestment rate risk.

c. Purchasing power risk.

d. Exchange rate risk.

The correct answer is a.

A fixed income security whose price has fallen as a result of an increase in interest rates in the market
place is

said to be subject to interest rate risk.

31.

The type of risk which may be eliminated through diversification is:

a. Market Risk.

b. Purchasing Power Risk.

c. Interest Rate.

d. Business Risk.

The correct answer is d.

Business risk may be eliminated through diversification. All others are systematic risks which cannot be
diversified

away.

32.
The risk which a firm may not be able to meets its debt obligations is known as:

a. Business risk.

b. Interest rate.

c. Default risk.

d. Financial risk.

The correct answer is c.

Default risk is the risk that a firm may not meet its debt obligations.

33.

William has an investment with the following annual returns for four years:

• Year 1: -2%

• Year 2: 9%

• Year 3: 15%

• Year 4: 5%

104 CHAPTER 9: INVESTMENTS

What is the Arithmetic Mean (AM) and what is the Geometric Mean (GM)?

a. AM = 6.12%, GM = 6.57%.

b. AM = 6.12%, GM = 6.02%.

c. AM = 6.75%, GM = 6.02%.

d. AM = 6.75%, GM = 6.57%.

The correct answer is a.

AM = (-0.02 + 0.09 + 0.15 + 0.05) / 4 = 6.75

GM = 4 (0.98) x (1.09) x (1.15) x (1.05) - 1 x 100

GM = 1.0657 - 1 x 100

GM = 6.57

34.

An investor purchased a bond for $980, received $75 in interest, and then sold the bond for $950 after

holding it for seven months. What is the holding period return?

a. 4.6%.

b. 4.7%.

c. 4.8%.

d. 4.9%.

The correct answer is a.

Holding Period Return = ($950 - $980 + $75) / $980 = 4.6%

35.

Which method of portfolio evaluation allows the comparison of a portfolio manager’s performance to

the expected return, using Beta as the measure of risk?

a. The Treynor Model.

b. The Jensen Model.

c. Information Ratio.

d. The Sharpe Model.

The correct answer is b.

Treynor and Sharpe require that one calculate the performance of the market to make a valid
comparison.

Information ratio compares actual performance to that of a market, using standard deviation.

MULTIPLE-CHOICE PROBLEMS 105

36. What is the weighted average beta of the following portfolio?

• Stock L has a beta of 1.45 and constitutes 10% of the portfolio;

• Stock M has a value of $125,000,with a beta of 0.93;

• While Stock N makes up 40% of the portfolio with a beta of 0.65, and

• Stock O, with a 2.2 beta has a dollar value of $175,000.

a. 1.24.

b. 1.31.

c. 1.54.

d. 1.76.

The correct answer is a.

Please be certain to avoid rounding errors in arriving at the correct solution. For weighted average beta,
use

only the two places to the right of the decimal.

Stock L = 10%; Stock M = $125,000; Stock N = 40%; Stock O = $175,000

L + N = 50%; therefore M + O = 50% or $300,000. Thus the total portfolio value is $600,000.

Stock L = $60,000 / $600,000 = 0.10 x 1.45 = 0.145.

Stock M = $125,000 / $600,000 = 0.2083 x 0.93 = 0.194.

Stock N = $240,000 / $600,000 = 0.40 x 0.65 = 0.260.

Stock O = $175,000 / $600,000 = 0.2917 x 2.2 = 0.642.

Adding these results (0.145 + 0.194 + 0.260 + 0.642 = 1.241) will result in the weighted average beta of
1.23.

37. Which of the following statements regarding investment risk is correct?

1. Beta is a measure of systematic, non-diversifiable risk.

2. Rational investors will form portfolios and eliminate systematic risk.

3. Rational investors will form portfolios and eliminate unsystematic risk.

4. Systematic risk is the relevant risk for a well-diversified portfolio.

5. Beta captures all the risk inherent in an individual security.

a. 1, 2 and 5.

b. 1, 3 and 4.

c. 2 and 5.

d. 2, 3 and 4.

The correct answer is b.

Statement 2 is untrue because systematic risk cannot be diversified away. Statement 5 is untrue
because beta

measures systematic risk, and not all risk inherent (in this case diversifiable risk) is measured by beta.

106 CHAPTER 9: INVESTMENTS

38.

Which of the following reveals the relationship of a given security’s movement relative to that of the

market?

a. Beta.

b. Correlation coefficient.

c. R-Squared.

d. Standard deviation.

The correct answer is a.

Correlation coefficient and covariance measure two stocks movements relative to one another.
Standard deviation

measures a security's performance relative to expectations of performance. Alpha reveals the level of
over

or underperformance of the security relative to market expectations. R-squared measures what

percentage of

return is explained by the market.

39.

The ideal correlation for portfolio construction is:

a. +1.0.

b. -1.0.

c. 0.0.

d. +0.70.

The correct answer is b.

Graphically depicted, a correlation of negative one (-1) means that any two investments move exactly
opposite

from one another.

40.

Which of the following would be considered a systematic risk?

a. Business Risk.

b. Financial Risk.

c. Company-specific Risk.

d. Market Risk.

The correct answer is d.

All of the others are unsystematic risk, or diversifiable risks. These are the direct result of limited
diversification, but can be eliminated through the broadening of the client’s portfolio.