Portfolio Management

Index
Topics Page no.

Portfolio Management : An Overview 1 - 10

Portfolio Risk and Return : Part I 11 - 40
Portfolio Risk and Return : Part II 41 - 68
Basic of Portfolio Planning and Construction 69 - 80

SUMMARY AT THE END OF THIS SECTION

 Portfolio
Management
 PORTFOLIO MANAGEMENT

PORTFOLIO MANAGEMENT: AN OVERVIEW

Overview —
 Los a Describe the portfolio approach to investing.

 Los b Describe types of investors and distinctive characteristics and needs of each.

 Los c Describe defined contribution and defined benefit pension plans.

 Los d Describe the steps in the portfolio management process.

 Los e Describe mutual funds and compare them with other pooled investment products.

PRACTICE PROBLEMS
1. Investors should use a portfolio approach to:
A. reduce risk.
B. monitor risk.
C. eliminate risk.
2. Which of the following is the best reason for an investor to be concerned with the composition of a portfolio?
A. Risk reduction.
B. Downside risk protection.
C. Avoidance of investment disasters.
3. With respect to the formation of portfolios, which of the following statements is most accurate?
A. Portfolios affect risk less than returns.
B. Portfolios affect risk more than returns.
C. Portfolios affect risk and returns equally.
4. Which of the following institutions will on average have the greatest need for liquidity?
A. Banks.
B. Investment companies.
C. Non-life insurance companies.
5. Which of the following institutional investors will most likely have the longest time horizon?
A. Defined benefit plan.
B. University endowment.
C. Life insurance company.
6. A defined benefit plan with a large number of retirees is likely to have a high need for
A. income.
B. liquidity.
C. insurance.
7. Which of the following institutional investors is most likely to manage investments in mutual funds?
A. Insurance companies.
B. Investment companies.
C. University endowments.

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8. With respect to the portfolio management process, the asset allocation is determined in the:
A. planning step.
B. feedback step.
C. execution step.
9. The planning step of the portfolio management process is least likely to include an assessment of the client’s
A. securities.
B. constraints.
C. risk tolerance.
10. With respect to the portfolio management process, the rebalancing of a portfolio’s composition is most
likely to occur in the:
A. planning step.
B. feedback step.
C. execution step.
11. An analyst gathers the following information for the asset allocations of three portfolios:
Portfolio Fixed Income (%) Equity (%) Alternative Assets (%)
1 25 60 15
2 60 25 15
3 15 60 25
Which of the portfolios is most likely appropriate for a client who has a high degree of risk tolerance?
A. Portfolio 1.
B. Portfolio 2.
C. Portfolio 3.
12. Which of the following investment products is most likely to trade at their net asset value per share?
A. Exchange traded funds.
B. Open-end mutual funds.
C. Closed-end mutual funds.
13. Which of the following financial products is least likely to have a capital gain distribution?
A. Exchange traded funds.
B. Open-end mutual funds.
C. Closed-end mutual funds.
14. Which of the following forms of pooled investments is subject to the least amount of regulation?
A. Hedge funds.
B. Exchange traded funds.
C. Closed-end mutual funds.
15. Which of the following pooled investments is most likely characterized by a few large investments?
A. Hedge funds.
B. Buyout funds.
C. Venture capital funds.
16. Compared to investing in a single security, diversification provides investors a way to:
A. increase the expected rate of return.
B. decrease the volatility of returns.
C. increase the probability of high returns.
17. Portfolio diversification is least likely to protect against losses:
A. during severe market turmoil.
B. when markets are operating normally.
C. when the portfolio securities have low return correlation.
18. In a defined contribution pension plan:
A. the employee accepts the investment risk.
B. the plan sponsor promises a predetermined retirement income to participants.
C. the plan manager attempts to match the fund's assets to its liabilities.

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19. In a defined benefit pension plan:
A. the employee assumes the investment risk.
B. the employer contributes to the employee's retirement account each period.
C. the plan sponsor promises a predetermined retirement income to participants.
20. Low risk tolerance and high liquidity requirements best describe the typical investment needs of am):
A. defined-benefit pension plan.
B. foundation.
C. insurance company.
21. A long time horizon and low liquidity requirements best describe the investment needs of a(n):
A. endowment.
B. insurance company.
C. bank.
22. Which of the following is least likely to be considered an appropriate schedule for reviewing and updating an
investment policy statement?
A. At regular intervals (e.g., every year).
B. When there is a major change in the client's constraints.
C. Frequently, based on the recent performance of the portfolio.
23. A top-down security analysis begins by:
A. analyzing a firm's business prospects and quality of management.
B. identifying the most attractive companies within each industry.
C. examining economic conditions.
24. Compared to exchange-traded funds (ETFs), open-end mutual funds are typically associated with lower:
A. brokerage costs.
B. minimum investment amounts.
C. management fees.
25. Both buyout funds and venture capital funds:
A. expect that only a small percentage of investments will payoff.
B. play an active role in the management of companies.
C. restructure companies to increase cash flow.
26. Hedge funds most likely:
A. have stricter reporting requirements than a typical investment firm because of their use of leverage and
derivatives.
B. hold equal values of long and short securities.
C. are not offered for sale to the general public.
27. Which of the following statements about the steps in the portfolio management process is NOT correct?
A. Rebalancing the investor's portfolio is done on an as-needed basis, and should be reviewed on a
regular schedule.
B. Implementing the plan is based on an analysis of the current and future forecast of financial and
economic conditions.
C. Developing an investment strategy is based on an analysis of historical performance in financial
markets and economic conditions.
28. Which of the following statements is NOT consistent with the assumption that individuals are risk averse
with their investment portfolios?
A. Many individuals purchase lottery tickets.
B. Higher betas are associated with higher expected returns.
C. There is a positive relationship between expected returns and expected risk.
29. Which of the following statements about investment constraints is least accurate?
A. Diversification efforts can increase tax liability.
B. Investors concerned about time horizon are not likely to worry about liquidity.
C. Unwillingness to invest in gambling stocks is a constraint.
30. A pool of investment assets owned by a government is best described as a(n):
A. state managed fund.
B. official reserve fund.
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 C. sovereign wealth fund.
31. A pooled investment with a share price significantly different from its net asset value (NAV) per share is
most likely a(n):
A. exchange-traded fund.
B. open-end fund.
C. closed-end fund.
32. A firm that invests the majority of a portfolio to track a benchmark index, and uses active investment
strategies for the remaining portion, is said to be using:
A. risk budgeting.
B. a core-satellite approach.
C. strategic asset allocation.
33. The major components of a typical investment policy statement (IPS) least likely include:
A. investment manager's compensation.
B. duties and responsibilities of investment manager, custodian, and client.
C. investment objectives, constraints, and guidelines.
34. A mutual fund that invests in short-term debt securities and maintains a net asset value of $1.00 per share
is best described as a:
A. balanced fund.
B. money market fund.
C. bond mutual fund.
35. Which of the following statements about risk is NOT correct? Generally, greater:
A. spending needs allows for greater risk.
B. existing wealth allows for greater risk.
C. insurance coverage allows for greater risk.
36. High risk tolerance, a long investment horizon, and low liquidity needs are most likely to characterize the
investment needs of a(n):
A. bank.
B. defined benefit pension plan.
C. insurance company.
37. Identifying a benchmark for a client portfolio is most likely to be part of the:
A. feedback step.
B. planning step.
C. execution step.
38. Which of the following is typically the first general step in the portfolio management process?
A. Write a policy statement.
B. Specify capital market expectations.
C. Develop an investment strategy.
39. Which of the following factors is least likely to affect an investor's risk tolerance?
A. Level of inflation in the economy.
B. Number of dependent family members.
C. Level of insurance coverage.
40. In the top-down approach to asset allocation, industry analysis should be conducted before company
analysis because:
A. the goal of the top-down approach is to identify those companies in non-cyclical industries with the
lowest P/E ratios.
B. most valuation models recommend the use of industry-wide average required returns, rather than
individual returns.
C. an industry's prospects within the global business environment are a major determinant of how well
individual firms in the industry perform.
41. In a defined contribution pension plan, investment risk is borne by the:
A. employer.
B. plan manager.
C. employee.
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42. An individual investor specifies to her investment advisor that her portfolio must produce a minimum
amount of cash each period. This investment constraint is best classified as:
A. legal and regulatory.
B. liquidity.
C. unique circumstances.
43. In the Markowitz framework, an investor should most appropriately evaluate a potential investment based
on its:
A. intrinsic value compared to market value.
B. expected return.
C. effect on portfolio risk and return.
44. Which of the following statements about risk and return is least accurate?
A. Return objectives may be stated in absolute terms.
B. Specifying investment objectives only in terms of return may expose an investor to inappropriately
high levels of risk.
C. Risk and return may be considered on a mutually exclusive basis.
45. The portfolio approach to investing is best described as evaluating each investment based on its:
A. contribution to the portfolio's overall risk and return.
B. potential to generate excess return for the investor.
C. fundamentals such as the financial performance of the issuer.
46. Which of the following is NOT a rationale for the importance of the policy statement in investing? It:
A. helps investors understand the risks and costs of investing.
B. forces investors to understand their needs and constraints.
C. identifies specific stocks the investor may wish to purchase.
47. Which of the following institutional investors is most likely to have low liquidity needs?
A. Bank.
B. Property insurance company.
C. Defined benefit pension plan.
48. All of the following affect an investor's risk tolerance EXCEPT:
A. family situation.
B. years of experience with investing in the markets.
C. tax bracket.
49. The ratio of a portfolio's standard deviation of return to the average standard deviation of the securities in
the portfolio is known as the:
A. Sharpe ratio.
B. relative risk ratio.
C. diversification ratio.
50. Which of the following types of investors is likely to have the shortest investment horizon?
A. Foundation.
B. Property and casualty insurance company.
C. Life insurance company.
51. Which of the following statements about risk and return is NOT correct?
A. Return objectives may be stated in dollar amounts.
B. Return objectives should be considered in conjunction with risk preferences.
C. Return-only objectives provide a more concise and efficient way to measure performance for
investment managers.
52. Which of the following is most likely?
A. The lower the diversification ratio, the greater the risk reduction benefits of diversification and the greater
the portfolio effect.
B. The higher the diversification ratio, the greater the risk reduction benefits of diversification and the
greater the portfolio effect.
C. The lower the diversification ratio, the lower the risk reduction benefits of diversification and the greater
the portfolio effect.

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53. Which of the following is most likely to have the lowest risk tolerance?
A. Banks
B. Foundations
C. Defined-benefit pension plans
54. Determining the portfolio’s asset allocation is part of the:
A. Planning phase.
B. Execution phase.
C. Feedback phase.
55. Consider the following statements:
Statement 1: Open-end funds need to keep cash to fund redemptions.
Statement 2: Closed-end funds cannot accept new investments into the fund.
Which of the following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are correct.
56. Consider the following statements:
Statement 1: ETFs are similar to open-end funds in that they usually trade close to their NAV per share.
Statement 2: ETFs are similar to closed-end funds in that they trade in the secondary market.
Which of the following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are correct.
57. A balanced fund typically invests in:
A. Debt securities only.
B. Short-term debt securities only.
C. Debt and equity securities.
58. Which of the following investment vehicles entail incentive-based fees for managers?
A. Hedge funds
B. Mutual funds
C. Separately managed accounts
59. Which of the following investment vehicles least likely have minimum investment requirements?
A. Separately managed accounts
B. Mutual funds
C. Hedge funds
60. Eventual exit strategy is an important consideration when investing in:
A. Hedge funds.
B. Exchange traded funds.
C. Venture capital funds.
61. Which of the following individuals is most likely to be risk averse?
A. An old person with large net worth
B. A young person with moderate income expectations
C. An old person with a low income stream

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 SOLUTIONS
1. A is correct. Combining assets into a portfolio should reduce the portfolio’s volatility. Specifically,
“individuals and institutions should hold portfolios to reduce risk.” As illustrated in the reading, however, risk
reduction may not be as great during a period of dramatic economic change.
2. A is correct. Combining assets into a portfolio should reduce the portfolio’s volatility. The portfolio approach
does not necessarily provide downside protection or guarantee that the portfolio always will avoid losses.
3. B is correct. As illustrated in the reading, portfolios reduce risk more than they increase returns.
4. A is correct. The excess reserves invested by banks need to be relatively liquid. Although investment
companies and non-life insurance companies have high liquidity needs, the liquidity need for banks is on
average the greatest.
5. B is correct. Most foundations and endowments are established with the intent of having perpetual lives.
Although defined benefit plans and life insurance companies have portfolios with a long time horizon, they
are not perpetual.
6. A is correct. Income is necessary to meet the cash flow obligation to retirees. Although defined benefit plans
have a need for income, the need for liquidity typically is quite low. A retiree may need life insurance;
however, a defined benefit plan does not need insurance.
7. B is correct. Investment companies manage investments in mutual funds. Although endowments and
insurance companies may own mutual funds, they do not issue or redeem shares of mutual funds.
8. C is correct. The client’s objectives and constraints are established in the investment policy statement and are
used to determine the client’s target asset allocation, which occurs in the execution step of the portfolio
management process.
9. A is correct. Securities are analyzed in the execution step. In the planning step, a client’s objectives and
constraints are used to develop the investment policy statement.
10. B is correct. Portfolio monitoring and rebalancing occurs in the feedback step of the portfolio management
process.
11. C is correct. Portfolio 3 has the same equity exposure as Portfolio 1 and has a higher exposure to alternative
assets, which have greater volatility (as discussed in the section of the reading comparing the endowments
from Yale University and the University of Virginia).
12. B is correct. Open-end funds trade at their net asset value per share, whereas closed-end funds and exchange
traded funds can trade at a premium or a discount.
13. A is correct. Exchange traded funds do not have capital gain distributions. If an investor sells shares of an
ETF (or open-end mutual fund or closed-end mutual fund), the investor may have a capital gain or loss on the
shares sold; however, the gain (or loss) from the sale is not a distribution.
14. A is correct. Hedge funds are currently exempt from the reporting requirements of a typical public
investment company.
15. B is correct. Buyout funds or private equity firms make only a few large investments in private companies
with the intent of selling the restructured companies in three to five years. Venture capital funds also have a
short time horizon; however, these funds consist of many small investments in companies with the
expectation that only a few will have a large payoff (and that most will fail).
16. B is correct. Diversification provides an investor reduced risk. However, the expected return is generally
similar or less than that expected from investing in a single risky security. Very high or very low returns
become less likely.
17. A is correct. Portfolio diversification has been shown to be relatively ineffective during severe market
turmoil. Portfolio diversification is most effective when the securities have low correlation and the markets
are operating normally.
18. A is correct. In a defined contribution pension plan, the employee accepts the investment risk. The plan
sponsor and manager neither promise a specific level of retirement income to participants nor make
investment decisions. These are features of a defined benefit plan.
19. C is correct. In a defined benefit plan, the employer promises a specific level of benefits to employees when
they retire. Thus, the employer bears the investment risk.

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20. C is correct. Insurance companies need to be able to pay claims as they arise, which leads to insurance firms
having low risk tolerance and high liquidity needs. Defined benefit pension plans and foundations both
typically have high risk tolerance and low liquidity needs.
21. A is correct. An endowment has a long time horizon and low liquidity needs, as an endowment generally
intends to fund its causes perpetually. Both insurance companies and banks require high liquidity.
22. C is correct. An IPS should be updated at regular intervals and whenever there is a major change in the
client's objectives or constraints. Updating an IPS based on portfolio performance is not recommended.
23. C is correct. A top-down analysis begins with an analysis of broad economic trends. After an industry that is
expected to perform well is chosen, the most attractive companies within that industry are identified. A
bottom-up analysis begins with criteria such as firms' business prospects and quality of management.
24. A is correct. Open-end mutual funds do not have brokerage costs, as the shares are purchased from and
redeemed with the fund company. Minimum investment amounts and management fees are typically higher
for mutual funds.
25. B is correct. Both buyout funds and venture capital funds play an active role in the management of
companies. Unlike venture capital funds, buyout funds expect that the majority of investments will payoff.
Venture capital funds do not typically restructure companies.
26. C is correct. Hedge funds may not be offered for sale to the general public; they can be sold only to qualified
investors who meet certain criteria. Hedge funds that hold equal values of long and short securities today
make up only a small percentage of funds; many other kinds of hedge funds exist that make no attempt to be
market neutral. Hedge funds have reporting requirements that are less strict than those of a typical investment
firm.
27. Answer C
Developing an investment strategy is based primarily on an analysis of the current and future financial
market and economic conditions. Historical analysis serves to help develop an expectation for future
conditions.
28. Answer A
Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will
always select the asset with the lowest level of risk. This means that there is a positive relationship
between expected returns (ER) and expected risk and the risk return line (capital market line [CML] and
security market line [SML]) is upward sweeping. However, investors can be risk averse in one area and
not others, as evidenced by their purchase of lottery tickets.
29. Answer B
Investors with a time horizon constraint may have little time for capital appreciation before they need the
money. Need for money in the near term is a liquidity constraint. Time horizon and liquidity constraints
often go hand in hand. Diversification often requires the sale of an investment and the purchase of another.
Investment sales often trigger tax liability. Younger investors should take advantage of tax deferrals while
they have time for the savings to compound, and while they are in their peak earning years. Many retirees
have little income and face less tax liability on investment returns.
30. Answer C
A sovereign wealth fund is a pool of investment assets owned by a government.
31. Answer C
Closed-end funds' share prices can differ significantly from their NAVs. Open-end fund shares can be
purchased and redeemed at their NAVs. Market forces keep exchange-traded fund share prices close to
their NAVs because arbitrageurs can profit by trading when there are differences.
32. Answer B
With a core-satellite approach, a firm invests the majority of a portfolio passively and uses active
strategies for the remaining portion. Strategic asset allocation refers to specifying the percentages of a
portfolio's value to allocate to specific asset classes. Risk budgeting refers to allocating a portfolio's overall
permitted risk among strategic asset allocation, tactical asset allocation, and security selection.
33. Answer A
Investment manager's compensation is not among the major components of a typical IPS. The major
components include a description of the client; a statement of purpose; a statement of duties and
responsibilities; procedures to update the IPS; investment objectives; investment constraints; investment
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 guidelines; and benchmark for evaluation of performance.
34. Answer B
Money market funds invest primarily in short-term debt securities and are managed to maintain a constant
net asset value, typically one unit of currency per share. A bond mutual fund typically invests in longer-
maturity securities than a money market fund. A balanced fund invests in both debt and equity securities.
35. Answer A
Greater spending needs usually allow for lower risk because there is a definite need to ensure that the
return may adequately fund the spending needs (a "fixed" cost).
36. Answer B
A defined benefit pension plan typically has a long investment time horizon, low liquidity needs, and high
risk tolerance. Insurance companies and banks typically have low risk tolerance and high liquidity needs.
Banks and property and casualty insurers typically have short investment horizons.
37. Answer B
Identification of the client's benchmark would be established in the planning step, to allow assessment of
performance in the feedback step.
38. Answer A
The policy statement is the foundation of the entire portfolio management process. Here, both risk and
return are integrated to determine the investor's goals and constraints.
39. Answer A
The level of inflation in the economy should be considered in determining the return objective. Risk
tolerance is a function of the investor's psychological makeup and the investor's personal factors such as
age, family situation, existing wealth, insurance coverage, current cash reserves and income.
40. Answer C
In general, an industry's prospects within the global business environment determine how well or poorly
individual firms in the industry do. Thus, industry analysis should precede company analysis. The goal is
to find the best companies in the most promising industries; even the best company in a weak industry is
not likely to perform well.
41. Answer C
In a defined contribution plan, the employee makes the investment decisions and assumes the investment
risk.
42. Answer B
Liquidity constraints arise from an investor's need for spendable cash.
43. Answer C
Modern portfolio theory concludes that an investor should evaluate potential investments from a portfolio
perspective and consider how the investment will affect the risk and return characteristics of an investor's
portfolio as a whole.
44. Answer C
Risk and return must always be considered together when expressing investment objectives. Return
objectives may be expressed either in absolute terms (dollar amounts) or in percentages.
45. Answer A
The portfolio approach to investing refers to evaluating individual investments based on their contribution
to the overall risk and return of the investor's portfolio.
46. Answer C
The policy statement outlines broad objectives and constraints but does not get into the details of specific
stocks for investment.
47. Answer C
A defined benefit pension plan has less need for liquidity than a bank or a property and casualty insurance
company. Banks have high liquidity needs because assets may have to be sold quickly if depositors
withdraw their funds. Property and casualty insurance companies need to keep liquid assets to meet claims
as they arise.
48. Answer C
Tax concerns play an important role in investment planning. However, these constitute an investment
constraint, not an investment objective (i.e. risk tolerance).
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49. Answer C
The diversification ratio is calculated by dividing a portfolio's standard deviation of returns by the average
standard deviation of returns of the individual securities in the portfolio.
50. Answer B
Foundations and life insurance companies typically have long investment horizons. Property and casualty
insurance companies typically have shorter investment horizons than life insurance companies because
claims against their policies occur sooner on average.
51. Answer C
Return-only objectives may actually lead to unacceptable behavior on the part of investment managers,
such as excessive trading (churning) to generate excessive commissions.
52. Answer: A
The diversification ratio is the ratio of the standard deviation of an equal-weighted portfolio to the standard
deviation of a randomly selected component of the portfolio. The lower the diversification ratio, the greater
the risk reduction benefits of diversification and the greater the portfolio effect.
53. Answer: A
Banks typically have low risk tolerance, while foundations and defined-benefit pension plans have longer
time horizons and a higher tolerance for risk.
54. Answer: B
Determining the portfolio’s asset allocation is part of the execution phase of constructing a portfolio.
55. Answer: C
Both statements are indeed correct.
56. Answer: C
Both statements are indeed correct.
57. Answer: C
Balanced or hybrid funds invest in both bonds and equity securities.
58. Answer: A
Management fees in hedge funds also have a performance-based component.
59. Answer: B
Investors can participate in mutual funds with a relatively small initial investment. This is not the case with
SMAs and hedge funds.
60. Answer: C
The eventual exit strategy is an important consideration when investing in venture capital funds.
61. Answer: C
Old people have a shorter investment time frame within which to make up any losses.
Further, low income streams cannot help cover any shortfalls. Therefore, they are not likely to take up risky
investments.

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 PORTFOLIO MANAGEMENT

PORTFOLIO RISK AND RETURN : PART I

Overview —
 Los a Calculate and interpret major return measure sand describe their appropriate uses.

 Los b Describe characteristics of the major asset classes that investors consider in forming
portfolios.

 Los c Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns
based on historical data.
 Los d Explain risk aversion and its implications for portfolio selection.

 Los e Calculate and interpret portfolio standard deviation.

 Los f Describe the effect on a portfolio's risk of investing in assets that are less than perfectly
correlated.
 Los g Describe and interpret the minimum-variance and efficient frontiers of risky assets and the
global minimum-variance portfolio.
 Los h Discuss the selection of an optimal portfolio, given an investor's utility (or risk aversion)and
the capital allocation line.

PRACTICE PROBLEMS
1. An investor purchased 100 shares of a stock for $34.50 per share at the beginning of the quarter. If the
investor sold all of the shares for $30.50 per share after receiving a $51.55 dividend payment at the end of
the quarter, the holding period return is closest to:
A. −13.0%.
B. −11.6%.
C. −10.1%.
2. An analyst obtains the following annual rates of return for a mutual fund:
Year Return (%)
2008 14
2009 −10
2010 −2
The fund’s holding period return over the three-year period is closest to:
A. 0.18%.
B. 0.55%.
C. 0.67%.
3. An analyst observes the following annual rates of return for a hedge fund:
Year Return (%)
2008 22
2009 −25
2010 11

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 The hedge fund’s annual geometric mean return is closest to:
A. 0.52%.
B. 1.02%.
C. 2.67%.
4. Which of the following return calculating methods is best for evaluating the annualized returns of a buy-
and-hold strategy of an investor who has made annual deposits to an account for each of the last five
years?
A. Geometric mean return.
B. Arithmetic mean return.
C. Money-weighted return.
5. An investor evaluating the returns of three recently formed exchange-traded funds gathers the following
information:
ETF Time Since Inception Return Since Inception (%)
1 146 days 4.61
2 5 weeks 1.10
3 15 months 14.35
The ETF with the highest annualized rate of return is:
A. ETF 1.
B. ETF 2.
C. ETF 3.
6. With respect to capital market theory, which of the following asset characteristics is least likely to impact
the variance of an investor’s equally weighted portfolio?
A. Return on the asset.
B. Standard deviation of the asset.
C. Covariances of the asset with the other assets in the portfolio.
7. A portfolio manager creates the following portfolio:
Expected
Security Security Weight (%)
Standard Deviation (%)
1 30 20
2 70 12
If the correlation of returns between the two securities is 0.40, the expected standard deviation of the
portfolio is closest to:
A. 10.7%.
B. 11.3%.
C. 12.1%.
8. A portfolio manager creates the following portfolio:
Security Security Weight (%) Expected Standard Deviation (%)
1 30 20
2 70 12
If the covariance of returns between the two securities is −0.0240, the expected standard deviation of the
portfolio is closest to:
A. 2.4%.
B. 7.5%.
C. 9.2%.
The following information relates to Questions 9–10
A portfolio manager creates the following portfolio:
Security Security Weight (%) Expected Standard Deviation (%)
1 30 20
2 70 12

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9. If the standard deviation of the portfolio is 14.40%, the correlation between the two securities is equal to:
A. −1.0.
B. 0.0.
C. 1.0.
10. If the standard deviation of the portfolio is 14.40%, the covariance between the two securities is equal to:
A. 0.0006.
B. 0.0240.
C. 1.0000.
The following information relates to Questions 11–14
An analyst observes the following historic geometric returns:
Asset Class Geometric Return (%)
Equities 8.0
Corporate Bonds 6.5
Treasury bills 2.5
Inflation 2.1
11. The real rate of return for equities is closest to:
A. 5.4%.
B. 5.8%.
C. 5.9%.
12. The real rate of return for corporate bonds is closest to:
A. 4.3%.
B. 4.4%.
C. 4.5%.
13. The risk premium for equities is closest to:
A. 5.4%.
B. 5.5%.
C. 5.6%.
14. The risk premium for corporate bonds is closest to:
A. 3.5%.
B. 3.9%.
C. 4.0%.
15. With respect to trading costs, liquidity is least likely to impact the:
A. stock price.
B. bid–ask spreads.
C. brokerage commissions.
16. Evidence of risk aversion is best illustrated by a risk–return relationship that is:
A. negative.
B. neutral.
C. positive.
17. With respect to risk-averse investors, a risk-free asset will generate a numerical utility that is:
A. the same for all individuals.
B. positive for risk-averse investors.
C. equal to zero for risk seeking investors.
18. With respect to utility theory, the most risk-averse investor will have an indifference curve with the:
A. most convexity.
B. smallest intercept value.
C. greatest slope coefficient.
1
19. With respect to an investor’s utility function expressed as: U=E(r)−12Aσ2 U = E(r) - Aσ 2 , which of the
2
following values for the measure for risk aversion has the least amount of risk aversion?
A. −4.
B. 0.

13
 C. 4.
The following information relates to Questions 20–23
A financial planner has created the following data to illustrate the application of utility theory to
portfolio selection:
Expected
Expected
Investment Standard Deviation
Return (%)
(%)
1 18 2
2 19 8
3 20 15
20. A risk-neutral investor is most likely to choose:
A. Investment 1.
B. Investment 2.
C. Investment 3.
1
21. If an investor’s utility function is expressed as U=E(r)−12Aσ2 U = E(r) - Aσ 2 and the measure for risk
2
aversion has a value of −2, the risk-seeking investor is most likely to choose:
A. Investment 2.
B. Investment 3.
C. Investment 4.
1
22. If an investor’s utility function is expressed as U=E(r)−12Aσ2 U = E(r) - Aσ 2 and the measure for risk
2
aversion has a value of 2, the risk-averse investor is most likely to choose:
A. Investment 1.
B. Investment 2.
C. Investment 3.
1
23. If an investor’s utility function is expressed as U=E(r)−12Aσ2 U = E(r) - Aσ 2 and the measure for risk
2
aversion has a value of 4, the risk-averse investor is most likely to choose:
A. Investment 1.
B. Investment 2.
C. Investment 3.
24. With respect to the mean–variance portfolio theory, the capital allocation line, CAL, is the combination of
the risk-free asset and a portfolio of all:
A. risky assets.
B. equity securities.
C. feasible investments.
25. Two individual investors with different levels of risk aversion will have optimal portfolios that are:
A. below the capital allocation line.
B. on the capital allocation line.
C. above the capital allocation line.
The following information relates to Questions 26–28
A portfolio manager creates the following portfolio:
Expected
Security Annual Expected Standard Deviation (%)
Return (%)
1 16 20
2 12 20

14
26. If the portfolio of the two securities has an expected return of 15%, the proportion invested in Security 1
is:
A. 25%.
B. 50%.
C. 75%.
27. If the correlation of returns between the two securities is −0.15, the expected standard deviation of an
equal-weighted portfolio is closest to:
A. 13.04%.
B. 13.60%.
C. 13.87%.
28. If the two securities are uncorrelated, the expected standard deviation of an equal-weighted portfolio
is closest to:
A. 14.00%.
B. 14.14%.
C. 20.00%.
29. As the number of assets in an equally-weighted portfolio increases, the contribution of each individual
asset’s variance to the volatility of the portfolio:
A. increases.
B. decreases.
C. remains the same.
30. With respect to an equally-weighted portfolio made up of a large number of assets, which of the following
contributes the most to the volatility of the portfolio?
A. Average variance of the individual assets.
B. Standard deviation of the individual assets.
C. Average covariance between all pairs of assets.
31. The correlation between assets in a two-asset portfolio increases during a market decline. If there is no
change in the proportion of each asset held in the portfolio or the expected standard deviation of the
individual assets, the volatility of the portfolio is most likely to:
A. increase.
B. decrease.
C. remain the same.
The following information relates to Questions 32–34
An analyst has made the following return projections for each of three possible outcomes with an equal
likelihood of occurrence:
Outcome 1 Outcome 2 Outcome 3 Expected Return
Asset
(%) (%) (%) (%)
1 12 0 6 6
2 12 6 0 6
3 0 6 12 6
32. Which pair of assets is perfectly negatively correlated?
A. Asset 1 and Asset 2.
B. Asset 1 and Asset 3.
C. Asset 2 and Asset 3.
33. If the analyst constructs two-asset portfolios that are equally-weighted, which pair of assets has
the lowest expected standard deviation?
A. Asset 1 and Asset 2.
B. Asset 1 and Asset 3.
C. Asset 2 and Asset 3.
34. If the analyst constructs two-asset portfolios that are equally weighted, which pair of assets provides
the least amount of risk reduction?
A. Asset 1 and Asset 2.
B. Asset 1 and Asset 3.
C. Asset 2 and Asset 3.

15
35. Which of the following statements is least accurate? The efficient frontier is the set of all attainable risky
assets with the:
A. highest expected return for a given level of risk.
B. lowest amount of risk for a given level of return.
C. highest expected return relative to the risk-free rate.
36. The portfolio on the minimum-variance frontier with the lowest standard deviation is:
A. unattainable.
B. the optimal risky portfolio.
C. the global minimum-variance portfolio.
37. The set of portfolios on the minimum-variance frontier that dominates all sets of portfolios below the
global minimum-variance portfolio is the:
A. capital allocation line.
B. Markowitz efficient frontier.
C. set of optimal risky portfolios.
38. The dominant capital allocation line is the combination of the risk-free asset and the:
A. optimal risky portfolio.
B. levered portfolio of risky assets.
C. global minimum-variance portfolio.
39. Compared to the efficient frontier of risky assets, the dominant capital allocation line has higher rates of
return for levels of risk greater than the optimal risky portfolio because of the investor’s ability to:
A. lend at the risk-free rate.
B. borrow at the risk-free rate.
C. purchase the risk-free asset.
40. With respect to the mean–variance theory, the optimal portfolio is determined by each individual investor’s:
A. risk-free rate.
B. borrowing rate.
C. risk preference.
41. An investor buys a share of stock for $40 at time t = 0, buys another share of the same stock for $50 at t =
1, and sells both shares for $60 each at t = 2. The stock paid a dividend of $1 per share at t = 1 and at t =
2. The periodic money ­ weighted rate of return on the investment is closest to:
A. 22.2%.
B. 23.0%.
C. 23.8%.
42. Which of the following asset classes has historically had the highest returns and standard deviation?
A. Small-cap stocks.
B. Large-cap stocks.
C. Long-term corporate bonds.
43. In a 5-year period, the annual returns on an investment are 5%, -3%, -4%, 2%, and 6%. The standard
deviation of annual returns on this investment is closest to:
A. 4.0%.
B. 4.5%.
C. 20.7%.
44. A measure of how the returns of two risky assets move in relation to each other is the:
A. range.
B. covariance.
C. standard deviation.
45. Which of the following statements about correlation is least accurate?
A. Diversification reduces risk when correlation is less than + 1.
B. If the correlation coefficient is 0, a zero variance portfolio can be constructed.
C. The lower the correlation coefficient, the greater the potential benefits from diversification.
46. The variance of returns is 0.09 for Stock A and 0.04 for Stock B. The covariance between the returns of A
and B is 0.006. The correlation of returns between A and B is:
A. 0.10.
B. 0.20.
C. 0.30.

16
47. Which of the following statements about risk-averse investors is most accurate? A risk-averse investor:
A. seeks out the investment with minimum risk, while return is not a major consideration.
B. will take additional investment risk if sufficiently compensated for this risk.
C. avoids participating in global equity markets.
Use the following data to answer Questions 48 and 49.
A portfolio was created by investing 25% of the funds in Asset A (standard deviation = 15%) and the
balance of the funds in Asset B (standard deviation = 10%).
48. If the correlation coefficient is 0.75, what is the portfolio's standard deviation?
A. 10.6%.
B. 12.4%.
C. 15.0%.
49. If the correlation coefficient is -0.75, what is the portfolio's standard deviation?
A. 2.8%.
B. 4.2%.
C. 5.3%.
50. Which of the following statements about covariance and correlation is least accurate?
A. A zero covariance implies there is no linear relationship between the returns on two assets.
B. If two assets have perfect negative correlation, the variance of returns for a portfolio that consists of
these two assets will equal zero.
C. The covariance of a 2-stock portfolio is equal to the correlation coefficient times the standard
deviation of one stock's returns times the standard deviation of the other stock's returns.
51. Which of the following available portfolios most likely falls below the efficient frontier?
Expected
Expected
Portfolio standard
return
deviation
A. A 7% 14%
B. B 9% 26%
C. C 12% 22%
52. The capital allocation line is a straight line from the risk-free asset through the:
A. global maximum-return portfolio.
B. optimal risky portfolio.
C. global minimum-variance portfolio.
53. Two assets are perfectly positively correlated. If 30% of an investor's funds were put in the asset with a
standard deviation of 0.3 and 70% were invested in an asset with a standard deviation of 0.4, what is the
standard deviation of the portfolio?
A) 0.151.
B) 0.426.
C) 0.370.
54. The optimal portfolio in the Markowitz framework occurs when an investor achieves the diversified
portfolio with the:
A) lowest risk.
B) highest return.
C) highest utility.
55. A portfolio manager adds a new stock that has the same standard deviation of returns as the existing
portfolio but has a correlation coefficient with the existing portfolio that is less than +1. Adding this stock
will have what effect on the standard deviation of the revised portfolio's returns? The standard deviation
will:
A) decrease only if the correlation is negative.
B) decrease.
C) increase.
56. There are benefits to diversification as long as:
A) there is perfect positive correlation between the assets.
B) the correlation coefficient between the assets is less than 1.
C) there must be perfect negative correlation between the assets.

17
57.
 Kendra Jackson, CFA, is given the following information on two stocks, Rockaway and Bridgeport.
 Covariance between the two stocks = 0.0325
 Standard Deviation of Bridgeport's returns = 0.13
Assuming that Jackson must construct a portfolio using only these two stocks, which of the following
combinations will result in the minimum variance portfolio?
A) 100% in Bridgeport.
B) 80% in Bridgeport, 20% in Rockaway.
C) 50% in Bridgeport, 50% in Rockaway.
58. According to Markowitz, an investor's optimal portfolio is determined where the:
A) investor's highest utility curve is tangent to the efficient frontier.
B) investor's utility curve meets the efficient frontier.
C) investor's lowest utility curve is tangent to the efficient frontier.
59. Which of the following statements about the optimal portfolio is NOT correct? The optimal portfolio:
A) lies at the point of tangency between the efficient frontier and the indifference curve with the highest
possible utility.
B) is the portfolio that gives the investor the maximum level of return.
C) may be different for different investors.
60. If the standard deviation of asset A is 12.2%, the standard deviation of asset B is 8.9%, and the correlation
coefficient is 0.20, what is the covariance between A and B?
A) 0.0022.
B) 0.0001.
C) 0.0031.
61. Stock A has a standard deviation of 10%. Stock B has a standard deviation of 15%. The covariance
between A and B is 0.0105. The correlation between A and B is:
A) 0.55
B) 0.25
C) 0.70
62. If the standard deviation of returns for stock A is 0.40 and for stock B is 0.30 and the covariance between
the returns of the two stocks is 0.007 what is the correlation between stocks A and B?
A) 17.14300.
B) 0.00084.
C) 0.05830.
63. Which of the following statements best describes risk aversion?
A) There is an indirect relationship between expected returns and expected risk.
B) The investor will always choose the asset with the least risk.
C) Given a choice between two assets of equal return, the investor will choose the asset with the least
risk.
64. Stock A has a standard deviation of 0.5 and Stock B has a standard deviation of 0.3. Stock A and Stock B
are perfectly positively correlated. According to Markowitz portfolio theory how much should be invested
in each stock to minimize the portfolio's standard deviation?
A) 50% in Stock A and 50% in Stock B.
B) 100% in Stock B.
C) 30% in Stock A and 70% in Stock B.
65. Which one of the following portfolios cannot lie on the efficient frontier?
Portfolio Expected Return Standard Deviation
A 20% 35%
B 11% 13%
C 8% 10%
D 8% 9%

18
 A) Portfolio C.
B) Portfolio D.
C) Portfolio A.
66. The covariance of the market's returns with the stock's returns is 0.008. The standard deviation of the
market's returns is 0.1 and the standard deviation of the stock's returns is 0.2. What is the correlation
coefficient between the stock and market returns?
A) 0.00016.
B) 0.40.
C) 0.91.
67. Adding a stock to a portfolio will reduce the risk of the portfolio if the correlation coefficient is less than
which of the following?
A) 0.00.
B) +1.00.
C) +0.50.
68. Which of the following portfolios falls below the Markowitz efficient frontier?
Portfolio Expected Return Expected Standard Deviation
A 12.1% 8.5%
B 14.2% 8.7%
C 15.1% 8.7%
A) Portfolio A.
B) Portfolio B.
C) Portfolio C.
69. If two stocks have positive covariance, which of the following statements is CORRECT?
A) The rates of return tend to move in the same direction relative to their individual means.
B) The two stocks must be in the same industry.
C) If one stock doubles in price, the other will also double in price.
70. The most appropriate measure of the increase in the purchasing power of a portfolio's value over a given
span of time is a(n):
A) after-tax return.
B) real return.
C) holding period return.
71. The graph below combines the efficient frontier with the indifference curves for two different investors, X
and Y.

Which of the following statements about the above graph is least accurate?
A) Investor X is less risk-averse than Investor Y.
B) The efficient frontier line represents the portfolios that provide the highest return at each risk level.
C) Investor X's expected return will always be less than that of Investor Y.
72. What is the variance of a two-stock portfolio if 15% is invested in stock A (variance of 0.0071) and 85%
in stock B (variance of 0.0008) and the correlation coefficient between the stocks is -0.04?
A) 0.0007.
B) 0.0026.
C) 0.0020.

19
73. If the standard deviation of stock A is 10.6%, the standard deviation of stock B is 14.6%, and the
covariance between the two is 0.015476, what is the correlation coefficient?
A) 0.
B) 0.0002.
C) +1.
74. An investor with a buy-and-hold strategy who makes quarterly deposits into an account should most
appropriately evaluate portfolio performance using the portfolio's:
A) arithmetic mean return.
B) geometric mean return.
C) money-weighted return.
75. Which one of the following statements about correlation is NOT correct?
A) The covariance is equal to the correlation coefficient times the standard deviation of one stock times
the standard deviation of the other stock.
B) If two assets have perfect negative correlation, it is impossible to reduce the portfolio's overall
variance.
C) Positive covariance means that asset returns move together.
76. Which one of the following statements about correlation is NOT correct?
A) If the correlation coefficient were 0, a zero variance portfolio could be constructed.
B) Potential benefits from diversification arise when correlation is less than +1.
C) If the correlation coefficient were -1, a zero variance portfolio could be constructed.
77. Assets A (with a variance of 0.25) and B (with a variance of 0.40) are perfectly positively correlated. If an
investor creates a portfolio using only these two assets with 40% invested in A, the portfolio standard
deviation is closest to:
A) 0.3400.
B) 0.3742.
C) 0.5795.
78. An investor begins with a $100,000 portfolio. At the end of the first period, it generates $5,000 of income,
which he does not reinvest. At the end of the second period, he contributes $25,000 to the portfolio. At the
end of the third period, the portfolio is valued at $123,000. The portfolio's money-weighted return per
period is closest to:
A) 0.94%.
B) -0.50%.
C) 1.20%.
79. A stock has an expected return of 4% with a standard deviation of returns of 6%. A bond has an expected
return of 4% with a standard deviation of 7%. An investor who prefers to invest in the stock rather than
the bond is best described as:
A) risk seeking.
B) risk averse.
C) risk neutral.
80. Gregg Goebel and Mason Erikson are studying for the Level I CFA examination. They have just started
the section on Portfolio Management and Erikson is having difficulty with the equations for the
covariance (cov1,2) and the correlation coefficient (r1,2) for two-stock portfolios. Goebel is confident
with the material and creates the following quiz for Erikson. Using the information in the table below, he
asks Erickson to fill in the question marks.
Portfolio J Portfolio K Portfolio L
Number of Stocks 2 2 2
Covariance ? cov1,2 = 0.020 cov1,2 = 0.003
Correlation coefficient r1,2 = 0.750 ? ?
Risk measure Stock 1 Std. Deviation1 = 0.08 Std. Deviation1 = 0.20 Std. Deviation1 = 0.18
Risk measure Stock 2 Std. Deviation2 = 0.18 Std. Deviation2 = 0.12 Variance2 = 0.09
Which of the following choices correctly gives the covariance for Portfolio J and the correlation
coefficients for Portfolios K and L?

20
 Portfolio J Portfolio K Portfolio L
A) 1.680 0.002 0.076
B) 0.011 0.833 0.056
C) 0.011 0.002 0.076
81. As the correlation between the returns of two assets becomes lower, the risk reduction potential becomes:
A) decreased by the same level.
B) greater.
C) smaller.
82. The particular portfolio on the efficient frontier that best suits an individual investor is determined by:
A) the individual's asset allocation plan.
B) the individual's utility curve.
C) the current market risk-free rate as compared to the current market return rate.
83. Historically, which of the following asset classes has exhibited the smallest standard deviation of monthly
returns?
A) Treasury bills.
B) Large-capitalization stocks.
C) Long-term corporate bonds.
84. An asset manager's portfolio had the following annual rates of return:
Year Return
20X7 +6%
20X8 -37%
20X9 +27%
The manager states that the return for the period is −5.34%. The manager has reported the:
A) arithmetic mean return
B) geometric mean return.
C) holding period return.
85. Which of the following statements regarding the covariance of rates of return is least accurate?
A) If the covariance is negative, the rates of return on two investments will always move in different
directions relative to their means.
B) It is a measure of the degree to which two variables move together over time.
C) It is not a very useful measure of the strength of the relationship, there is absent information about the
volatility of the two variables.
86. An analyst observes the following return behavior between stocks X and Y.
Time Period X's Return Y's Return
1 7 5
2 9 8
3 10 11
4 10 8
What is the covariance of returns between stocks X and Y?
A) +1.5.
B) +3.0.
C) -3.0.
87. Betsy Minor is considering the diversification benefits of a two stock portfolio. The expected return of
stock A is 14 percent with a standard deviation of 18 percent and the expected return of stock B is 18
percent with a standard deviation of 24 percent. Minor intends to invest 40 percent of her money in stock
A, and 60 percent in stock B. The correlation coefficient between the two stocks is 0.6. What is the
variance and standard deviation of the two stock portfolio?
A) Variance = 0.03836; Standard Deviation = 19.59%.
B) Variance = 0.04666; Standard Deviation = 21.60%.
C) Variance = 0.02206; Standard Deviation = 14.85%.

21
88. On a graph of risk, measured by standard deviation and expected return, the efficient frontier represents:
A) all portfolios plotted in the northeast quadrant that maximize return.
B) the group of portfolios that have extreme values and therefore are "efficient" in their allocation.
C) the set of portfolios that dominate all others as to risk and return.
89. If the standard deviation of stock A is 7.2%, the standard deviation of stock B is 5.4%, and the covariance
between the two is -0.0031, what is the correlation coefficient?
A) -0.80.
B) -0.19.
C) -0.64.
90. A portfolio currently holds Randy Co. and the portfolio manager is thinking of adding either XYZ Co. or
Branton Co. to the portfolio. All three stocks offer the same expected return and total risk. The covariance
of returns between Randy Co. and XYZ is +0.5 and the covariance between Randy Co. and Branton Co. is
-0.5. The portfolio's risk would decrease:
A) most if she put half your money in XYZ Co. and half in Branton Co.
B) more if she bought XYZ Co.
C) more if she bought Branton Co.
91. An analyst gathered the following data for Stock A and Stock B:
Time Period Stock A Returns Stock B Returns

1 10% 15%
2 6% 9%
3 8% 12%
What is the covariance for this portfolio?
A) 6.
B) 12.
C) 3.
92. Which of the following portfolios falls below the Markowitz efficient frontier?
Portfolio Expected Return Expected Standard Deviation
A 7% 14%
B 9% 26%
C 15% 30%
D 12% 22%
A) B.
B) D.
C) C.
93. Which of the following statements about portfolio diversification is CORRECT?
A) When a risk-averse investor is confronted with two investment opportunities having the same
expected return, the investor will take the opportunity with the lower risk.
B) The efficient frontier represents individual securities.
C) As the correlation coefficient moves from +1 to zero, the potential for diversification diminishes.
94. Stock A has a standard deviation of 4.1% and Stock B has a standard deviation of 5.8%. If the stocks are
perfectly positively correlated, which portfolio weights minimize the portfolio's standard deviation?
Stock A Stock B
A) 0% 100%
B) 100% 0%
C) 63% 37%
95. Which one of the following portfolios does not lie on the efficient frontier?
Portfolio Expected Return Standard Deviation
A 7 5
B 9 12

22
 C 11 10
D 15 15
A) C.
B) A.
C) B.
96. The correlation coefficient between stocks A and B is 0.75. The standard deviation of stock A's returns is
16% and the standard deviation of stock B's returns is 22%. What is the covariance between stock A and
B?
A) 0.0352.
B) 0.3750.
C) 0.0264.
97. Which of the following statements about risk aversion is CORRECT?
A) Given a choice between two assets with equal rates of return, the investor will always select the asset
with the lowest level of risk.
B) Risk averse investors will not take on risk.
C) Risk aversion implies that the risk-return line, the CML, and the SML are downward sloping curves.
98. The basic premise of the risk-return trade-off suggests that risk-averse individuals purchasing investments
with higher non-diversifiable risk should expect to earn:
A) higher rates of return.
B) lower rates of return.
C) rates of return equal to the market.
99. Which of the following statements about portfolio theory is least accurate?
A) When the return on an asset added to a portfolio has a correlation coefficient of less than one with the
other portfolio asset returns but has the same risk, adding the asset will not decrease the overall
portfolio standard deviation.
B) Assuming that the correlation coefficient is less than one, the risk of the portfolio will always be less
than the simple weighted average of individual stock risks.
C) For a two-stock portfolio, the lowest risk occurs when the correlation coefficient is close to negative
one.
100. Over the long term, the annual returns and standard deviations of returns for major asset classes have
shown:
A) a negative relationship.
B) a positive relationship.
C) no clear relationship.
101. An investor has identified the following possible portfolios. Which portfolio cannot be on the efficient
frontier?
Portfolio Expected Return Standard
Deviation
V 18% 35%
W 12% 16%
X 10% 10%
Y 14% 20%
Z 13% 24%
A) X.
B) Y.
C) Z.
102. The standard deviation of the rates of return is 0.25 for Stock J and 0.30 for Stock K. The covariance
between the returns of J and K is 0.025. The correlation of the rates of return between J and K is:
A) 0.20.
B) 0.10.
C) 0.33.
103. Three portfolios have the following expected returns and risk:

23
 Portfolio Expected return Standard deviation
Jones 4% 2%
Kelly 6% 5%
Lewis 7% 8%
A risk-averse investor choosing from these portfolios could rationally select:
A) any of these portfolios.
B) Jones or Kelly, but not Lewis.
C) Jones, but not Kelly or Lewis.
104. Which of the following measures is NOT considered when calculating the risk (variance) of a two-asset
portfolio?
A) Each asset's standard deviation.
B) The beta of each asset.
C) Each asset weight in the portfolio.
105. A security portfolio earns a gross return of 7.0% and a net return of 6.5%. The difference of 0.5% most
likely results from:
A) fees.
B) taxes.
C) inflation.
106. An investment manager is looking at ten possible stocks to include in a client's portfolio. In order to
achieve the maximum efficiency of the portfolio, the manager must:
A) find the combination of stocks that produces a portfolio with the maximum expected rate of return at a
given level of risk.
B) include all ten stocks in the portfolio in equal amounts.
C) include only the stocks that have the lowest volatility at a given expected rate of return.
107. Investors who are less risk averse will have what type of indifference curves for risk and expected
return?
A) Inverted.
B) Flatter.
C) Steeper.
108. Which of the following statements about the efficient frontier is least accurate?
A) Portfolios falling on the efficient frontier are fully diversified.
B) The efficient frontier shows the relationship that exists between expected return and total risk in the
absence of a risk-free asset.
C) Investors will want to invest in the portfolio on the efficient frontier that offers the highest rate of
return.
109. Risk aversion means that if two assets have identical expected returns, an individual will choose the asset
with the:
A) lower risk level.
B) shorter payback period.
C) higher standard deviation.
110. A bond analyst is looking at historical returns for two bonds, Bond 1 and Bond 2. Bond 2's returns are
much more volatile than Bond 1. The variance of returns for Bond 1 is 0.012 and the variance of returns
of Bond 2 is 0.308. The correlation between the returns of the two bonds is 0.79, and the covariance is
0.048. If the variance of Bond 1 increases to 0.026 while the variance of Bond 2 decreases to 0.188 and
the covariance remains the same, the correlation between the two bonds will:
A) decrease.
B) remain the same.
C) increase.
111. Which of the following inputs is least likely required for the Markowitz efficient frontier? The:
A) expected return of all securities.
B) covariation between all securities.
C) level of risk aversion in the market.
112. In a set of portfolios, the portfolio with the highest rate of return, but the same variance of the rate of
return as the others, would be considered a(n):
A) positive alpha portfolio.

24
 B) positive beta portfolio.
C) efficient portfolio.
113. If the standard deviation of stock A is 13.2 percent, the standard deviation of stock B is 17.6 percent, and
the covariance between the two is 0, what is the correlation coefficient?
A) 0.31.
B) 0.
C) +1.
114. A line that represents the possible portfolios that combine a risky asset and a risk free asset is most
accurately described as a:
A) characteristic line.
B) capital allocation line.
C) capital market line.
115. In a two-asset portfolio, reducing the correlation between the two assets moves the efficient frontier in
which direction?
A) The efficient frontier is stable unless return expectations change. If expectations change, the efficient
frontier will extend to the upper right with little or no change in risk.
B) The frontier extends to the left, or northwest quadrant representing a reduction in risk while
maintaining or enhancing portfolio returns.
C) The efficient frontier is stable unless the asset's expected volatility changes. This depends on each
asset's standard deviation.
116. Using the following correlation matrix, which two stocks would combine to make the lowest-risk
portfolio? (Assume the stocks have equal risk and returns.)
Stock A B C
A +1 -- --
B - 0.2 +1 --
C + 0.6 - 0.1 +1
A) A and B.
B) A and C.
C) C and B.
117. A study shows that over the last 10 years, there has been a positive relationship between risk and return
on equity securities. This finding most likely supports the conclusion that market prices are predominantly
determined by investors who are:
A. Risk neutral.
B. Risk seeking.
C. Risk averse.
118. Which of the following is most likely?
A. The higher an investor’s risk tolerance, the higher the level of risk acceptable to the investor and the
lower her risk aversion.
B. The lower an investor’s risk tolerance, the lower the level of risk acceptable to the investor and the
lower her risk aversion.
C. The higher an investor’s risk tolerance, the lower the level of risk acceptable to the investor and the
higher her risk aversion.
119. The risk aversion coefficient is most likely highest for:
A. A risk-averse investor
B. A risk-seeking investor
C. A risk-neutral investor
120. Consider the following statements:
Statement 1: The risk aversion coefficient for a risk-neutral investor equals one.
Statement 2: Given a utility function, the risk-free asset offers the same level of utility to risk-averse,
risk-seeking, and risk-neutral investors.
Which of the following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.

25
 C. Both statements are incorrect.
121. Consider the following statements:
Statement 1: The lower the risk aversion coefficient, the lower the negative impact of risk on portfolio
utility.
Statement 2: The fact that indifference curves are upward sloping suggests that investors experience
diminishing marginal utility of wealth.
Which of the following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are incorrect.
122. Which of the following is most likely regarding the slope of indifference curves for risk-neutral and risk-
seeking investors respectively?
Risk-Neutral Investors Risk-Seeking Investors
A. Zero Negative
B. One Positive
C. Negative Zero
123. Consider the following statements:
Statement 1: The risk aversion coefficient and the slope of an investor’s indifference curves are
negatively related.
Statement 2: Given two indifference curves, the one that lies further to the southeast offers a lower level
of utility.
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are incorrect.
Use the following information to answer Questions 124 to 127:
An analyst gathered the following information regarding three investments:
Investment Expected Return Standard Deviation
Investment A 11% 18%
Investment B 18% 24%
Investment C 14% 22%
Investment D 22% 29%
Utility formula:
U = E(R)–(1/2 × A σ 2)
124. A risk-averse investor with a risk aversion coefficient of 4 will most likely choose:
A. Investment A.
B. Investment B.
C. Investment D.
125. A risk-averse investor with a risk aversion coefficient of 6 will most likely choose:
A. Investment A.
B. Investment C.
C. Investment D.
126. A risk-neutral investor will most likely choose:
A. Investment B.
B. Investment C.
C. Investment D.
127. A risk-loving investor will most likely choose:
A. Investment A.
B. Investment B.
C. Investment D.
128. The dependent and independent variable in the capital allocation line equation are most likely:
Dependent Variable Independent Variable
A. Expected return Total risk

26
 B. Total risk Market risk premium
C. Expected return Market risk premium
129. If an indifference curve intersects the investor’s capital allocation line at two different points it is most
likely that:
A. The investor is not maximizing her total utility.
B. The higher of the two points offers a higher level of utility.
C. The portfolios are leveraged portfolios.
130. Consider the following statements:
Statement 1: At a given level of risk, the indifference curve for a more risk-seeking investor would have
a greater slope than that of a less risk-seeking investor.
Statement 2: The optimal portfolio for a more risk-averse investor would lie above and to the right of the
optimal portfolio for a less risk-averse investor.
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are incorrect.
131. A two-asset portfolio’s standard deviation is minimized when the correlation between the two assets
equals:
A. +1
B. Zero
C. −1
132. Consider the following statements:
Statement 1: At a given level of risk, the indifference curve for a more risk-seeking investor would have
a greater slope than that of a less risk-seeking investor.
Statement 2: The optimal portfolio for a more risk-averse investor would lie above and to the right of the
optimal portfolio for a less risk-averse investor.
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are incorrect.
133. An investor’s investment opportunity set most likely consists of:
A. Individual assets only.
B. Individual assets and portfolios.
C. Portfolios only.
134. The minimum variance frontier most likely consists of:
A. Individual assets only.
B. Portfolios only.
C. Individual assets and portfolios.
135. Consider the following statements:
Statement 1: The risk-return characteristics of portfolios that combine the risk-free asset with a risky
asset or a portfolio of risky assets lie along a straight line.
Statement 2: All other things remaining the same, the greater the slope of the capital allocation line, the
better the risk-return characteristics of portfolios that lie on it.
Which of the following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are correct.
136. The decision regarding which point along her CAL an investor selects as her portfolio is known as her:
A. Investing decision.
B. Operating decision.
C. Financing decision.
Use the following information to answer Questions 137 and 138:
Alicia invested 30% of her funds in Asset A (standard deviation = 12%). She then invested the rest of her
funds in Asset B whose variance was estimated to be 0.02.
137. Compute her portfolio’s standard deviation, if the correlation between the two assets equals 0.7.
A. 8.05%

27
 B. 12.68%
C. 7.06%
138. Compute her portfolio’s standard deviation, if the covariance between the two assets equals 0.014.
A. 13.03%
B. 10.58%
C. 8.59%
139. The indifference curve of a relatively aggressive investor will be:
A. Upward sloping and relatively flat.
B. Downward sloping and relatively steep.
C. Upward sloping and relatively steep.
140. Consider the following statements:
Statement 1: Risk-averse investors will only take on more risk if they are compensated for the additional
risk in the form of higher expected return.
Statement 2: Risk-averse investors prefer higher risk to lower risk for a given level of expected returns.
Which of the following is most likely?
A. Only one statement is correct.
B. Both statements are incorrect.
C. Both statements are correct.
141. Which of the following statements regarding the indifference curves is least accurate?
A. Their slope decreases as more risk is taken.
B. A less risk-averse investor would have a flatter indifference curve.
C. They are upward sloping.
142. An investor will be indifferent between two investments with:
A. Different expected returns, if the investment with the lower expected return entails a lower level of
risk.
B. The same expected returns, if the investments have different levels of risk.
C. Different expected returns, if the investment with the higher expected return entails a lower level of
risk.
143. Susan has a portfolio whose standard deviation is estimated to be 11.68%. She is thinking of adding
another asset to her portfolio whose standard deviation of returns is the same as her existing portfolio, but
has a correlation coefficient with the existing portfolio of 0.65. If she adds the new asset to her portfolio,
the standard deviation of the new portfolio will be:
A. Equal to 11.68%.
B. Less than 11.68%.
C. More than 11.68%.
144. Juan wants to invest in a portfolio consisting of two risky assets, A and B. He gathered the following
information:
Standard deviation of returns of asset A = 2.03%
Standard deviation of returns of asset B = 3.55%
Given that 35% of the funds are invested in asset A and the rest in asset B, the maximum risk of this
portfolio as measured by its standard deviation is closest to:
A. 1.597%
B. 3.018%
C. 2.414%
145. Consider the following statements:
Statement 1: Maximum diversification benefits occur when the correlation coefficient equals +1.
Statement 2: If the correlation coefficient between assets is negative, portfolio standard deviation is
greater than when correlation coefficient equals zero.
Which of the following is most likely?
A. Only one statement is correct.
B. Both statements are incorrect.
C. Both statements are correct.
146. A conservative investor wants to diversify his current portfolio of investments by investing in a high-
risk, high-return asset. However, he also wants to reduce his overall risk. Which of the following

28
 correlation of returns between those on his new investment and his original portfolio offers the lowest
risk?
A. 0.354
B. −0.567
C. −0.242
147. An analyst gathered the following information regarding three portfolios. Which portfolio is most likely
to plot below the Markowitz efficient frontier?
Portfolio Expected Return Standard Deviation
A 8% 13%
B 15% 16%
C 11% 20%
148. Consider the following statements:
Statement 1: As correlation falls, the curvature of the line between the two assets’ risk-return profiles
decreases.
Statement 2: The expected return of the portfolio decreases as the correlation coefficient of the two assets
decreases.
Which of the following is most likely?
A. Only one statement is correct.
B. Both statements are incorrect.
C. Both statements are correct.
149. Which of the following statements is least accurate?
A. An optimal portfolio for an investor occurs where the indifference curve is tangent to the efficient
frontier.
B. The efficient frontier represents a set of portfolios that have the maximum expected risk for every
given level of expected return.
C. The slope of the indifference curve represents the amount of extra return required by the investor to
take on an additional unit of risk.
150. Which of the following statements is untrue regarding arithmetic and geometric return calculations?
A. The arithmetic return is a simple average of all holding period returns.
B. The geometric return basically represents a buy-and-hold strategy.
C. The arithmetic return will always be lower than the geometric return.
151. Which of the following risk factors comprises the bulk of risk for a fully diversified portfolio?
A. Variance
B. Standard deviation
C. Covariance
152. If Suzanne allocated to two different asset classes, each of which had a standard deviation of 20% and a
correlation 0.9, what would her portfolio standard deviation be?
A. 20%
B. Higher than 20%
C. Lower than 20%

29
 SOLUTIONS
1. C is correct. −10.1% is the holding period return, which is calculated as: (3,050 − 3,450 + 51.55)/3,450,
which is comprised of a dividend yield of 1.49% = 51.55/(3,450) and a capital loss yield of −11.59% = –
400/(3,450).
2. B is correct. [(1 + 0.14)(1 − 0.10)(1 − 0.02)] – 1 = 0.0055 = 0.55%.
3. A is correct. [(1 + 0.22)(1 − 0.25)(1 + 0.11)] (1/3) − 1 = 1.0157(1/3) − 1 = 0.0052 = 0.52%
4. A is correct. The geometric mean return compounds the returns instead of the amount invested.
5. B is correct. The annualized rate of return for ETF 2 is 12.05% = (1.0110 52/5) − 1, which is greater than
the annualized rate of ETF 1, 11.93% = (1.0461 365/146) − 1, and ETF 3, 11.32% = (1.1435 12/15) − 1.
Despite having the lowest value for the periodic rate, ETF 2 has the highest annualized rate of return
because of the reinvestment rate assumption and the compounding of the periodic rate.
6. A is correct. The asset’s returns are not used to calculate the portfolio’s variance [only the assets’ weights,
standard deviations (or variances), and covariances (or correlations) are used].
7. C is correct.
σ port=w21σ21+w22σ22+2w1w2ρ1,2σ1σ2=(0.3)2(20%)2+(0.7)2(12%)2+2(0.3)(0.7)(0.40)(20%)(12%)=(0
.3600%+0.7056%+0.4032%)0.5=(1.4688%)0.5=12.11%.
2 2 2 2
σ port = w σ + w σ + 2w 1w 2ρ1 ,2 σ1σ2
1 1 2 2
2 2 2 2
= (0.3) (20%) + (0.7) (12%) + 2(0.3)(0.7)(0.40)(20%)(12%)
0.5 0.5
= (0.3600% + 0.7056% + 0.4032%) = (1.4688%) = 12.11%.
8. A is correct.
σ port=w21σ21+w22σ22+2w1w2Cov(R1R2)=(0.3)2(20%)2+(0.7)2(12%)2+2(0.3)(0.7)(−0.0240)=(0.3600
%+0.7056%−1.008%)0.5=(0.0576%)0.5=2.40%.
2 2 2 2
σ port = w σ + w σ + 2w 1w 2Cov(R 1R 2 )
1 1 2 2
2 2 2 2
= (0.3) (20%) + (0.7) (12%) + 2(0.3)(0.7)(-0.0240)
0.5 0.5
= (0.3600% + 0.7056% - 1.008%) = (0.0576%) = 2.40%.
9. C is correct. A portfolio standard deviation of 14.40% is the weighted average, which is possible only if
the correlation between the securities is equal to 1.0.
10. B is correct. A portfolio standard deviation of 14.40% is the weighted average, which is possible only if
the correlation between the securities is equal to 1.0. If the correlation coefficient is equal to 1.0, then the
covariance must equal 0.0240, calculated as: Cov(R1,R2) = ρ12σ1σ2 = (1.0)(20%)(12%) = 2.40% = 0.0240.
11. B is correct. (1 + 0.080)/(1 + 0.0210) = 5.8%
12. A is correct. (1 + 0.065)/(1 + 0.0210) = 4.3%
13. A is correct. (1 + 0.080)/(1 + 0.0250) = 5.4%
14. B is correct. (1 + 0.0650)/(1 + 0.0250) = 3.9%
15. C is correct. Brokerage commissions are negotiated with the brokerage firm. A security’s liquidity
impacts the operational efficiency of trading costs. Specifically, liquidity impacts the bid–ask spread and
can impact the stock price (if the ability to sell the stock is impaired by the uncertainty associated with
being able to sell the stock).
16. C is correct. Historical data over long periods of time indicate that there exists a positive risk–return
relationship, which is a reflection of an investor’s risk aversion.
17. A is correct. A risk-free asset has a variance of zero and is not dependent on whether the investor is risk
neutral, risk seeking or risk averse. That is, given that the utility function of an investment is expressed as
1
U=E(r)−12Aσ2 , U = E(r) - Aσ 2
2
where A is the measure of risk aversion, then the sign of A is irrelevant if the variance is zero (like that of
a risk-free asset).

30
18. C is correct. The most risk-averse investor has the indifference curve with the greatest slope.
19. A is correct. A negative value in the given utility function indicates that the investor is a risk seeker.
20. C is correct. Investment 3 has the highest rate of return. Risk is irrelevant to a risk-neutral investor, who
would have a measure of risk aversion equal to 0. Given the utility function, the risk-neutral investor
would obtain the greatest amount of utility from Investment 3.
Expected Expected Utility
Investment Return (%) Standard Deviation (%) A = 0
1 18 2 0.1800
2 19 8 0.1900
3 20 15 0.2000
4 18 30 0.1800
21. C is correct. Investment 4 provides the highest utility value (0.2700) for a risk-seeking investor, who has a
measure of risk aversion equal to −2.
Expected Expected Utility
Investment Return (%) Standard Deviation (%) A = –2
1 18 2 0.1804
2 19 8 0.1964
3 20 15 0.2225
4 18 30 0.2700
22. B is correct. Investment 2 provides the highest utility value (0.1836) for a risk-averse investor who has a
measure of risk aversion equal to 2.
Expected Expected Utility
Investment Return (%) Standard Deviation (%) A=2
1 18 2 0.1796
2 19 8 0.1836
3 20 15 0.1775
4 18 30 0.0900
23. A is correct. Investment 1 provides the highest utility value (0.1792) for a risk-averse investor who has a
measure of risk aversion equal to 4.
Expected Expected Utility
Investment Return (%) Standard Deviation (%) A=4
1 18 2 0.1792
2 19 8 0.1772
3 20 15 0.1550
4 18 30 0.0000
24. A is correct. The CAL is the combination of the risk-free asset with zero risk and the portfolio of all risky
assets that provides for the set of feasible investments. Allowing for borrowing at the risk-free rate and
investing in the portfolio of all risky assets provides for attainable portfolios that dominate risky assets
below the CAL.
25. B is correct. The CAL represents the set of all feasible investments. Each investor’s indifference curve
determines the optimal combination of the risk-free asset and the portfolio of all risky assets, which must
lie on the CAL.
26. C is correct.
Rp=w1×R1+(1−w1)×R2Rp=w1×16%+(1−w1)×12%15%=0.75(16%)+0.25(12%)
R p = w1 × R1 + (1 - w1 )× R 2

R p = w1 ×16% + (1 - w 1 )×12%

15% = 0.75(16%) + 0.25(12%)

31
27. A is correct.
σport=w21σ21+w22σ22+2w1w2ρ1,2σ1σ2=(0.5)2(20%)2+(0.5)2(20%)2+2(0.5)(0.5)(−0.15)(20%)(20%)=(
1.0000%+1.0000%−0.3000%)0.5=(1.7000%)0.5=13.04%
2 2 2 2
σ port = w σ + w σ + 2w 1w 2ρ1 ,2 σ1σ2
1 1 2 2
2 2 2 2
= (0.5) (20%) + (0.5) (20%) + 2(0.5)(0.5)(-0.15)(20%)(20%)
0.5 0.5
= (1.0000% + 1.0000% - 0.3000%) = (1.7000%) = 13.04%
28. B is correct.
σport=w21σ21+w22σ22+2w1w2ρ1,2σ1σ2=(0.5)2(20%)2+(0.5)2(20%)2+2(0.5)(0.5)(0.00)(20%)(20%)=(1.
0000%+1.0000%+0.0000%)0.5=(2.0000%)0.5=14.14%
2 2 2 2
σ port = w σ + w σ + 2w 1w 2ρ1 ,2 σ1σ2
1 1 2 2
2 2 2 2
= (0.5) (20%) + (0.5) (20%) + 2(0.5)(0.5)(0.00)(20%)(20%)
0.5 0.5
= (1.0000% + 1.0000% + 0.0000%) = (2.0000%) = 14.14%
29. B is correct. The contribution of each individual asset’s variance (or standard deviation) to the portfolio’s
volatility decreases as the number of assets in the equally weighted portfolio increases. The contribution
of the co-movement measures between the assets increases (i.e., covariance and correlation) as the
number of assets in the equally weighted portfolio increases. The following equation for the variance of
an equally weighted portfolio illustrates these points:σ2p=σ¯2N+N−1NCOV¯=σ¯2N+N−1Nρ¯ σ¯2 .
2 2
2 σ N -1 σ N -1 2
σ = + COV = + ρσ
p N N N N
30. C is correct. The co-movement measures between the assets increases (i.e., covariance and correlation) as
the number of assets in the equally weighted portfolio increases. The contribution of each individual
asset’s variance (or standard deviation) to the portfolio’s volatility decreases as the number of assets in the
equally weighted portfolio increases. The following equation for the variance of an equally weighted
portfolio illustrates these points:
σ2p=σ¯2N+N−1NCOV¯=σ¯2N+N−1Nρ¯ σ¯2
2 2
2 σ N -1 σ N -1 2
σ = + COV = + ρσ
p N N N N
31. A is correct. Higher correlations will produce less diversification benefits provided that the other
components of the portfolio standard deviation do not change (i.e., the weights and standard deviations of
the individual assets).
32. C is correct. Asset 2 and Asset 3 have returns that are the same for Outcome 2, but the exact opposite
returns for Outcome 1 and Outcome 3; therefore, because they move in opposite directions at the same
magnitude, they are perfectly negatively correlated.
33. C is correct. An equally weighted portfolio of Asset 2 and Asset 3 will have the lowest portfolio standard
deviation, because for each outcome, the portfolio has the same expected return (they are perfectly
negatively correlated).
34. A is correct. An equally weighted portfolio of Asset 1 and Asset 2 has the highest level of volatility of the
three pairs. All three pairs have the same expected return; however, the portfolio of Asset 1 and Asset 2
provides the least amount of risk reduction.
35. C is correct. The minimum-variance frontier does not account for the risk-free rate. The minimum-
variance frontier is the set of all attainable risky assets with the highest expected return for a given level of
risk or the lowest amount of risk for a given level of return.
36. C is correct. The global minimum-variance portfolio is the portfolio on the minimum-variance frontier
with the lowest standard deviation. Although the portfolio is attainable, when the risk-free asset is
considered, the global minimum-variance portfolio is not the optimal risky portfolio.

32
37. B is correct. The Markowitz efficient frontier has higher rates of return for a given level of risk. With
respect to the minimum-variance portfolio, the Markowitz efficient frontier is the set of portfolios above
the global minimum-variance portfolio that dominates the portfolios below the global minimum-variance
portfolio.
38. A is correct. The use of leverage and the combination of a risk-free asset and the optimal risky asset will
dominate the efficient frontier of risky assets (the Markowitz efficient frontier).
39. B is correct. The CAL dominates the efficient frontier at all points except for the optimal risky portfolio.
The ability of the investor to purchase additional amounts of the optimal risky portfolio by borrowing
(i.e., buying on margin) at the risk-free rate makes higher rates of return for levels of risk greater than the
optimal risky asset possible.
40. C is correct. Each individual investor’s optimal mix of the risk-free asset and the optimal risky asset is
determined by the investor’s risk preference.
41. C Using the cash flow functions on your financial calculator, enter CFO = -40; CF1 = -50 + 1 = -49; CF2
= 60 x 2 + 2 = 122; CPT IRR = 23.82%.
42. A Small-cap stocks have had the highest annual return and standard deviation of return over time. Large-
cap stocks and bonds have historically had lower risk and return than small-cap stocks.
43. B Mean annual return = (5% - 3% - 4% + 2% + 6%) / 5 = 1.2% Squared deviations from the mean:
5% - 1.2% = 3.8% 3.82 = 14.44
-3% -1.2% = -4.2% -4.22 = 17.64
-4% -1.2% = -5.2% -5.22 = 27.04
2% -1.2% = 0.8% 0.82 = 0.64
6% -1.2% = 4.8% 4.82 = 23.04
Sum of squared deviations = 14.44 + 17.64 + 27.04 + 0.64 + 23.04 = 82.8
Sample variance = 82.8 / (5 - 1) = 20.7
Sample standard deviation = 20.7112= 4.55%
44. B The covariance is defined as the co-movement of the returns of two assets or how well the returns of
two risky assets move together. Range and standard deviation are measures of dispersion and measure
risk, not how assets move together.
45. B A zero-variance portfolio can only be constructed if the correlation coefficient between assets is -1.
Diversification benefits can be had when correlation is less than +1, and the lower the correlation, the
greater the potential benefit.
46. A
A = 0.09 = 0.30
B = 0.04 = 0.20
Correlation = 0.006/ [(0.30)(0.20)] = 0.10
47. B Risk-averse investors are generally willing to invest in risky investments, if the return of the investment
is sufficient to reward the investor for taking on this risk. Participants in securities markets are generally
assumed to be risk-averse investors.
48. A
2 2 2 2
 0.25  0.15    0.75   0.10   2  0.25  0.75  0.15  0.10  0.75  
0.001406  0.005625  0.004219  0.01125  0.106  10.6%
49. C
2 2 2 2
 0.25  0.15   0.75   0.10   2  0.25  0.75  0.15  0.10  0.75 

0.001406  0.005625  0.004219  0.002812  0.053  5.3%

50. B If the correlation of returns between the two assets is -1, the set of possible portfolio risk/return
combinations becomes two straight lines (see Figure 2). A portfolio of these two assets will have a
positive returns variance unless the portfolio weights are those that minimize the portfolio variance.
Covariance is equal to the correlation coefficient multiplied by the product of the standard deviations of
the returns of the two stocks in a 2-stock portfolio. If covariance is zero, then correlation is also zero,
which implies that there is no linear relationship between the two stocks' returns.

33
51. B Portfolio B must be the portfolio that falls below the Markowitz efficient frontier because there is a
portfolio (Portfolio C) that offers a higher return and lower risk.
52. B An investor's optimal portfolio will lie somewhere on the capital allocation line, which begins at the
risk-free asset and runs through the optimal risky portfolio.
53. Answer C
1/2
σ portfolio =  W12σ12 + W22σ 22 + 2W1W2σ1σ 2r1,2  given r1,2 = +1
 
1/2 1/2
 2
σ =  W12σ12 + W22σ 22 + 2W1W2σ1σ 2 
  
=  W1σ1 + W2σ 2 
 

 
σ = W1σ1 + W2σ 2 =  0.3 0.3 +  0.7  0.4  = 0.09 + 0.28 = 0.37
54. Answer C
The optimal portfolio in the Markowitz framework occurs when the investor achieves the diversified
portfolio with the highest utility.
55. Answer B
If the correlation coefficient is less than 1, there are benefits to diversification. Thus, adding the stock will
reduce the portfolio's standard deviation.
56. Answer B
There are benefits to diversification as long as the correlation coefficient between the assets is less than 1.
57. Answer A
First, calculate the correlation coefficient to check whether diversification will provide any benefit.
rBridgeport, Rockaway = covBridgeport, Rockaway / [( sBridgeport) × (sRockaway) ] = 0.0325 / (0.13 ×
0.25) = 1.00
Since the stocks are perfectly positively correlated, there are no diversification benefits and we select the
stock with the lowest risk (as measured by variance or standard deviation), which is Bridgeport.
58. Answer A
The optimal portfolio for an investor is determined as the point where the investor's highest utility curve is
tangent to the efficient frontier.
59. Answer B
This statement is incorrect because it does not specify that risk must also be considered.
60. Answer A
The formula is: (correlation)(standard deviation of A)(standard deviation of B) = (0.20)(0.122)(0.089) =
0.0022.
61. Answer C
CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x
Then, (rA,B) = CovA,B / (SDA × SDB) = 0.0105 / (0.10 × 0.15) = 0.700
62. Answer C
CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x
Then, (rA,B) = CovA,B / (SDA × SDB) = 0.007 / (0.400 × 0.300) = 0.0583
63. Answer A
Risk aversion is best defined as: given a choice between two assets of equal return, the investor will
choose the asset with the least risk. The investor will not always choose the asset with the least risk or the
asset with the least risk and least return. As well, there is a positive, not indirect, relationship between risk
and return.
64. Answer B
Since the stocks are perfectly correlated, there is no benefit from diversification. So, invest in the stock
with the lowest risk.
65. Answer A
Portfolio C cannot lie on the frontier because it has the same return as Portfolio D, but has more risk.
66. Answer B
CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x
Then, (rA,B) = CovA,B / (SDA × SDB) = 0.008 / (0.100 × 0.200) = 0.40
Remember: The correlation coefficient must be between -1 and 1.

34
67. Answer B
Adding any stock that is not perfectly correlated with the portfolio (+1) will reduce the risk of the
portfolio.
68. Answer B
Portfolio B is inefficient (falls below the efficient frontier) because for the same risk level (8.7%), you
could have portfolio C with a higher expected return (15.1% versus 14.2%).
69. Answer A
This is a correct description of positive covariance.
If one stock doubles in price, the other will also double in price is true if the correlation coefficient = 1.
The two stocks need not be in the same industry.
70. Answer B
A real return is adjusted for the effects of inflation and is used to measure the increase in purchasing
power over time.
71. Answer A
Investor X has a steep indifference curve, indicating that he is risk-averse. Flatter indifference curves,
such as those for Investor Y, indicate a less risk-averse investor. The other choices are true. A more risk-
averse investor will likely obtain lower returns than a less risk-averse investor.
72. Answer A
The variance of the portfolio is found by:
 W 2σ 2 + W 2σ 2 + 2W W σ σ r  , or 0.15 2 0.0071  + 0.85 2 0.0008  + 2 0. 15  0.85  0.0843 0.0283 -0.04   = 0.0007
 1 1 2 2 1 2 1 2 1,2   
73. Answer C
The formula is: (Covariance of A and B) / [(Standard deviation of A)(Standard Deviation of B)] =
(Correlation Coefficient of A and B) = (0.015476) / [(0.106)(0.146)] = 1.
74. Answer B
Geometric mean return (time-weighted return) is the most appropriate method for performance
measurement as it does not consider additions to or withdrawals from the account.
75. Answer B
This statement should read, "If two assets have perfect negative correlation, it is possible to reduce the
portfolio's overall variance to zero."
76. Answer A
A correlation coefficient of zero means that there is no relationship between the stock's returns. The other
statements are true.
77. Answer C
The portfolio standard deviation = [(0.4)2(0.25) + (0.6)2(0.4) + 2(0.4)(0.6)1(0.25)0.5(0.4)0.5]0.5 = 0.5795
78. Answer A
Using the financial calculator, the initial investment (CF0) is -100,000. The income is +5,000 (CF1), and
the contribution is -25,000 (CF2). Finally, the ending value is +123,000 (CF3) available to the investor.
Compute IRR = 0.94
79. Answer B
Given two investments with the same expected return, a risk averse investor will prefer the investment
with less risk. A risk neutral investor will be indifferent between the two investments. A risk seeking
investor will prefer the investment with more risk.
80. Answer B
The calculations are as follows:
Portfolio J covariance = cov1,2 = (r1,2) × (s1) × (s2) = 0.75 × 0.08 × 0.18 = 0.0108, or 0.011.
Portfolio K correlation coefficient = (r1,2) = cov1,2 / [ (s1) × (s2) ] = 0.02 / (0.20 × 0.12) = 0.833.
Portfolio L correlation coefficient = (r1,2) = cov1,2 / [ (s1) × (s2)1/2 ] = 0.003 / (0.18 × 0.091/2) = 0.003
/ (0.18 × 0.30) = 0.056.
81. Answer B
Perfect positive correlation (r = +1) of the returns of two assets offers no risk reduction, whereas perfect
negative correlation (r = -1) offers the greatest risk reduction.
82. Answer B
The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient
frontier. The optimal portfolio is the portfolio that gives the investor the greatest possible utility.

35
83. Answer A
Based on data for securities in the United States from 1926 to 2008, Treasury bills exhibited a lower
standard deviation of monthly returns than both large-cap stocks and long-term corporate bonds.
84. Answer B
Geometric Mean Return = 3
1  0.06 1  0.37 1  0.27  - 1 = −5.34% Holding period return = (1 +
0.06)(1 − 0.37)(1 + 0.27) − 1 = −15.2%
Arithmetic mean return = (6% − 37% + 27%) / 3 = −1.33%.
85. Answer A
Negative covariance means rates of return will tend to move in opposite directions on average. For the
returns to always move in opposite directions, they would have to be perfectly negatively correlated.
Negative covariance by itself does not imply anything about the strength of the negative correlation.
86. Answer B
Covariance = {Σ[(ReturnX − MeanX)(ReturnY − MeanY)]} / (n − 1) MeanX = (7 + 9 + 10 + 10) / 4 = 9;
MeanY = (5 + 8 + 11 + 8) / 4 = 8
CovX,Y = [(7 − 9)(5 − 8) + (9 − 9)(8 − 8) + (10 − 9)(11 − 8) + (10 − 9)(8 − 8)] / (4 − 1) = 3.0
87. Answer A
(0.40)2 (0.18)2 + (0.60)2(0.24)2 + 2(0.4)(0.6)(0.18)(0.24)(0.6) = 0.03836.
0.038360 .5 = 0.1959 or 19.59%.
88. Answer C
The efficient set is the set of portfolios that dominate all other portfolios as to risk and return. That is, they
have highest expected return at each level of risk.
89. Answer A
The formula is: (Covariance of A and B)/[(Standard deviation of A)(Standard Deviation of B)] =
(Correlation Coefficient of A and B) = (-0.0031)/[(0.072)(0.054)] = -0.797.
90. Answer C
In portfolio composition questions, return and standard deviation are the key variables. Here you are told
that both returns and standard deviations are equal. Thus, you just want to pick the companies with the
lowest covariance, because that would mean you picked the ones with the lowest correlation coefficient.
1/ 2
σ portfolio =  W12 σ12 + W22 σ 22 + 2W1W2σ1σ 2 r1,2  where σ Randy = YBranton   XYZ so you want to pick the
lowest covariance which is between Randy and Branton.
91. Answer C
The formula for the covariance for historical data is:
cov1,2 = {Σ[(Rstock A − Mean RA)(Rstock B − Mean RB)]} / (n − 1) Mean RA = (10 + 6 + 8) / 3 = 8,
Mean RB = (15 + 9 + 12) / 3 = 12
Here, cov1,2 = [(10 − 8)(15 − 12) + (6 − 8)(9 − 12) + (8 − 8)(12 − 12)] / 2 = 6
92. Answer A
Portfolio B is not on the efficient frontier because it has a lower return, but higher risk, than Portfolio D.
93. Answer A
The other statements are false. The lower the correlation coefficient; the greater the potential for
diversification. Efficient portfolios lie on the efficient frontier.
94. Answer B
Because there is a perfectly positive correlation, there is no benefit to diversification. Therefore, the
investor should put all his money into Stock A (with the lowest standard deviation) to minimize the risk
(standard deviation) of the portfolio.
95. Answer C
Portfolio B has a lower expected return than Portfolio C with a higher standard deviation.
96. Answer C
cov1,2 = 0.75 × 0.16 × 0.22 = 0.0264 = covariance between A and B.
97. Answer A
Risk aversion implies that an investor will not assume risk unless compensated.
98. Answer A
Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will
always select the asset with the lowest level of risk. This means that there is a positive relationship

36
 between expected returns (ER) and expected risk (Es) and the risk return line (capital market line [CML]
and security market line [SML]) is upward sweeping.
99. Answer A
When the return on an asset added to a portfolio has a correlation coefficient of less than one with the
other portfolio asset returns but has the same risk, adding the asset will decrease the overall portfolio
standard deviation. Any time the correlation coefficient is less than one, there are benefits from
diversification. The other choices are true.
100. Answer B
In most markets and for most asset classes, higher average returns have historically been associated with
higher risk (standard deviation of returns).

101. Answer C
Portfolio Z must be inefficient because its risk is higher than Portfolio Y and its expected return is lower
than Portfolio Y.
102. Answer C
CovJ,K = (rJ,K)(SDJ)(SDK), where r = correlation coefficient and SDx = standard deviation of stock x
Then, (rJ,K) = CovJ,K / (SDJ × SDK) = 0.025 / (0.25 × 0.30) = 0.333
103. Answer A
Risk aversion means that to accept greater risk, an investor must be compensated with a higher expected
return. For the three portfolios given, higher risk is associated with higher expected return. Therefore a
risk-averse investor may select any of these portfolios. A risk-averse investor will not select a portfolio if
another portfolio offers a higher expected return with the same risk, or lower risk with the same expected
return.
104. Answer B
The formula for calculating the variance of a two-asset portfolio is:
σ 2P = WA2 σ 2A + WB2 σ B2 + 2WA WBCov  a, b 
105. Answer A
The net return on a portfolio is its gross return minus management and administrative fees. A return
adjusted for taxes is called an after-tax return. A return adjusted for inflation is called a real return.
106. Answer A
The most efficient portfolio will be the one that lies on the efficient frontier. It will offer the highest
expected return at a given level of risk compared to all other possible portfolios.
107. Answer B
Investors who are less risk averse will have flatter indifference curves, meaning they are willing to take on
more risk for a slightly higher return. Investors who are more risk averse require a much higher return to
accept more risk, producing steeper indifference curves.
108. Answer C
The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient
frontier.
109. Answer A
Investors are risk averse. Given a choice between assets with equal rates of expected return, the investor
will always select the asset with the lowest level of risk. This means that there is a positive relationship
between expected returns (ER) and expected risk (Es) and the risk return line (capital market line [CML]
and security market line [SML]) is upward sloping.Standard deviation is a way to quantify risk. The
payback period is used to evaluate capital projects, not investment returns.
110. Answer A
P1,2 = 0.048/(0.0260.5 × 0.1880.5) = 0.69 which is lower than the original 0.79.
111. Answer C
The level of risk aversion in the market is not a required input. The model requires that investors know the
expected return and variance of each security as well as the covariance between all securities.
112. Answer C
The efficient frontier, which represents the set of portfolios that provides the highest return at each level
of risk, is comprised of efficient portfolios. The optimal portfolio for each investor is the point on the
highest indifference curve that is tangent to the efficient frontier.

37
113. Answer B
Since covariance is zero, the correlation coefficient must be zero.
114. Answer B
The line that represents possible combinations of a risky asset and the risk-free asset is referred to as a
capital allocation line (CAL). The capital market line (CML) represents possible combinations of the
market portfolio with the risk-free asset. A characteristic line is the best fitting linear relationship between
excess returns on an asset and excess returns on the market and is used to estimate an asset's beta.
115. Answer B
Reducing correlation between the two assets results in the efficient frontier expanding to the left and
possibly slightly upward. This reflects the influence of correlation on reducing portfolio risk.
116. Answer A
Portfolios A and B have the lowest correlation coefficient and will thus create the lowest-risk portfolio.
1/2
The standard deviation of a portfolio =  W12σ 12 + W22σ 22 + 2W1W2σ 1σ 2r1,2 
The correlation coefficient, r1,2, varies from + 1 to - 1. The smaller the correlation coefficient, the smaller
σportfolio can be. If the correlation coefficient were - 1, it would be possible to make σportfolio go to
zero by picking the proper weightings of W1 and W2.
117. Answer: C
Historically, there has been a positive relationship between risk and return, which suggests that market
prices are primarily determined by investors who are predominantly risk averse.
118. Answer: A
The greater the level of risk an investor can tolerate, the higher the level of risk she would be willing to
take in her portfolio and the lower her aversion to risk.
119. Answer: A
The risk aversion coefficient is higher for investors who are more risk averse, as additional risk reduces
the total utility they derive from their portfolios.
120. Answer: B
The risk aversion coefficient for a risk-neutral investor equals zero, as her level of utility is unrelated to
the risk inherent in her portfolio.
The risk-free asset has zero risk so it offers the same level of utility to all investors.
121. Answer: A
Statement 1 is correct. A lower risk aversion coefficient means that the effect of risk on portfolio utility
will be lower.
The fact that indifference curves are curved suggests that investors exhibit diminishing marginal utility of
wealth. As more risk is added to the portfolio, the increase in return required increases at an increasing
rate. The upward slope of indifference curve tells us that investors are risk averse—in order to be
indifferent between two portfolios with different levels of risk, the high risk portfolio must offer a higher
return as well.
122. Answer: A
Risk-neutral investors have perfectly horizontal indifference curves, while risk-seeking investors have
downward-sloping or negatively sloped indifference curves.
123. Answer: B
The risk aversion coefficient and the slope of the investor’s indifference curve are positively related. For
example, a risk-seeking investor has a negative risk aversion coefficient and a negatively sloped
indifference curve.
The indifference curve furthest to the northwest offers the highest level of utility.
124. Answer: B
Investments Expected Return Standard Deviation Utility at A = 4
Investment A 11% 18% 0.0452
Investment B 18% 24% 0.0648
Investment C 14% 22% 0.0432
Investment D 22% 29% 0.0518
Therefore, an investor with a risk aversion coefficient of 4 will choose Investment B.

38
125. Answer: A
Investments Expected Return Standard Deviation Utility at A = 6
Investment A 11% 18% 0.0128
Investment B 18% 24% 0.0072
Investment C 14% 22% −0.0052
Investment D 22% 29% −0.0323
Therefore, an investor with a risk aversion coefficient of 4 will choose Investment A.
126. Answer: C
A risk-neutral investor’s risk aversion coefficient is 0. She wants the highest return possible and therefore,
will choose Investment D.
127. Answer: C
A risk-loving investor likes both higher risk and higher return. Therefore, she will choose Investment D.
128. Answer: A
The CAL has expected return on the y-axis and portfolio risk on the x-axis.
129. Answer: A
An investor maximizes her utility when her indifference curve is tangent to the CAL. If the indifference
curve intersects the CAL at two different points, an investor can optimize her utility by moving to an
indifference curve that lies further north-west.
All points on a given indifference curve offer the same level of utility.
It is not necessary for the portfolios to be leveraged portfolios.
130. Answer: C
A more risk-seeking (aggressive) investor’s indifference curve would be less steep (have a lower slope) as
he does not require as much of an additional return to take more risk.
The optimal portfolio for a more risk-averse (conservative) investor would lie below and to the left of the
optimal portfolio for a less risk-averse (aggressive) investor.
131. Answer: C
Portfolio standard deviation is minimized when the correlation between the two assets equals −1.
132. Answer: C
At a given level of risk, the indifference curve for a more risk-seeking investor would be flatter than that
of a less risk-seeking investor.
The optimal portfolio for a more risk-averse investor would lie above and to the left of the optimal
portfolio for a less risk-averse investor.
133. Answer: B
The IOS consists of individual securities and portfolios that can be formed by combining those individual
securities.
134. Answer: B
Assets with low correlations can be combined into portfolios that have a lower risk than any of the
individual assets in the portfolio. The minimum variance frontier consists of portfolios that minimize the
level of risk for each level of expected return.
135. Answer: C
The risk-return characteristics of portfolios that combine the risk-free asset with a risky asset or a portfolio
of risky assets lie along a straight line as the correlation between the risk-free asset and any risky asset
equals zero. All capital allocation lines have a constant gradient or slope.
Portfolios on capital allocation lines with a steeper positive slope dominate all portfolios that lie on CALs
with a lower slope (that lie below it).
136. Answer: C
Which portfolio along the CAL an investor chooses to invest in is her financing decision (how much she
wants to invest at or borrow at the risk-free rate).
137. Answer: B
[(0.32 × 0.122) + (0.72 × 0.02) + 2 (0.3) (0.7) (0.12) (0.1414) (0.7)] 0.5 = 12.68%
138. Answer: A
[(0.32 × 0.122) + (0.72 × 0.02) + 2 (0.3) (0.7) (0.014)] 0.5 = 13.03%
139. Answer: A

39
 A less risk-averse or aggressive investor would require lower additional return as compensation for
bearing addition risk. Therefore, her indifference curve will be relatively flat.
140. Answer: A
Only Statement 1 is correct.
Risk-averse investors prefer lower risk to higher risk for a given level of expected returns.
141. Answer: A
The slope of an indifference curve becomes steeper as more risk is taken.
142. Answer: A
An investor will be indifferent between two investments with different expected returns only if the
investment with the lower expected return entails a lower level of risk.
143. Answer: B
Whenever the correlation coefficient is less than +1, diversification benefits occur and reduce the overall
standard deviation of the portfolio.
144. Answer: B
The maximum value for portfolio standard deviation will be obtained when the correlation coefficient
equals +1.
Portfolio standard deviation:
[(0.352 × 0.02032) + (0.652 × 0.03552) + (2 × 0.35 × 0.65 × 0.0203 × 0.0355 × 1)] 0.5
Portfolio standard deviation = 0.03018 or 3.018%
145. Answer: B
Maximum diversification benefits occur when the correlation coefficient equals −1. If the correlation
coefficient between assets is negative, portfolio standard deviation is lower than when correlation
coefficient equals zero.
146. Answer: B
A conservative investor can experience a higher return and a lower risk by diversifying into a high-risk,
higher-return asset if the correlation between the assets is fairly low. Among the given choices, choice
“B” offers the lowest correlation of returns between those on his new investment and his original portfolio
and hence, offers the lowest risk.
147. Answer: C
Portfolio C lies below the Markowitz efficient frontier because Portfolio B offers a higher return at lower
risk.
148. Answer: B
As correlation falls, the curvature of the line between the two assets’ risk-return profiles increases. The
expected return of the portfolio does not vary with the correlation coefficient of the two assets.
149. Answer: B
The efficient frontier represents a set of portfolios that have the minimum expected risk for every given
level of expected return. Alternatively, it represents the set of portfolios that have the maximum expected
return for every given level of risk.
150. Answer: C
The arithmetic return will always be higher than the geometric return due to the compounding nature of
the equation.
151. Answer: C
The covariance among the assets in the portfolio accounts for the bulk of risk.
152. Answer: C
Anytime a correlation between two assets is less than 1, diversification benefits are achieved. In this
example, portfolio standard deviation would fall, but not by a large amount.

40
 PORTFOLIO MANAGEMENT

PORTFOLIO RISK AND RETURN : PART II

Overview —
 Los a Describe the implications of combining a risk-free asset with a portfolio of risky assets.

 Los b Explain the capital allocation line (CAL) and the capital market line (CML).

 Los c Explain systematic and nonsystematic risk, including why an investor should not expect to
receive additional return for bearing nonsystematic risk.

 Los d Explain return generating models (including the market model) and their uses.

 Los e Calculate and interpret beta.

 Los f Explain the capital asset pricing model (CAPM), including its assumptions, and the security
market line (SML).

 Los g Calculate and interpret the expected return of an asset using the CAPM.

 Los h Describe and demonstrate applications of the CAPM and the SML.

PRACTICE PROBLEMS
1. The line depicting the risk and return of portfolio combinations of a risk-free asset and any risky asset is
the:
A. security market line.
B. capital allocation line.
C. security characteristic line.
2. 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:
A. −1.0.
B. 0.0.
C. 1.0.
3. 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:
A. expected return.
B. indifference curve.
C. capital allocation line slope.
4. Highly risk-averse investors will most likely invest the majority of their wealth in:
A. risky assets.
B. risk-free assets.
C. the optimal risky portfolio.
5. The capital market line, CML, is the graph of the risk and return of portfolio combinations consisting of
the risk-free asset and:
A. any risky portfolio.
B. the market portfolio.
C. the leveraged portfolio.

41
6. Which of the following statements most accurately defines the market portfolio in capital market theory?
The market portfolio consists of all:
A. risky assets.
B. tradable assets.
C. investable assets.
7. With respect to capital market theory, the optimal risky portfolio:
A) is the market portfolio.
B) has the highest expected return.
C) has the lowest expected variance.
8. Relative to portfolios on the CML, any portfolio that plots above the CML is considered:
A) inferior.
B) inefficient.
C) unachievable.
9. A portfolio on the capital market line with returns greater than the returns on the market portfolio
represents a(n):
A) lending portfolio.
B) borrowing portfolio.
C) unachievable portfolio.
10. 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):
A) lending portfolio.
B) borrowing portfolio.
C) unachievable portfolio.
11. Which of the following types of risk is most likely avoided by forming a diversified portfolio?
A. Total risk.
B. Systematic risk.
C. Nonsystematic risk.
12. Which of the following events is most likely an example of nonsystematic risk?
A. A decline in interest rates.
B. The resignation of chief executive officer.
C. An increase in the value of the U.S. dollar.
13. With respect to the pricing of risk in capital market theory, which of the following statements is most
accurate?
A. All risk is priced.
B. Systematic risk is priced.
C. Nonsystematic risk is priced.
14. The sum of an asset’s systematic variance and its nonsystematic variance of returns is equal to the asset’s:
A. beta.
B. total risk.
C. total variance.
15. With respect to return-generating models, the intercept term of the market model is the asset’s estimated:
A. beta.
B. alpha.
C. variance.
16. With respect to return-generating models, the slope term of the market model is an estimate of the asset’s:
A. total risk.
B. systematic risk.
C. nonsystematic risk.
17. With respect to return-generating models, which of the following statements is most accurate? Return-
generating models are used to directly estimate the:
A. expected return of a security.
B. weights of securities in a portfolio.
C. parameters of the capital market line.
The following information relates to Questions 18–20
An analyst gathers the following information:

42
 Expected Expected Correlation
Security Annual Standard between Security
Return (%) Deviation (%) 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
18. Which security has the highest total risk?
A. Security 1.
B. Security 2.
C. Security 3.
19. Which security has the highest beta measure?
A. Security 1.
B. Security 2.
C. Security 3.
20. Which security has the least amount of market risk?
A. Security 1.
B. Security 2.
C. Security 3.
21. With respect to capital market theory, the average beta of all assets in the market is:
A. less than 1.0.
B. equal to 1.0.
C. greater than 1.0.
22. The slope of the security characteristic line is an asset’s:
A. beta.
B. excess return.
C. risk premium.
23. The graph of the capital asset pricing model is the:
A. capital market line.
B. security market line.
C. security characteristic line.
24. With respect to capital market theory, correctly priced individual assets can be plotted on the:
A. capital market line.
B. security market line.
C. capital allocation line.
25. With respect to the capital asset pricing model, the primary determinant of expected return of an
individual asset is the:
A. asset’s beta.
B. market risk premium.
C. asset’s standard deviation.
26. 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?
A. −0.5
B. 0.0
C. 0.5
27. With respect to the capital asset pricing model, the market risk premium is:
A. less than the excess market return.
B. equal to the excess market return.
C. greater than the excess market return.

43
 The following information relates to Questions 28–31
An analyst gathers the following information:
Expected
Security Beta
Standard Deviation (%)
Security 1 25 1.50
Security 2 15 1.40
Security 3 20 1.60
28. 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:
A. 9.0%.
B. 12.0%.
C. 13.5%.
29. 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:
A. 8.4%.
B. 9.0%.
C. 10.3%.
30. With respect to the capital asset pricing model, if the expected market risk premium is 6% the security
with the highestexpected return is:
A. Security 1.
B. Security 2.
C. Security 3.
31. 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:
A. Security 1.
B. Security 2.
C. Security 3.
32. Which of the following performance measures is consistent with the CAPM?
A. M-squared.
B. Sharpe ratio.
C. Jensen’s alpha.
33. Which of the following performance measures does not require the measure to be compared to another
value?
A. Sharpe ratio.
B. Treynor ratio.
C. Jensen’s alpha.
34. Which of the following performance measures is most appropriate for an investor who is not fully
diversified?
A. M-squared.
B. Treynor ratio.
C. Jensen’s alpha.
35. 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:
A. overvalued.
B. undervalued.
C. properly valued.
36. 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:
A. the same optimal risky portfolio.
B. the Standard and Poor’s 500 Index.
C. assets with the same amount of risk.

44
37. With respect to capital market theory, which of the following assumptions allows for the existence of the
market portfolio? All investors:
A. are price takers.
B. have homogeneous expectations.
C. plan for the same, single holding period.
38. 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:
A. beta.
B. ratio.
C. alpha.
39. Portfolio managers who are maximizing risk-adjusted returns will seek to invest more in securities with:
A. lower values of Jensen’s alpha.
B. values of Jensen’s alpha equal to 0.
C. higher values of Jensen’s alpha.
40. Portfolio managers, who are maximizing risk-adjusted returns, will seek to invest less in securities with:
A. lower values for nonsystematic variance.
B. values of nonsystematic variance equal to 0.
C. higher values for nonsystematic variance.
41. An investor put 60% of his portfolio into a risky asset offering a 10% return with a standard deviation of
returns of 8% and put the balance of his portfolio in a risk-free asset offering 5%. What is the expected
return and standard deviation of his portfolio?
Expected return Standard deviation
A. 6.0% 6.8%
B. 8.0% 4.8%
C. 10.0% 6.6%
42. What is the risk measure associated with the capital market line (CML)?
A. Beta risk.
B. Unsystematic risk.
C. Total risk.
43. A portfolio to the right of the market portfolio on the CML is:
A. a lending portfolio.
B. a borrowing portfolio.
C. an inefficient portfolio.
44. As the number of stocks in a portfolio increases, the portfolio's systematic risk:
A. can increase or decrease.
B. decreases at a decreasing rate.
C. decreases at an increasing rate.
45. Total risk equals:
A. unique plus diversifiable risk.
B. market plus nondiversifiable risk.
C. systematic plus unsystematic risk.
46. A return generating model is least likely to be based on a security's exposure to:
A. statistical factors.
B. macroeconomic factors.
C. fundamental factors.
47. The covariance of the market's returns with a stock's returns is 0.005 and the standard deviation of the
market's returns is 0.05. What is the stock's beta?
A. 1.0.
B. 1.5.
C. 2.0.
48. The covariance of the market's returns with the stock's returns is 0.008. The standard deviation of the
market's returns is 0.08, and the standard deviation of the stock's returns is 0.11. What is the correlation
coefficient of the returns of the stock and the returns of the market?
A. 0.91.
B. 1.00.

45
 C. 1.25.
49. According to the CAPM, what is the expected rate of return for a stock with a beta of 1.2, when the risk-
free rate is 6% and the market rate of return is 12%?
A. 7.2%.
B. 12.0%.
C. 13.2%.
50. According to the CAPM, what is the required rate of return for a stock with a beta of 0.7, when the risk-
free rate is 7% and the expected market rate of return is 14%?
A. 11.9%.
B. 14.0%.
C. 16.8%.
51. The risk-free rate is 6%, and the expected market return is 15%. A stock with a beta of 1.2 is selling for
$25 and will pay a $1 dividend at the end of the year. If the stock is priced at $30 at year-end, it is:
A. overpriced, so short it.
B. underpriced, so buy it.
C. underpriced, so short it.
52. A stock with a beta of 0.7 currently priced at $50 is expected to increase in price to $55 by year-end and
pay a $1 dividend. The expected market return is 15%, and the risk-free rate is 8%. The stock is:
A. overpriced, so do not buy it.
B. underpriced, so buy it.
C. properly priced, so buy it.
53. Which of the following statements about the SML and the CML is least accurate?
A. Securities that plot above the SML are undervalued.
B. Investors expect to be compensated for systematic risk.
C. Securities that plot on the SML have no value to investors.
54. An analyst collected the following data for three possible investments.
Stock Price Forecast Dividend Beta
Today Price*
Alpha 25 31 2 1.6
Omega 105 110 1 1.2
Lambda 10 10.80 0 0.5
*Expected price one year from today.
The expected return on the market is 12% and the risk-free rate is 4%. According to the security
market line (SML), which of the three securities is correctly priced?
A) Lambda.
B) Omega.
C) Alpha.
55. Which of the following is NOT an assumption of capital market theory?
A) Interest rates never change from period to period.
B) Investors can lend at the risk-free rate, but borrow at a higher rate.
C) The capital markets are in equilibrium.
56. The correlation of returns on the risk-free asset with returns on a portfolio of risky assets is:
A) positive.
B) zero.
C) negative.
57. In the context of the CML, the market portfolio includes:
A) all existing risky assets.
B) the risk-free asset.
C) 12-18 stocks needed to provide maximum diversification.

46
58. An analyst collected the following data for three possible investments.
Stock Price Forecast Dividend Beta
Today Price*
Alpha 25 31 2 1.6
Omega 105 110 1 1.2
Lambda 10 10.80 0 0.5
*Expected price one year from today.
The expected return on the market is 12% and the risk-free rate is 4%. Assuming that capital markets
are in equilibrium, what is the required return for Omega?
A) 1.2%.
B) 13.6%.
C) 17.4%.
59. Which is NOT an assumption of capital market theory?
A) There are no taxes or transaction costs.
B) Investments are not divisible.
C) There is no inflation.
60. The expected rate of return is 2.5 times the 12% expected rate of return from the market. What is the
beta if the risk-free rate is 6%?
A) 5.
B) 3.
C) 4.
61. The beta of stock D is -0.5. If the expected return of Stock D is 8%, and the risk-free rate of return is
5%, what is the expected return of the market?
A) -1.0%.
B) +3.0%.
C) +3.5%.
62. A portfolio's excess return per unit of systematic risk is known as its:
A) Jensen's alpha.
B) Treynor measure.
C) Sharpe ratio.
63. If the standard deviation of the market's returns is 5.8%, the standard deviation of a stock's returns is
8.2%, and the covariance of the market's returns with the stock's returns is 0.003, what is the beta of the
stock?
A) 0.89.
B) 0.05.
C) 1.07.
64. The expected rate of return is 1.5 times the 16% expected rate of return from the market. What is the
beta if the risk free rate is 8%?
A) 3.
B) 4.
C) 2.
65. If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3,
what is the required return on the stock?
A) 12.4%.
B) 11.3%.
C) 7.8%.
66. The market portfolio in Capital Market Theory is determined by:
A) the intersection of the efficient frontier and the investor's highest utility curve.
B) a line tangent to the efficient frontier, drawn from any point on the expected return axis.
C) a line tangent to the efficient frontier, drawn from the risk-free rate of return.
67. Which of the following statements about the capital market line (CML) is least accurate?
A) The market portfolio lies on the CML and has only unsystematic risk.
B) The CML will not be a linear relationship if investors' borrowing and lending rates are not equal.

47
 C) Investors choose a portfolio on the CML by varying their weightings of the risk-free asset and the
market portfolio.
68. Level I CFA candidate Adeline Bass is a member of an investment club. At the next meeting, she is to
recommend whether or not the club should purchase the stocks of CS Industries and MG Consolidated.
The risk-free rate is at 6% and the expected return on the market is 15%. Prior to the meeting, Bass
gathers the following information on the two stocks:
CS Industries MG Consolidated

Current Market Value $25 $50

Expected Market Value in One Year $30 $55
Expected Dividend $1 $1

Beta 1.2 0.80

Bass should recommend that the club:
A) purchase both stocks.
B) purchase MG only.
C) purchase CS only.
69. Given the following data, what is the correlation coefficient between the two stocks and the Beta of
stock A?
 standard deviation of returns of Stock A is 10.04%
 standard deviation of returns of Stock B is 2.05%
 standard deviation of the market is 3.01%
 covariance between the two stocks is 0.00109
 covariance between the market and stock A is 0.002
Correlation Coefficient Beta (stock A)
A) 0.5296 0.06
B) 0.5296 2.20
C) 0.6556 2.20
70. An active manager will most likely short a security with an expected Jensen's alpha that is:
A) negative.
B) positive.
C) zero.
71. In the context of the capital market line (CML), which of the following statements is CORRECT?
A) Market risk can be reduced through diversification.
B) The two classes of risk are market risk and systematic risk.
C) Firm-specific risk can be reduced through diversification.
72. Which of the following statements about risk is is NOT correct?
A) Total risk = systematic risk - unsystematic risk.
B) Unsystematic risk is diversifiable risk.
C) The market portfolio consists only of systematic risk.
73. What is the expected rate of return on a stock that has a beta of 1.4 if the market risk premium is 9%
and the risk-free rate is 4%?
A) 13.0%.
B) 11.0%.
C) 16.6%.
74. An equally weighted portfolio of a risky asset and a risk-free asset will exhibit:
A) more than half the returns standard deviation of the risky asset.
B) half the returns standard deviation of the risky asset.
C) less than half the returns standard deviation of the risky asset.
75. A model that estimates expected excess return on a security based on the ratio of the firm's book value
to its market value is best described as a:
A) multifactor model.

48
 B) single-factor model.
C) market model.
76. Which of the following is an assumption of capital market theory? All investors:
A) select portfolios that lie above the efficient frontier to optimize the risk-return relationship.
B) see the same risk/return distribution for a given stock.
C) have multiple-period time horizons.
77. One of the assumptions underlying the capital asset pricing model is that:
A) each investor has a unique time horizon.
B) only whole shares or whole bonds are available.
C) there are no transactions costs or taxes.
78. The slope of the characteristic line is used to estimate:
A) a risk premium.
B) risk aversion.
C) beta.
79. Which of the following statements about a stock's beta is CORRECT? A beta greater than one is:
A) risky, while a beta less than one is risk-free.
B) undervalued, while a beta less than one is overvalued.
C) riskier than the market, while a beta less than one is less risky than the market.
80. Given a beta of 1.25 and a risk-free rate of 6%, what is the expected rate of return assuming a 12%
market return?
A) 31%.
B) 10%.
C) 13.5%.
81. Beta is least accurately described as:
A) a standardized measure of the total risk of a security.
B) a measure of the sensitivity of a security's return to the market return.
C) the covariance of a security's returns with the market return, divided by the variance of market
returns.
82. What is the risk measure associated with the CML?
A) Beta.
B) Standard deviation.
C) Market risk.
83. Which of the following statements regarding the Capital Asset Pricing Model is least accurate?
A) It is when the security market line (SML) and capital market line (CML) converge.
B) Its accuracy depends upon the accuracy of the beta estimates.
C) It is useful for determining an appropriate discount rate.
84. Given a beta of 1.55 and a risk-ree rate of 8%, what is the expected rate of return, assuming a 14%
market return?
A) 17.3%.
B) 20.4%.
C) 12.4%.
85. Given a beta of 1.10 and a risk-free rate of 5%, what is the expected rate of return assuming a 10%
market return?
A) 5.5%.
B) 15.5%.
C) 10.5%.
86. Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has instructed him to put
only securities that are undervalued on the buy list. Today, Snow is to make a recommendation on the
following two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an
expected return of 15% and a beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.
Snow places:
A) only Cubb on the list.
B) only Bahre on the list.
C) neither security on the list.

49
87. Beta is a measure of:
A) systematic risk.
B) total risk.
C) company-specific risk.
88. The expected rate of return is twice the 12% expected rate of return from the market. What is the beta
if the risk-free rate is 6%?
A) 4.
B) 3.
C) 2.
89. Which of the following measures produces the same portfolio rankings as the Sharpe ratio but is stated
in percentage terms?
A) Treynor measure.
B) Jensen's alpha.
C) M-squared.
90. Which of the following statements about systematic and unsystematic risk is most accurate?
A) Total risk equals market risk plus firm-specific risk.
B) The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms in the
same industry.
C) As an investor increases the number of stocks in a portfolio, the systematic risk will remain
constant.
91. When the market is in equilibrium:
A) investors own 100% of the market portfolio.
B) all assets plot on the CML.
C) all assets plot on the SML.
92. A stock's abnormal rate of return is defined as the:
A) rate of return during abnormal price movements.
B) actual rate of return less the expected risk-adjusted rate of return.
C) expected risk-adjusted rate of return minus the market rate of return.
93. Portfolios that plot on the security market line in equilibrium:
A) must be well diversified.
B) have only systematic (beta) risk.
C) may be concentrated in only a few stocks.
94. The market portfolio in the Capital Market Theory contains which types of investments?
A) All risky assets in existence.
B) All stocks in existence.
C) All risky and risk-free assets in existence.
95. Which of the following is the risk that disappears in the portfolio construction process?
A) Unsystematic risk.
B) Systematic risk.
C) Interest rate risk.
96. Luis Green is an investor who uses the security market line to determine whether securities are
properly valued. He is evaluating the stocks of two companies, Mia Shoes and Video Systems. The
stock of Mia Shoes is currently trading at $15 per share, and the stock of Video Systems is currently
trading at $18 per share. Green expects the prices of both stocks to increase by $2 in a year. Neither
company pays dividends. Mia Shoes has a beta of 0.9 and Video Systems has a beta of (-0.30). If the
market return is 15% and the risk-free rate is 8%, which trading strategy will Green employ?
Mia Shoes Video Systems
A) Sell Buy
B) Buy Buy
C) Buy Sell
97. An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by how
much (expressed as percentage return). The analyst gathers the following information on the stock:
 Market standard deviation = 0.70
 Covariance of Dover with the market = 0.85

50
  Dover's current stock price (P0) = $35.00
 The expected price in one year (P1) is $39.00
 Expected annual dividend = $1.50
 3-month Treasury bill yield = 4.50%.
 Historical average S&P 500 return = 12.0%.
Dover Holdings stock is:
A) undervalued by approximately 1.8%.
B) undervalued by approximately 2.1%.
C) overvalued by approximately 1.8%.
98. Consider the following graph of the Security Market Line (SML). The letters X, Y, and Z represent
risky asset portfolios. The SML crosses the y-axis at the point 0.07. The expected market return equals
13.0%. Note: The graph is NOT drawn to scale.

Using the graph above and the information provided, which of the following statements is most
accurate?
A) The expected return (or holding period return) for Portfolio Z equals 14.8%.
B) Portfolio X's required return is greater than the market expected return.
C) Portfolio Y is undervalued.
99. All portfolios on the capital market line are:
A) distinct from each other.
B) unrelated except that they all contain the risk-free asset.
C) perfectly positively correlated.
100. Which of the following is least likely considered a source of systematic risk for bonds?
A) Purchasing power risk.
B) Default risk.
C) Market risk.
101. An analyst has developed the following data for two companies, PNS Manufacturing (PNS) and
InCharge Travel (InCharge). PNS has an expected return of 15% and a standard deviation of 18%.
InCharge has an expected return of 11% and a standard deviation of 17%. PNS's correlation with the
market is 75%, while InCharge's correlation with the market is 85%. If the market standard deviation
is 22%, which of the following are the betas for PNS and InCharge?
Beta of PNS Beta of InCharge
A) 0.66 0.61
B) 0.92 1.10
C) 0.61 0.66
102. The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return
is 6%, what is the expected return of Stock A?
A) 15.6%.
B) 13.8%.
C) 14.2%.
103. The following information is available for the stock of Park Street Holdings:
 The price today (P0) equals $45.00.
 The expected price in one year (P1) is $55.00. The stock's beta is 2.31.
 The firm typically pays no dividend.
 The 3-month Treasury bill is yielding 4.25%.
 The historical average S&P 500 return is 12.5%.
Park Street Holdings stock is:

51
 A) undervalued by 1.1%.
B) undervalued by 3.7%.
C) overvalued by 1.1%.
104. The expected market premium is 8%, with the risk-free rate at 7%. What is the expected rate of return
on a stock with a beta of 1.3?
A) 16.3%.
B) 17.4%.
C) 10.4%.
105. Given the following information, what is the required rate of return on Bin Co?
 inflation premium = 3%
 real risk-free rate = 2%
 Bin Co. beta = 1.3
 market risk premium = 4%
A) 7.6%.
B) 16.7%.
C) 10.2%.
106. For an investor to move further up the Capital Market Line than the market portfolio, the investor
must:
A) diversify the portfolio even more.
B) reduce the portfolio's risk below that of the market.
C) borrow and invest in the market portfolio.
107. A portfolio to the right of the market portfolio on the capital market line (CML) is created by:
A) holding both the risk-free asset and the market portfolio.
B) fully diversifying.
C) holding more than 100% of the risky asset.
108. Consider a stock selling for $23 that is expected to increase in price to $27 by the end of the year and
pay a $0.50 dividend. If the risk-free rate is 4%, the expected return on the market is 8.5%, and the
stock's beta is 1.9, what is the current valuation of the stock? The stock:
A) is undervalued.
B) is correctly valued.
C) is overvalued.
109. A stock that plots below the Security Market Line most likely:
A) has a beta less than one.
B) is below the efficient frontier.
C) is overvalued.
110. Which of the following is the vertical axis intercept for the Capital Market Line (CML)?
A) Expected return on the portfolio.
B) Risk-free rate.
C) Expected return on the market.
111. What is the required rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the
market is offering 12%?
A) 13.2%.
B) 7.2%.
C) 6.0%.
112. The slope of the capital market line (CML) is a measure of the level of:
A) expected return over the level of inflation.
B) excess return per unit of risk.
C) risk over the level of excess return.
113. Based on Capital Market Theory, an investor should choose the:
A) portfolio that maximizes his utility on the Capital Market Line.
B) market portfolio on the Capital Market Line.
C) portfolio with the highest return on the Capital Market Line.

52
114. The market model of the expected return on a risky security is best described as a(n):
A) single-factor model.
B) arbitrage-based model.
C) two-factor model.
115. Portfolios that represent combinations of the risk-free asset and the market portfolio are plotted on the:
A) capital asset pricing line.
B) utility curve.
C) capital market line.
116. In Fama and French's multifactor model, the expected return on a stock is explained by:
A) firm size, book-to-market ratio, and excess return on the market portfolio.
B) firm size, book-to-market ratio, and price momentum.
C) excess return on the market portfolio, book-to-market ratio, and price momentum.
117. Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-diversified
portfolios with approximately equal market values. He expects Portfolio X to return 13% and Portfolio
Y to return 14% over the upcoming year. Because of an unexpected need for cash, Smith is forced to
sell at least one of the portfolios. He uses the security market line to determine whether his portfolios
are undervalued or overvalued. Portfolio X's beta is 0.9 and Portfolio Y's beta is 1.1. The expected
return on the market is 12% and the risk-free rate is 5%. Smith should sell:
A) either portfolio X or Y because they are both properly valued.
B) both portfolios X and Y because they are both overvalued.
C) portfolio Y only.
118. Which of the following statements about portfolio management is most accurate?
A) The security market line (SML) measures systematic and unsystematic risk versus expected return;
the CML measures total risk.
B) Combining the capital market line (CML) (risk-free rate and efficient frontier) with an investor's
indifference curve map separates out the decision to invest from the decision of what to invest in.
C) As an investor diversifies away the unsystematic portion of risk, the correlation between his
portfolio return and that of the market approaches negative one.
119. An investor believes Stock M will rise from a current price of $20 per share to a price of $26 per
share over the next year. The company is not expected to pay a dividend. The following information
pertains:
 RF = 8%
 ERM = 16%
 Beta = 1.7
Should the investor purchase the stock?
A) No, because it is overvalued.
B) Yes, because it is undervalued.
C) No, because it is undervalued.
120. According to capital market theory, which of the following represents the risky portfolio that should
be held by all investors who desire to hold risky assets?
A) The point of tangency between the capital market line (CML) and the efficient frontier.
B) Any point on the efficient frontier and to the right of the point of tangency between the CML and
the efficient frontier.
C) Any point on the efficient frontier and to the left of the point of tangency between the CML and
the efficient frontier.
121. In equilibrium, investors should only expect to be compensated for bearing systematic risk because:
A) nonsystematic risk can be eliminated by diversification.
B) individual securities in equilibrium only have systematic risk.
C) systematic risk is specific to the securities the investor selects.
122. The greater the disparity between an investor’s cost of borrowing and the risk-free rate:
A. The greater the slope of the CML.
B. The more significant the kink in the CML.
C. The greater the expected return on the market portfolio.

53
123. A model that uses the relationship between security returns and earnings growth is most likely an
example of a:
A. Macroeconomic factor model.
B. Statistical factor model.
C. Fundamental factor model.
124. A regression of ABC Stock’s historical monthly returns against the return on the S&P 500 gives an alpha
of 0.003 and a beta of 0.95. Given that ABC Stock rises by 4% during a month in which the market rose
2.25%, calculate the abnormal return on ABC Stock.
A. 1.75%
B. 1.56%
C. 2.44%
125. Beta is least likely defined as:
A. The ratio of the covariance of the stock’s return and the market return to the standard deviation of
market returns.
B. The correlation between the asset and the market times the ratio of the standard deviation of the asset
to the standard deviation of the market.
C. A measure of the sensitivity of the return on the asset to the market’s return.
126. Can the CML be applied to price individual assets and inefficient portfolios?
Individual Assets Inefficient Portfolios
A. Yes Yes
B. No No
C. Yes No
127. The SML and CAPM can be used to price:
A. Individual assets and efficient portfolios only, not inefficient portfolios.
B. All assets and portfolios.
C. Efficient and inefficient portfolios, but not individual assets.
128. Jennifer invests 30% of her funds in the risk-free asset, 45% in the market portfolio, and the rest in Beta
Corp, a U.S. stock that has a beta of 0.9. Given that the risk-free rate and the expected return on the
market are 7% and 16% respectively, the portfolio’s expected return is closest to:
A. 13.08%
B. 16.00%
C. 15.10%
129. Which of the following portfolio performance measures equals the slope of the capital allocation line?
A. Sharpe ratio
B. Jensen’s alpha
C. Treynor ratio
130. Which of the following is most likely based on systematic risk?
A. Sharpe ratio
B. Treynor ratio
C. M2
131. Which of the following most likely indicates the maximum fee an investor should pay a portfolio manager?
A. Sharpe ratio
B. Jensen’s alpha
C. Treynor ratio
Use the following information to answer Questions 132 to 136:
The following information is available regarding the portfolio performance of three investment managers:
Manager Return Standard Deviation Beta
A 19% 27% 0.7
B 14% 22% 1.2
C 16% 19% 0.9
Market (M) 11% 24%
Risk-free rate 5%

54
132. Manager B’s expected return is closest to:
A. 9.20%
B. 12.20%
C. 10.40%
133. Manager A’s Sharpe ratio is closest to:
A. 0.5185
B. 0.4091
C. 0.2000
134. Manager C’s Treynor ratio is closest to:
A. 0.2000
B. 0.1222
C. 0.5789
135. Manager B’s M2 value is closest to:
A. 3.82%
B. 6.44%
C. 1.80%
136. Manager C’s Jensen’s alpha is closest to:
A. 7.89%
B. 10.40%
C. 5.60%
137. Which of the following is most likely regarding the security characteristic line?
A. It plots a security’s expected return against beta risk.
B. It plots a security’s excess return against total risk.
C. It plots a security’s excess return against excess returns on the market.
Use the following information to answer Questions 138 to 140:
An investor gathered the following information regarding three stocks, which are not in the market
portfolio:
Stock Expected return Standard deviation Beta
A 22% 25% 1.1
B 17% 30% 1.4
C 19% 23% 0.8
The return on the market portfolio is 15% with a standard deviation of 21%, and the risk-free rate of
return is 4%.
138. Stock C’s Jensen’s alpha is closest to:
A. 5.90%
B. 6.20%
C. 12.80%
139. Stock A’s nonsystematic variance is closest to:
A. 0.0036
B. 0.0247
C. 0.0091
140. Which stock should the investor least likely add to the market portfolio?
A. Stock A
B. Stock B
C. Stock C
141. Which of the following is least likely a limitation of the CAPM?
A. It is a multi-period model.
B. It is a single-factor model.
C. A true market portfolio is inobservable.
142. Which of the following statements is most accurate?
A. The capital market line plots returns against market risk.
B. The security market line plots returns against total risk.
C. The capital market line plots returns against standard deviation.

55
143. A portfolio that lies to the left of the market portfolio on the CML is:
A. A borrowing portfolio.
B. A lending portfolio.
C. An efficient portfolio.
144. An analyst gathered the following information:
Risk-free rate: 5%
Market risk premium: 6%
Beta: 0.8
The required rate of return for the stock is closest to:
A. 6%
B. 5.8%
C. 9.8%
145. An analyst gathered the following information regarding two stocks:
Stock A Stock B
Beta 0.7 1.1
Current market price $20 $35
Expected dividend $1 $1
Expected price at year end $23 $37
Assuming a risk-free rate of 5% and the expected market return of 12%, which of the following
statements is most accurate?
A. Stock A is overpriced and therefore the analyst should sell it.
B. Stock B is underpriced and therefore the analyst should buy it.
C. Stock A is underpriced and therefore the analyst should buy it.
146. If the covariance of the market’s returns with a stock’s returns is 0.007, and the standard deviation of the
market’s returns is 0.07, the stock’s beta is closest to:
A. 0.1
B. 1.43
C. 0.7
147. Consider the following statements:
Statement 1: All the portfolios on the capital market line are perfectly positively correlated.
Statement 2: A risk-free asset has zero correlation with all other risky assets.
Which of the following is most likely?
A. Both statements are incorrect.
B. Both statements are correct.
C. Only one statement is correct.
148. Which of the following statements is most accurate?
A. If the beta for an asset is greater than 1, it will lie above the security market line.
B. Beta can be viewed as a standardized measure of unsystematic risk.
C. Any security that plots below the security market line is considered overpriced.
149. Which of the following statements is most accurate?
A. A security whose required rate of return is greater than the expected rate of return is considered
overvalued and plots above the security market line.
B. If the stock’s alpha is positive, it is considered undervalued and plots above the security market line.
C. A security whose estimated rate of return is greater than the required rate of return is considered
overvalued and plots below the security market line.
150. Jessica is considering investing in two assets, A and B, with betas 2.1 and 1.6 respectively. Her broker
tells her that the return on the market portfolio is 14% and that the risk-free rate is 6%. Given that the
expected return on both the assets is 20%, she should most likely invest in:
A. Asset B only.
B. Asset A only.
C. None of the assets.

56
151. Juan gathered the following information regarding the stocks of three companies, A, B, and C:
Stock Current share price ($) Expected price in one year ($) Beta
A 24 29 1.6
B 32 39 1.3
C 28 33 1.2
Given that the risk-free rate is 6% and that the current market risk premium is 10%, which of the above
stocks will least likely plot below the security market line?
A. Stock B
B. Stock C
C. Stock A

57
 SOLUTIONS
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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).
8. 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.
9. 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.
10. 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.
11. 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.
12. B is correct. Nonsystematic risk is specific to a firm, whereas systematic risk affects the entire economy.
13. B is correct. Only systematic risk is priced. Investors do not receive any return for accepting
nonsystematic or diversifiable risk.
14. 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.
15. B is correct. In the market model, Ri=αi+βiRm+ei R i = α i + β iR m + e i , the intercept, αi, and slope
coefficient, βi, are estimated using historical security and market returns.
16. B is correct. In the market model, Ri=αi+βiRm+ei R i = α i + βiR m + ei , the slope coefficient, βi, is an
estimate of the asset’s systematic or market risk.
17. A is correct. In the market model, Ri=αi+βiRm+ei R i = α i + βiR m + 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.
18. A is correct. Security 1 has the highest total variance; 0.0625=0.25 2 compared to Security 2 and Security 3
with a total variance of 0.0400.
19. C is correct. Security 3 has the highest beta value; 1.07=ρ3,mσ3σm=(0.80)(20%)15%
ρ ,m σ3 (0.80)(20%)
1.07 = 3 = compared to Security 1 and Security 2 with beta values of 1.00 and 0.93,
σm 15%
respectively.

58
20. B is correct. Security 2 has the lowest beta value; .93=ρ2,mσ2σm=(0.70)(20%)15%
ρ ,m σ2 (0.70)(20%)
.93 = 2 = compared to Security 1 and 3 with beta values of 1.00 and 1.07,
σm 15%
respectively.
21. B is correct. The average beta of all assets in the market, by definition, is equal to 1.0.
22. 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.
23. 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.
24. 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.
25. 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.
26. 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.
27. 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.
28. 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]
E(R i ) = R f + β i E(R m ) - R f  .
29. 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] E ( Ri )  Rf   i[ E ( Rm )  Rf ] ,
11.4% = 3% + 1.4(X%), where X% = (11.4% − 3%)/1.4 = 6.0% = market risk premium.
30. 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]
E ( Ri )  Rf   i[ E ( Rm )  Rf ]
31. 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.
32. C is correct. Jensen’s alpha adjusts for systematic risk, and M-squared and the Sharpe Ratio adjust for
total risk.
33. 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.
34. A is the correct. M-squared adjusts for risk using standard deviation (i.e., total risk).
35. 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).
36. 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).
37. 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.
38. 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.
39. 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.

59
40. 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.
41. B Expected return: (0.60 x 0.10) + (0.40 x 0.05) = 0.08, or 8.0%.
Standard deviation: 0.60 x 0.08 = 0.048, or 4.8%.
42. C The capital market line (CML) plots return against total risk which is measured by standard deviation of
returns.
43. B A portfolio to the right of a portfolio on the CML has more risk than the market portfolio. Investors
seeking to take on more risk will borrow at the risk-free rate to purchase more of the market portfolio.
44. A When you increase the number of stocks in a portfolio, unsystematic risk will decrease at a decreasing
rate. However, the portfolio's systematic risk can be increased by adding higher-beta stocks or decreased
by adding lower-beta stocks.
45. C Total risk equals systematic plus unsystematic risk. Unique risk is diversifiable and is unsystematic.
Market (systematic) risk is nondiversifiable risk.
46. A Macroeconomic, fundamental, and statistical factor exposures can be included in a return generating
model to estimate the expected return of an investment. However, statistical factors may not have any
theoretical basis, so analysts prefer macroeconomic and fundamental factor models.
47. C Beta = covariance / market variance
Market variance = 0.052 = 0.0025
Beta = 0.005 / 0.0025 = 2.0
48. A
Cov1,2 0.008
ρ1,2 = = = 0.909
σ1σ 2  0.08  0.11
49. C 6 + 1.2(12 - 6) = 13.2%
50. A 7 + 0.7(14 - 7) = 11.9%
51. B Required rate = 6 + 1.2(15 - 6) = 16.8%
Return on stock = (30 - 25 + 1) / 25 = 24%
Based on risk, the stock plots above the SML and is underpriced, so buy it.
52. A Required rate = 8 + 0.7(15 - 8) = 12.9%
Return on stock = (55 - 50 + 1) / 50 = 12%
The stock falls below the SML so it is overpriced.
53. C Securities that plot on the SML are expected to earn their equilibrium rate of return and, therefore, do
have value to an investor and may have diversification benefits as well. The other statements are true.
54. Answer A
In the context of the SML, a security is underpriced if the required return is less than the holding
period (or expected) return, is overpriced if the required return is greater the holding period (or
expected) return, and is correctly priced if the required return equals the holding period (or expected)
return.
Here, the holding period (or expected) return is calculated as: (ending price - beginning price + any
cash flows / dividends) / beginning price. The required return uses the equation of the SML: risk free
rate + Beta × (expected market rate − risk free rate).
 For Alpha: ER = (31 - 25 + 2) / 25 = 32%, RR = 4 + 1.6 × (12 − 4) = 16.8%. Stock is underpriced.
 For Omega: ER = (110 - 105 + 1) / 105 = 5.7%, RR = 4 + 1.2 × (12 − 4) = 13.6%. Stock is overpriced.
 For Lambda, ER = (10.8 - 10 + 0) / 10 = 8%, RR = 4 + 0.5 × (12 − 4) = 8%. Stock is correctly priced.
55. Answer B
Capital market theory assumes that investors can borrow or lend at the risk-free rate. The other
statements are basic assumptions of capital market theory.
56. Answer B
The risk-free asset has zero correlation of returns with any portfolio of risky assets.
57. Answer A
The market portfolio has to contain all the stocks, bonds, and risky assets in existence. Because this
portfolio has all risky assets in it, it represents the ultimate or completely diversified portfolio.
58. Answer B
RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, Rf = risk-free rate, and

60
 (RMarket − Rf) = market premium
RRStock = 4 + (12 − 4) × 1.2 = 4 + 9.6 = 13.6%.
59. Answer B
Capital market theory assumes that all investments are infinitely divisible. The other statements are
basic assumptions of capital market theory.
60. Answer C
30 = 6 + β (12 - 6)
24 = 6β
β=4
61. Answer A
RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate
A bit of algebraic manipulation results in:
RMarket = [RRStock − Rf + (BetaStock × Rf)] / BetaStock = [8 − 5 + (-0.5 × 5)] / -0.5 = 0.5 / -0.5 = -1%
62. Answer B
The Treynor measure is excess return relative to beta. The Sharpe ratio measures excess return relative
to standard deviation. Jensen's alpha measures a portfolio's excess return relative to return of a
portfolio on the SML that has the same beta.
63. Answer A
The formula for beta is: (Covstock,market)/(Varmarket), or (0.003)/(0.058)2 = 0.89.
64. Answer C
24 = 8 + β (16 − 8)
24 = 8 + 8β
16 = 8β
16 / 8 = β
β=2
65. Answer B
The formula for the required return is: ERstock = Rf + (ERM - Rf) × Betastock, or 0.035 + (0.095 -
0.035) × 1.3 = 0.113, or 11.3%.
66. Answer C
The Capital Market Line is a straight line drawn from the risk-free rate of return (on the Y axis)
through the market portfolio. The market portfolio is determined as where that straight line is exactly
tangent to the efficient frontier.
67. Answer A
The first part of this statement is true - the market portfolio does lie on the CML. However, the market
portfolio is well diversified and thus has no unsystematic risk. The risk that remains is market risk, or
nondiversifiable, or systematic risk.
The CML measures standard deviation (or total risk) against returns. The CML will "kink" if the
borrowing rate and lending rate are not equal. Investors choose a portfolio on the CML by lending or
borrowing at the risk-free rate to vary the weighting of their investments in the risk-free asset and the
market portfolio.
68. Answer C
In the context of the SML, a security is underpriced if the required return is less than the holding
period (or expected) return, is overpriced if the required return is greater than the holding period (or
expected) return, and is correctly priced if the required return equals the holding period (or expected)
return.
Here, the holding period (or expected) return is calculated as: (ending price - beginning price + any
cash flows / dividends) / beginning price. The required return uses the equation of the SML: risk free
rate + Beta × (expected market rate − risk-free rate).
 For CS Industries: ER = (30 - 25 + 1) / 25 = 24%, RR = 6 + 1.2 × (15 − 6) = 16.8%. Stock is
underpriced - purchase.
 For MG Consolidated: ER = (55 - 50 + 1) / 50 = 12%, RR = 6 + 0.80 × (15 − 6) = 13.2%. Stock is
overpriced - do not purchase.
69. Answer B
correlation coefficient = 0.00109 / (0.0205)(0.1004) = 0.5296.

61
 beta of stock A = covariance between stock and the market / variance of the market
Beta = 0.002 / 0.03012 = 2.2
70. Answer A
A security's expected Jensen's alpha is the difference between an active manager's estimate of a
security's expected return and the CAPM expected return. A security that is expected to have a
negative alpha will plot below the SML (i.e., the security is overvalued and should be sold or sold
short).
71. Answer C
The other statements are false. Market risk cannot be reduced through diversification; market risk =
systematic risk. The two classes of risk are unsystematic risk and systematic risk.
72. Answer A
Total risk = systematic risk + unsystematic risk
73. Answer C
Using the security market line (SML) equation:
4% + 1.4(9%) = 16.6%.
74. Answer B
A risk free asset has a standard deviation of returns equal to zero and a correlation of returns with any
risky asset also equal to zero. As a result, the standard deviation of returns of a portfolio of a risky
asset and a risk-free asset is equal to the weight of the risky asset multiplied by its standard deviation
of returns. For an equally weighted portfolio, the weight of the risky asset is 0.5 and the portfolio
standard deviation is 0.5 × the standard deviation of returns of the risky asset.
75. Answer B
A model that estimates a stock's expected excess return based only on the book-to-market ratio is a
single-factor model. The market model is a single-factor model that estimates expected excess return
based on a security's sensitivity to the expected excess return of the market portfolio. A multifactor
model would estimate expected excess return based on more than one factor.
76. Answer B
All investors select portfolios that lie along the efficient frontier, based on their utility functions. All
investors have the same one-period time horizon, and have the same risk/return expectations.
77. Answer C
The CAPM assumes frictionless markets, i.e., no taxes or transactions costs. Among the other
assumptions of the CAPM are that all investors have the same one-period time horizon and that all
investments are infinitely divisible.
78. Answer C
Beta for an individual security can be estimated by the slope of its characteristic line, a least-squares
regression of the security's excess returns against the market's excess returns.
79. Answer C
Beta is a measure of the volatility of a stock. The overall market's beta is one. A stock with higher
systematic risk than the market will have a beta greater than one, while a stock that has a lower
systematic risk will have a beta less than one.
80. Answer C
k = 6 + 1.25 (12 − 6)
= 6 + 1.25(6)
= 6 + 7.5
= 13.5
81. Answer A
Beta is a standardized measure of the systematic risk of a security. β = Covr,mkt / σ2mkt. Beta is multiplied
by the market risk premium in the CAPM: E(Ri) = RFR + β[E(Rmkt) - RFR].
82. Answer B
In the context of the CML, the measure of risk (x-axis) is total risk, or standard deviation. Beta
(systematic risk) is used to measure risk for the security market line (SML).
83. Answer A
The CML plots expected return versus standard deviation risk. The SML plots expected return versus
beta risk. Therefore, they are lines that are plotted in different two-dimensional spaces and will not
converge.

62
84. Answer A
k = 8 + 1.55(14-8)
= 8 + 1.55(6)
= 8 + 9.3
= 17.3
85. Answer C
k = 5 + 1.10 (10 - 5) = 10.5
86. Answer C
In the context of the SML, a security is underpriced if the required return is less than the holding
period (or expected) return, is overpriced if the required return is greater the holding period (or
expected) return, and is correctly priced if the required return equals the holding period (or expected)
return.
Here, the holding period (or expected) return is calculated as: (ending price - beginning price + any
cash flow or dividends) / beginning price. The required return uses the equation of the SML: risk free
rate + Beta × (expected market rate - risk free rate).
 For Bahre: ER = 10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced - do not
put on buy list.
 For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly priced - do
not put on buy list (per Snow's manager).
87. Answer A
Beta is a measure of systematic risk.
88. Answer A
24 = 6 + β (12 − 6)
18 = 6β
β=3
89. Answer C
M-squared measures the excess return of a leveraged portfolio relative to the market portfolio and
produces the same portfolio rankings as Sharpe ratio.
90. Answer A
Total risk equals systematic (market) plus unsystematic (firm-specific) risk.
The unsystematic risk for a specific firm is not similar to the unsystematic risk for other firms in the
same industry. Unsystematic risk is firm-specific or unique risk.
Systematic risk of a portfolio can be changed by adding high-beta or low-beta stocks.
91. Answer C
When the market is in equilibrium, expected returns equal required returns. Since this means that all
assets are correctly priced, all assets plot on the SML.
By definition, all stocks and portfolios other than the market portfolio fall below the CML. (Only the
market portfolio is efficient.
92. Answer B
Abnormal return = Actual return - expected risk-adjusted return
93. Answer C
All portfolios plot on the SML in equilibrium according to the capital asset pricing model.
94. Answer A
The market portfolio contains all risky assets in existence. It does not contain any risk-free assets.
95. Answer A
Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-
diversified portfolio.
96. Answer A
The required return for Mia Shoes is 0.08 + 0.9 × (0.15-0.08) = 14.3%. The forecast return is $2/$15 =
13.3%. The stock is overvalued and the investor should sell it. The required return for Video Systems
is 0.08 - 0.3 × (0.15-0.08) = 5.9%. The forecast return is $2/$18 = 11.1%. The stock is undervalued and
the investor should buy it.
97. Answer C
To determine whether a stock is overvalued or undervalued, we need to compare the expected return
(or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).

63
 Step 1: Calculate Expected Return (Holding period return)
The formula for the (one-year) holding period return is:
HPR = (D1 + S1 - S0) / S0, where D = dividend and S = stock price.
Here, HPR = (1.50 + 39 - 35) / 35 = 15.71%
Step 2: Calculate Required Return
The formula for the required return is from the CAPM: RR = Rf + (ERM - Rf) × Beta
Here, we are given the information we need except for Beta. Remember that Beta can be calculated
with: Betastock = [covS,M] / [σ2M]. Here we are given the numerator and the denominator, so the
calculation is: 0.85 / 0.702 = 1.73. RR = 4.50% + (12.0 -
4.50%) × 1.73 = 17.48%.
Step 3: Determine over/under valuation
The required return is greater than the expected return, so the security is overvalued.
The amount = 17.48% − 15.71% = 1.77%.
98. Answer A
At first, it appears that we are not given the information needed to calculate the holding period, or
expected return (beginning price, ending price, or annual dividend). However, we are given the
information required to calculate the required return (CAPM) and since Portfolio Z is on the SML, we
know that the required return (RR) equals the expected return (ER). So, ER = RR = Rf + (ERM - Rf) ×
Beta = 7.0% + (13.0% − 7.0%) × 1.3 = 14.8%.
The SML plots beta (or systematic risk) versus expected return, the CML plots total risk (systematic
plus unsystematic risk) versus expected return. Portfolio Y is overvalued - any portfolio located below
the SML has an RR > ER and is thus overpriced. Since Portfolio X plots above the SML, it is
undervalued and the statement should read, "Portfolio X's required return is less than the market
expected return."
99. Answer C
The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This
straight efficient frontier line is called the capital market line (CML). Since the line is straight, the
math implies that any two assets falling on this line will be perfectly, positively correlated with each
other. Note: When ra,b = 1, then the equation for risk changes to sport = WAsA + WBsB,which is a
straight line.
100. Answer B
Default risk is based on company-specific or unsystematic risk.
101. Answer C
Betai = (si/sM) × rI, M
BetaPNS = (0.18/0.22) × 0.75 = 0.6136
BetaInCharge = (0.17/0.22) × 0.85 = 0.6568
102. Answer B
RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate
Here, RRStock = 6 + (12 - 6) × 1.3 = 6 + 7.8 = 13.8%.
103. Answer C
To determine whether a stock is overvalued or undervalued, we need to compare the expected return
(or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).
Step 1: Calculate Expected Return (Holding period return):
The formula for the (one-year) holding period return is:
HPR = (D1 + S1 - S0) / S0, where D = dividend and S = stock price. Here, HPR = (0 + 55 - 45) / 45 =
22.2%
Step 2: Calculate Required Return:
The formula for the required return is from the CAPM: RR = Rf + (ERM - Rf) × Beta
RR = 4.25% + (12.5 - 4.25%) × 2.31 = 23.3%.
Step 3: Determine over/under valuation:
The required return is greater than the expected return, so the security is overvalued. The amount =
23.3% − 22.2% = 1.1%.
104. Answer B

64
 RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate,
and (RMarket − Rf) = market premium
Here, RRStock = 7 + (8 × 1.3) = 7 + 10.4 = 17.4%.
105. Answer C
Use the capital asset pricing model (CAPM) to find the required rate of return. The approximate risk-
free rate of interest is 5% (2% real risk-free rate + 3% inflation premium).
k = 5% + 1.3(4%) = 10.2%.
106. Answer C
Portfolios that lie to the right of the market portfolio on the capital market line ("up" the capital market
line) are created by borrowing funds to own more than 100% of the market portfolio (M).
The statement, "diversify the portfolio even more" is incorrect because the market portfolio is fully
diversified.
107. Answer C
Portfolios that lie to the right of the market portfolio on the capital market line are created by borrowing
funds to own more than 100% of the market portfolio (M).
The statement, "holding both the risk-free asset and the market portfolio" refers to portfolios that lie to
the left of the market portfolio. Portfolios that lie to the left of point M are created by lending funds (or
buying the risk free-asset). These investors own less than 100% of both the market portfolio and more
than 100% of the risk-free asset. The portfolio at point Rf (intersection of the CML and the y-axis) is
created by holding 100% of the risk-free asset. The statement, "fully diversifying" is incorrect because
the market portfolio is fully diversified.
108. Answer A
The required return based on systematic risk is computed as:
ERstock = Rf + (ERM - Rf) × Betastock, or 0.04 + (0.085 - 0.04) × 1.9 = 0.1255, or 12.6%. The expected
return is computed as: (P1 - P0 + D1) / P0, or ($27 - $23 + $0.50) / $23 = 0.1957, or 19.6%. The stock is
above the security market line ER > RR, so it is undervalued.
109. Answer C
Since the equation of the SML is the capital asset pricing model, you can determine if a stock is over-
or underpriced graphically or mathematically. Your answers will always be the same.
Graphically: If you plot a stock's expected return on the SML and it falls below the line, it indicates
that the stock is currently overpriced, causing its expected return to be too low. If the plot is above the
line, it indicates that the stock is underpriced. If the plot falls on the SML, it indicates the stock is
properly priced.
Mathematically: In the context of the SML, a security is underpriced if the required return is less than
the holding period (or expected) return, is overpriced if the required return is greater the holding period
(or expected) return, and is correctly priced if the required return equals the holding period (or
expected) return.
110. Answer B
The CML originates on the vertical axis from the point of the risk-free rate.
111. Answer A
RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate.
Here, RRStock = 6 + (12 - 6) × 1.2 = 6 + 7.2 = 13.2%.
112. Answer B
The slope of the CML indicates the excess return (expected return less the risk-free rate) per unit of
risk.
113. Answer A
Given the Capital Market Line, the investor chooses the portfolio that maximizes his utility. That
portfolio may be exactly the market portfolio or it may be some combination of the risk-free asset and
the market portfolio.
114. Answer A
The market model is a single-factor model. The single factor is the expected excess return on the
market portfolio, or [E(Rm) - RFR].
115. Answer C
The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This

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 straight efficient frontier line is called the capital market line (CML). Investors at point Rf have 100%
of their funds invested in the risk-free asset. Investors at point M have 100% of their funds invested in
market portfolio M. Between Rf and M, investors hold both the risk-free asset and portfolio M. To the
right of M, investors hold more than 100% of portfolio M. All investors have to do to get the risk and
return combination that suits them is to simply vary the proportion of their investment in the risky
portfolio M and the risk-free asset.
Utility curves reflect individual preferences.
116. Answer A
In the Fama and French model, the three factors that explain individual stock returns are firm size, the
firm's book value-to-market value ratio, and the excess return on the market portfolio. The Carhart
model added price momentum as a fourth factor.
117. Answer C
Portfolio X's required return is 0.05 + 0.9 × (0.12-0.05) = 11.3%. It is expected to return 13%. The
portfolio has an expected excess return of 1.7%
Portfolio Y's required return is 0.05 + 1.1 × (0.12-0.05) = 12.7%. It is expected to return 14%. The
portfolio has an expected excess return of 1.3%.
Since both portfolios are undervalued, the investor should sell the portfolio that offers less excess
return. Sell Portfolio Y because its excess return is less than that of Portfolio X.
118. Answer B
Combining the CML (risk-free rate and efficient frontier) with an investor's indifference curve map
separates out the decision to invest from what to invest in and is called the separation theorem. The
investment selection process is thus simplified from stock picking to efficient portfolio construction
through diversification.
The other statements are false. As an investor diversifies away the unsystematic portion of risk, the
correlation between his portfolio return and that of the market approaches positive one. (Remember that
the market portfolio has no unsystematic risk). The SML measures systematic risk, or beta risk.

119. Answer B
In the context of the SML, a security is underpriced if the required return is less than the holding
period (or expected) return, is overpriced if the required return is greater the holding period (or
expected) return, and is correctly priced if the required return equals the holding period (or expected)
return.
Here, the holding period (or expected) return is calculated as: (ending price - beginning price + any
cash flows/dividends) / beginning price. The required return uses the equation of the SML: risk free
rate + Beta × (expected market rate − risk free rate).
ER = (26 − 20) / 20 = 0.30 or 30%, RR = 8 + (16 − 8) × 1.7 = 21.6%. The stock is underpriced
therefore purchase.
120. Answer A
Capital market theory suggests that all investors should invest in the same portfolio of risky assets, and
this portfolio is located at the point of tangency of the CML and the efficient frontier of risky assets.
Any point below the CML is suboptimal, and points above the CML are not feasible.
121. Answer A
In equilibrium, investors should not expect to earn additional return for bearing nonsystematic risk
because this risk can be eliminated by diversification. Individual securities have both systematic and
nonsystematic risk. Systematic risk is market risk; nonsystematic risk is specific to individual
securities.
122. Answer: B
The slope of the CML for lending portfolios (where a portion of the investor’s funds are invested in the
risk-free asset) is dictated by the difference between the risk-free rate and the market portfolio.
The slope of the CML for leveraged or borrowing portfolios (where the weight of the market portfolio of
the investor’s portfolio is greater than 100%) is dictated by the difference between the cost of borrowing
and the market portfolio.
The greater the difference between the risk-free rate and the cost of borrowing, the greater the significance
of the kink in the CML.
123. Answer: C

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 Fundamental factor models use relationships between security returns and underlying fundamentals (e.g.,
earnings, earnings’ growth, and cash flow growth) to estimate returns.
124. Answer: B
ABC Stock’s expected return for the month = 0.003 + 0.95 × 0.0225 = 0.0244 or 2.44%
ABC’s company-specific return (abnormal return) = 0.04 – 0.0244 = 0.0156 or 1.56%
125. Answer: A
Beta is the ratio of the covariance of the stock’s return and the market return to the variance of market returns.
126. Answer: B
The CAL and the CML only applied to efficient portfolios, not to individual assets or inefficient
portfolios. They use total risk on the x-axis, and since only systematic risk is priced, they can only be used
for efficient portfolios (those with no unsystematic risk and whose total risk therefore was the same as
their systematic risk).
127. Answer: B
The SML and the CAPM can be applied to any security or portfolio, regardless of whether it is efficient.
This is because they are based only on a security’s systematic risk, not total risk.
128. Answer: A
Beta of the portfolio = w1 β 1 + w2 β 2 + w3 β 3
Beta of the portfolio = (0.3 × 0) + (0.45 × 1) + (0.25 × 0.9) = 0.675
Expected return of the portfolio = Rf + β (Rm – Rf)
Expected return of the portfolio = 0.07 + 0.675 (0.16 – 0.07) = 0.1308 or 13.08%
129. Answer: A
The slope of the CAL equals the difference between the asset/portfolio’s return and the risk-free rate
divided by the standard deviation of the asset/portfolio.
130. Answer: B
The Sharpe ratio and M2 are based on total risk. The Treynor ratio is based on beta risk only.
131. Answer: B
Jensen’s alpha equals the difference between the portfolio’s actual return and the required return (as
predicted by the CAPM) based on the asset’s systematic risk. An investor should not pay the portfolio
manager a fee greater than the portfolio’s Jensen’s alpha, as such a fee would take the portfolio’s net
return lower than the risk of a passively managed portfolio.
132. Answer: B
Expected return = Rf + β (Rm – Rf)
Expected return = 0.05 + 1.2 (0.11 – 0.05) = 12.20%
133. Answer: A
Sharpe ratio = (RA – Rf) / σA = (0.19 – 0.05) / 0.27 = 0.5185
134. Answer: B
Treynor ratio = (RC – Rf) / β C = (0.16 – 0.05) / 0.9 = 0.1222
135. Answer: A
M2 = (RA – Rf) σm / σC – (Rm – Rf) = [(0.14 – 0.05) × 0.24 / 0.22] – (0.11 – 0.05)
M2 = 3.82%
136. Answer: C
Manager C’s expected return = Rf + β (Rm – Rf) = 0.05 + 0.9 (0.11 – 0.05) = 10.4%
Jensen’s alpha = 16% − 10.4% = 5.6%
137. Answer: C
The security characteristic line (SCL) plots the excess returns of a security against the excess returns on
the market.
138. Answer: B
Stock C’s expected return = Rf + β (Rm – Rf) = 0.04 + 0.8 (0.15 – 0.04) = 12.8%
Jensen’s alpha = 19% − 12.8% = 6.2%
139. Answer: C
Nonsystematic variance = (0.252) – (1.12 × 0.212) = 0.009139
140. Answer: B
Stock A’s expected return = 0.04 + 1.1 (0.15 – 0.04) = 16.1%
Stock A’s Jensen’s alpha = 22% – 16.1% = 5.9%
Stock B’s expected return = 0.04 + 1.4 (0.15 – 0.04) = 19.4%

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 Stock B’s Jensen’s alpha = 17% – 19.4% = −2.4%
Stock B has a negative Jensen’s alpha and therefore should not be included in the market portfolio.
141. Answer: A
The CAPM is a single period model.
142. Answer: C
The capital market line plots returns against total risk as measured by the standard deviation of returns.
143. Answer: B
A portfolio to the left of the market portfolio on the CML is less risky, as investors lend a proportion of
their funds at the risk-free rate.
144. Answer: C
Required rate of return = 5% + 0.8 (6%) = 9.8%
145. Answer: C
Required return of Stock A = 5% + 0.7 (12% − 5%) = 9.9%
Expected return of Stock A = (23 – 20 + 1) / 20 = 20%
Since the expected return of Stock A is greater than its required return, it is underpriced and therefore the
analyst should buy it.
Required return of Stock B = 5% + 1.1 (12% − 5%) = 12.7%
Expected return of Stock B = (37 – 35 + 1) / 35 = 8.57%
Since the expected return of Stock B is less than its required return, it is overpriced and therefore the
analyst should sell it.
146. Answer: B
Variance of market’s returns = 0.072 = 0.0049
Beta = 0.007 / 0.0049 = 1.43
147. Answer: B
Both statements are correct.
148. Answer: C
Beta can be viewed as a standardized measure of systematic risk.
All efficiently priced securities should lie on the security market line. Beta only determines where the
security will lie on the security market line. If the beta for an asset is greater than 1, the asset has a higher
normalized systematic risk than the market, which means that it is more volatile than the overall market
portfolio and plots to the right of the market portfolio on the SML.
149. Answer: B
A security whose required rate of return is greater than the expected rate of return is considered
overvalued and plots below the security market line.
A security whose expected rate of return is greater than the required rate of return is considered
undervalued and plots above the security market line.
150. Answer: A
Required return on Asset A = 0.06 + [2.1 × (0.14 – 0.06)] = 22.8%
The required return on Asset A (22.8%) is more than the expected return (20%). Therefore, Jessica should
not invest in it.
Required return on Asset B = 0.06 + [1.6 × (0.14 – 0.06)] = 18.8%
The required return on Asset B (18.8%) is less than the expected return (20%). Therefore, Jessica should invest in it.
151. Answer: A
Expected return on stock A = (29 / 24) – 1 = 20.83%
Required return on stock A = 0.06 + (1.6 × 0.1) = 22%
The expected return (20.83%) is less than the required return (22%). Therefore, it is overvalued and will
plot below the security market line.
Expected return on stock B = (39 / 32) – 1 = 21.88%
Required return on stock B = 0.06 + (1.3 × 0.1) = 19%
The expected return (21.88%) is more than the required return (19%). Therefore, it is undervalued and
will plot above the security market line.
Expected return on stock C = (33 / 28) – 1 = 17.86%
Required return on stock C = 0.06 + (1.2 × 0.1) = 18%
The expected return (17.86%) is less than the required return (18%). Therefore, it is overvalued and will
plot below the security market line.

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 PORTFOLIO MANAGEMENT

BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION

Overview —
 Los a Describe the reasons for a written investment policy statement (IPS).

 Los b Describe the major components of an IPS.

 Los c Describe risk and return objectives and how they may be developed for a client.

 Los d Distinguish between the willingness and the ability (capacity) to take risk in analyzing an
investor's financial risk tolerance.
 Los e Describe the investment constraints of liquidity, time horizon, tax concerns, legal and
regulatory factors, and unique circumstances and their implications for the choice of portfolio
assets.
 Los f Explain the specification of asset classes in relation to asset allocation.

 Los g Describe the principles of portfolio construction and the role of asset allocation in relation to
the IPS.

PRACTICE PROBLEMS
1. Which of the following is least important as a reason for a written investment policy statement (IPS)?
A. The IPS may be required by regulation.
B. Having a written IPS is part of best practice for a portfolio manager.
C. Having a written IPS ensures the client’s risk and return objectives can be achieved.
2. Which of the following best describes the underlying rationale for a written investment policy statement
(IPS)?
A. A written IPS communicates a plan for trying to achieve investment success.
B. A written IPS provides investment managers with a ready defense against client lawsuits.
C. A written IPS allows investment managers to instruct clients about the proper use and purpose of
investments.
3. A written investment policy statement (IPS) is most likely to succeed if:
A. it is created by a software program to assure consistent quality.
B. it is a collaborative effort of the client and the portfolio manager.
C. it reflects the investment philosophy of the portfolio manager.
4. The section of the investment policy statement (IPS) that provides information about how policy may be
executed, including investment constraints, is best described as the:
A. Investment Objectives.
B. Investment Guidelines.
C. Statement of Duties and Responsibilities.
5. Which of the following is least likely to be placed in the appendices to an investment policy statement
(IPS)?
A. Rebalancing Policy.
B. Strategic Asset Allocation.

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 C. Statement of Duties and Responsibilities.
6. Which of the following typical topics in an investment policy statement (IPS) is most closely linked to the
client’s “distinctive needs”?
A. Procedures.
B. Investment Guidelines.
C. Statement of Duties and Responsibilities.
7. An investment policy statement that includes a return objective of outperforming the FTSE 100 by 120
basis points is bestcharacterized as having a(n):
A. relative return objective.
B. absolute return objective.
C. arbitrage-based return objective.
8. Risk assessment questionnaires for investment management clients are most useful in measuring:
A. value at risk.
B. ability to take risk.
C. willingness to take risk.
9. Which of the following is best characterized as a relative risk objective?
A. Value at risk for the fund will not exceed US$3 million.
B. The fund will not underperform the DAX by more than 250 basis points.
C. The fund will not lose more than €2.5 million in the coming 12-month period.
10. In preparing an investment policy statement, which of the following is most difficult to quantify?
A. Time horizon.
B. Ability to accept risk.
C. Willingness to accept risk.
11. After interviewing a client in order to prepare a written investment policy statement (IPS), you have
established the following:
 The client has earnings that vary dramatically between £30,000 and £70,000 (pre-tax) depending on
weather patterns in Britain.
 In three of the previous five years, the after-tax income of the client has been less than £20,000.
 The client’s mother is dependent on her son (the client) for approximately £9,000 per year support.
 The client’s own subsistence needs are approximately £12,000 per year.
 The client has more than 10 years’ experience trading investments including commodity futures, stock
options, and selling stock short.
 The client’s responses to a standard risk assessment questionnaire suggest he has above average risk
tolerance.
The client is best described as having a:
A. low ability to take risk, but a high willingness to take risk.
B. high ability to take risk, but a low willingness to take risk.
C. high ability to take risk and a high willingness to take risk.
12. After interviewing a client in order to prepare a written investment policy statement (IPS), you have
established the following:
 The client has earnings that have exceeded €120,000 (pre-tax) each year for the past five years.
 She has no dependents.
 The client’s subsistence needs are approximately €45,000 per year.
 The client states that she feels uncomfortable with her lack of understanding of securities markets.
 All of the client’s current savings are invested in short-term securities guaranteed by an agency of her
national government.
 The client’s responses to a standard risk assessment questionnaire suggest she has low risk tolerance.
The client is best described as having a:
A. low ability to take risk, but a high willingness to take risk.
B. high ability to take risk, but a low willingness to take risk.
C. high ability to take risk and a high willingness to take risk.
13. A client who is a 34-year old widow with two healthy young children (aged 5 and 7) has asked you to
help her form an investment policy statement. She has been employed as an administrative assistant in a
bureau of her national government for the previous 12 years. She has two primary financial goals—her

70
 retirement and providing for the college education of her children. This client’s time horizon
is best described as being:
A. long term.
B. short term.
C. medium term.
14. The timing of payouts for property and casualty insurers is unpredictable (“lumpy”) in comparison with
the timing of payouts for life insurance companies. Therefore, in general, property and casualty insurers
have:
A. lower liquidity needs than life insurance companies.
B. greater liquidity needs than life insurance companies.
C. a higher return objective than life insurance companies.
15. A client who is a director of a publicly listed corporation is required by law to refrain from trading that
company’s stock at certain points of the year when disclosure of financial results are pending. In
preparing a written investment policy statement (IPS) for this client, this restriction on trading:
A. is irrelevant to the IPS.
B. should be included in the IPS.
C. makes it illegal for the portfolio manager to work with this client.
16. Consider the pairwise correlations of monthly returns of the following asset classes:
Brazilian East Asian European US
Equities Equities Equities Equities
Brazilian equities 1.00 0.70 0.85 0.76
East Asian equities 0.70 1.00 0.91 0.88
European equities 0.85 0.91 1.00 0.90
US equities 0.76 0.88 0.90 1.00
Based solely on the information in the above table, which equity asset class is most sharply distinguished
from US equities?
A. Brazilian equities.
B. European equities.
C. East Asian equities.
17. Returns on asset classes are best described as being a function of:
A. the failure of arbitrage.
B. exposure to the idiosyncratic risks of those asset classes.
C. exposure to sets of systematic factors relevant to those asset classes.
18. In defining asset classes as part of the strategic asset allocation decision, pairwise correlations within asset
classes should generally be:
A. equal to correlations among asset classes.
B. lower than correlations among asset classes.
C. higher than correlations among asset classes.
19. Tactical asset allocation is best described as:
A. attempts to exploit arbitrage possibilities among asset classes.
B. the decision to deliberately deviate from the policy portfolio.
C. selecting asset classes with the desired exposures to sources of systematic risk in an investment
portfolio.
20. Investing the majority of the portfolio on a passive or low active risk basis while a minority of the assets is
managed aggressively in smaller portfolios is best described as:
A. the core–satellite approach.
B. a top-down investment policy.
C. a delta-neutral hedge approach.
21. The investment policy statement is most accurately considered the:
A. starting point of the portfolio management process.
B. key intermediate step in the portfolio management process.
C. end product of the portfolio management process.

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22. The component of an investment policy statement that defines the investment objectives is most likely to
include information about:
A. the investor's risk tolerance.
B. unique needs and preferences of the investor.
C. permitted asset types and use of leverage in the investment account.
23. A client exhibits an above-average willingness to take risk but a below-average ability to take risk. When
assigning an overall risk tolerance, the investment adviser is most likely to assess the client's overall risk
tolerance as:
A. above average.
B. average.
C. below average.
24. Which of the following is least likely an example of a portfolio constraint?
A. Higher tax rate on dividend income than on capital gains.
B. Significant spending requirements in the near future.
C. Minimum total return requirement of 8%.
25. In determining the appropriate asset allocation for a client's investment account, the manager should:
A. consider only the investor's risk tolerance.
B. incorporate forecasts of future economic conditions.
C. consider the investor's risk tolerance and future needs, but not forecasts of market conditions.
26. When developing the strategic asset allocation in an IPS, the correlations of returns:
A. within an asset class should be relatively high.
B. among asset classes should be relatively high.
C. within an asset class should be relatively low.
27. Which of the following would be assessed first in a top-down valuation approach?
A. Industry risks.
B. Fiscal policy.
C. Industry return on equity (ROE).
28. A portfolio manager who believes equity securities are overvalued in the short term reduces the weight of
equities in her portfolio to 35% from its longer-term target weight of 40%. This decision is best described
as an example of:
A. rebalancing.
B. strategic asset allocation.
C. tactical asset allocation.
29. Which of the following statements about the importance of risk and return in the investment objective is
least accurate?
A. Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of
return.
B. The return objective may be stated in dollar amounts even if the risk objective is stated in percentages.
C. The investor's risk tolerance is likely to determine what level of return will be feasible.
30. The manager of the Fullen Balanced Fund is putting together a report that breaks out the percentage of the
variation in portfolio return that is explained by the target asset allocation, security selection, and tactical
variations from the target, respectively. Which of the following sets of numbers was the most likely
conclusion for the report?
A. 90%, 6%, 4%.
B. 33%, 33%, 33%.
C. 50%, 25%, 25%.
31. The top-down analysis approach is most likely to be employed in which step of the portfolio management
process?
A. The feedback step.
B. The planning step.
C. The execution step.
32. An investment manager has constructed an efficient frontier based on a client's investable asset classes.
The manager should choose one of these portfolios for the client based on:
A. the investment policy statement (IPS).
B. relative valuation of the asset classes.

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 C. a risk budgeting process.
33. Which of the following actions is best described as taking place in the execution step of the portfolio
management process?
A. Developing an investment policy statement.
B. Rebalancing the portfolio.
C. Choosing a target asset allocation.
34. When preparing a strategic asset allocation, how should asset classes be defined with respect to the
correlations of returns among the securities in each asset class?
A. Low correlation within asset classes and high correlation between asset classes.
B. Low correlation within asset classes and low correlation between asset classes.
C. High correlation within asset classes and low correlation between asset classes.
35. Which of the following asset class specifications is most appropriate for asset allocation purposes?
A. Consumer discretionary.
B. Domestic bonds.
C. Emerging markets.
36. Which of the following is NOT a rationale for the importance of the policy statement in investing? It:
A. allows the investor to judge performance by objective standards.
B. forces investors to take risks.
C. specifies a benchmark against which to judge performance.
37. While assessing an investor's risk tolerance, a financial adviser is least likely to ask which of the following
questions?
A. "How much insurance coverage do you have?"
B. "What rate of investment return do you expect?"
C. "Is your home life stable?"
38. Which of the following best describes the importance of the policy statement? It:
A. states the standards by which the portfolio's performance will be judged.
B. outlines the best investments.
C. limits the risks taken by the investor.
39. Which of the following is least likely to be considered a constraint when preparing an investment policy
statement?
A. Tax concerns.
B. Liquidity needs.
C. Risk tolerance.
40. Which of the following should least likely be included as a constraint in an investment policy statement
(IPS)?
A. Any unique needs or preferences an investor may have.
B. How funds are spent after being withdrawn from the portfolio.
C. Constraints put on investment activities by regulatory agencies.
41. All of the following are investment constraints EXCEPT:
A. pension plan contributions of the employer.
B. liquidity needs.
C. tax concerns.
42. A return objective is said to be relative if the objective is:
A. stated in terms of probability.
B. compared to a specific numerical outcome.
C. based on a benchmark index or portfolio.
43. A pooled investment fund buys all the shares of a publicly traded company. The fund reorganizes the
company and replaces its management team. Three years later, the fund exits the investment through an
initial public offering of the company's shares. This pooled investment fund is best described as a(n):
A. venture capital fund.
B. event-driven fund.
C. private equity fund.
44. Brian Nebrik, CFA, meets with a new investment management client. They compose a statement that
defines each of their responsibilities concerning this account and choose a benchmark index with which
to evaluate the account's performance. Which of these items should be included in the client's Investment

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 Policy Statement (IPS)?
A. Neither of these items.
B. Both of these items.
C. Only one of these items.
45. An endowment is required by statute to pay out a minimum percentage of its asset value each period to its
beneficiaries. This investment constraint is best classified as:
A. liquidity.
B. legal and regulatory.
C. unique circumstances.
46. In a defined benefit pension plan:
A. the employee is promised a periodic payment upon retirement.
B. the employee is responsible for making investment decisions.
C. the employer's pension expense is equal to its contributions to the plan.
47. Which of the following pooled investments is least likely to employ large amounts of leverage?
A. Private equity buyout fund.
B. Global macro hedge fund.
C. Venture capital fund.
48. Which of the following statements regarding the portfolio management process is least accurate?
A. A portfolio’s performance should be evaluated relative to the highest return that can be achieved.
B. The investment policy statement must be periodically reviewed and updated.
C. The investor’s needs and financial market expectations jointly determine her investment strategy.
49. An investment policy statement least likely:
A. Creates a standard to judge the performance of the portfolio manager.
B. Guarantees investment success.
C. Helps the investor decide on realistic investment goals.
50. Javier is a relatively risk-averse investor. He tells his portfolio manager not to invest in securities with
standard deviation of returns of more than 4%. This is most likely a(n):
A. Relative risk objective.
B. Absolute risk objective.
C. Combination of relative and absolute risk objective.
51. Susan is a young marketing professional who recently inherited $2 million from her grandfather. With an
annual income of $300,000 she already enjoys a good lifestyle and is thinking of investing her inheritance
so that she can reap the benefits 30 years later when she retires. However, in light of the recent financial
crisis, she is only looking to invest in government bonds and commodities such as gold.
Which of the following statements is most accurate?
A. Susan has a high ability as well as willingness to take risk.
B. Susan has a low ability to take risk, but a high willingness to take risk.
C. Susan has a high ability to take risk, but a low willingness to take risk.
52. Consider the following statements:
Statement 1: The portfolio should achieve returns within 5% of the returns on the S&P 500 index.
Statement 2: The portfolio should outperform the benchmark index (the S&P 500 index) by one
percentage point each year.
Which of the following is most accurate?
Statement 1 is a(n): Statement 2 is a(n):
A Relative return objective Absolute return objective
B Relative risk objective Relative return objective
C Absolute return objective Relative return objective
53. Consider the following investors:
Investor A wants to invest in securities that make regular payments so that he can pay his daughter’s
college tuition.
Investor B does not want to invest in stocks of Alpha Corp. (his employer), as he has access to material
nonpublic information about the company.
Which of the following is most accurate?

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 Investor A has: Investor B has:
A Liquidity constraints Unique needs and circumstances
B Time horizon constraints Unique needs and circumstances
C Liquidity constraints Legal and regulatory constraints
54. The primary determinant of portfolio returns is how the portfolio manager allocates funds across:
A. Securities within an asset class.
B. Different geographic regions.
C. Various asset classes.
55. Which of the following is most accurate regarding how portfolio managers develop risk and return
expectations of various asset classes?
Return expectations can be Risk expectations can be
developed from: developed from:
A Economic analysis Historical data
B Historical data Valuation models
C Economic analysis Valuation models
56. Which of the following is least likely a consideration when defining asset classes?
A. Asset classes should cover all investment alternatives.
B. The correlations among assets within a class should be relatively low.
C. The correlations among different asset classes should be relatively low.
57. Consider the following statements:
Statement 1: A change in the investor’s objectives or constraints would cause a movement in the efficient
frontier.
Statement 2: A shift in the investor’s indifference curve would require the strategic asset allocation to be
adjusted.
Which of the following is most likely?
A. Only Statement 1 is incorrect.
B. Only Statement 2 is incorrect.
C. Both statements are correct.
58. A portfolio manager expects commodities to outperform equities in the coming weeks and therefore
allocates more funds to commodities. This is most likely referred to as:
A. Strategic asset allocation.
B. Security selection.
C. Tactical asset allocation.
59. Under the core-satellite approach, investors invest most of their funds in:
A. Active investments.
B. Equity securities.
C. Passive investments.

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 SOLUTIONS
1. C is correct. Depending on circumstances, a written IPS or its equivalent may be required by law or
regulation and a written IPS is certainly consistent with best practices. The mere fact that a written IPS is
prepared for a client, however, does notensure that risk and return objectives will in fact be achieved.
2. A is correct. A written IPS is best seen as a communication instrument allowing clients and portfolio
managers to mutually establish investment objectives and constraints.
3. B is correct. A written IPS, to be successful, must incorporate a full understanding of the client’s situation
and requirements. As stated in the reading, “The IPS will be developed following a fact finding discussion
with the client.”
4. B is correct. The major components of an IPS are listed in Section 2.2 of the reading. Investment
Guidelines are described as the section that provides information about how policy may be executed,
including investment constraints. Statement of Duties and Responsibilities “detail[s] the duties and
responsibilities of the client, the custodian of the client’s assets, the investment managers, and so
forth.” Investment Objectives is “a section explaining the client’s objectives in investing.”
5. C is correct. The major components of an IPS are listed in Section 2.2 of the reading. Strategic Asset
Allocation (also known as the policy portfolio) and Rebalancing Policy are often included as appendices
to the IPS. The Statement of Duties and Responsibilities, however, is an integral part of the IPS and is
unlikely to be placed in an appendix.
6. B is correct. According to the reading, “The sections of an IPS that are most closely linked to the client’s
distinctive needs are those dealing with investment objectives and constraints.” Investment
Guidelines “[provide] information about how policy may be executed, including investment
constraints.” Procedures “[detail] the steps to be taken to keep the IPS current and the procedures to
follow to respond to various contingencies.” Statement of Duties and Responsibilities “detail[s] the duties
and responsibilities of the client, the custodian of the client’s assets, the investment managers, and so
forth.”
7. A is correct. Because the return objective specifies a target return relative to the FTSE 100 Index, the
objective is best described as a relative return objective.
8. C is correct. Risk attitude is a subjective factor and measuring risk attitude is difficult. Oftentimes,
investment managers use psychometric questionnaires, such as those developed by Grable and Joo (2004),
to assess a client’s willingness to take risk.
9. B is correct. The reference to the DAX marks this response as a relative risk objective. Value at risk
establishes a minimum value of loss expected during a specified time period at a given level of
probability. A statement of maximum allowed absolute loss (€2.5 million) is an absolute risk objective.
10. C is correct. Measuring willingness to take risk (risk tolerance, risk aversion) is an exercise in applied
psychology. Instruments attempting to measure risk attitudes exist, but they are clearly less objective than
measurements of ability to take risk. Ability to take risk is based on relatively objective traits such as
expected income, time horizon, and existing wealth relative to liabilities.
11. A is correct. The volatility of the client’s income and the significant support needs for his mother and
himself suggest that the client has a low ability to take risk. The client’s trading experience and his
responses to the risk assessment questionnaire indicate that the client has an above average willingness to
take risk.
12. B is correct. On the one hand, the client has a stable, high income and no dependents. On the other hand,
she exhibits above average risk aversion. Her ability to take risk is high, but her willingness to take risk is
low.
13. A is correct. The client’s financial objectives are long term. Her stable employment indicates that her
immediate liquidity needs are modest. The children will not go to college until 10 or more years later. Her
time horizon is best described as being long term.

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14. B is correct. The unpredictable nature of property and casualty (P&C) claims forces P&C insurers to
allocate a substantial proportion of their investments into liquid, short maturity assets. This need for
liquidity also forces P&C companies to accept investments with relatively low expected returns. Liquidity
is of less concern to life insurance companies given the greater predictability of life insurance payouts.
15. B is correct. When a client has a restriction in trading, such as this obligation to refrain from trading, the
IPS “should note this constraint so that the portfolio manager does not inadvertently trade the stock on the
client’s behalf.”
16. A is correct. The correlation between US equities and Brazilian equities is 0.76. The correlations between
US equities and East Asian equities and the correlation between US equities and European equities both
exceed 0.76. Lower correlations indicate a greater degree of separation between asset classes. Therefore,
using solely the data given in the table, returns on Brazilian equities are most sharply distinguished from
returns on US equities.
17. C is correct. Strategic asset allocation depends on several principles. As stated in the reading, “One
principle is that a portfolio’s systematic risk accounts for most of its change in value over the long run.” A
second principle is that, “the returns to groups of like assets… predictably reflect exposures to certain sets
of systematic factors.” This latter principle establishes that returns on asset classes primarily reflect the
systematic risks of the classes.
18. C is correct. As the reading states, “an asset class should contain homogeneous assets… paired
correlations of securities would be high within an asset class, but should be lower versus securities in
other asset classes.”
19. B is correct. Tactical asset allocation allows actual asset allocation to deviate from that of the strategic
asset allocation (policy portfolio) of the IPS. Tactical asset allocation attempts to take advantage of
temporary dislocations from the market conditions and assumptions that drove the policy portfolio
decision.
20. A is correct. The core–satellite approach to constructing portfolios is defined as “investing the majority of
the portfolio on a passive or low active risk basis while a minority of the assets is managed aggressively in
smaller portfolios.”
21. A is correct. An investment policy statement is considered to be the starting point of the portfolio
management process. The IPS is a plan for achieving investment success.
22. A is correct. Investment objectives are defined based on both the investor's return requirements and risk
tolerance. Investment constraints include the investor's time horizon, liquidity needs, tax considerations,
legal and regulatory requirements, and unique needs and preferences. Policies regarding permitted asset
types and the amount of leverage to use are best characterized as investment guidelines.
23. C is correct. When assigning an overall risk tolerance, the prudent approach is to use the lower of ability
to take risk and willingness to take risk.
24. C is correct. Return objectives are part of a policy statement's objectives, not constraints.
25. B is correct. An adviser's forecasts of the expected returns and expected volatilities (risk) of different
asset classes are an important part of determining an appropriate asset allocation.
26. Answer A
Asset classes are defined such that correlations of returns within an asset class are relatively high. Low
correlations of returns among asset classes increase the benefits of diversification across asset classes.
27. Answer B
In the top-down valuation approach, the investor should analyze macroeconomic influences first, then
industry influences, and then company influences. Fiscal policy, as part of the macroeconomic landscape,
should be analyzed first.
28. Answer C
Tactical asset allocation refers to deviating from a portfolio's target asset allocation weights in the short
term to take advantage of perceived opportunities in specific asset classes. Strategic asset allocation is
determining the target asset allocation percentages for a portfolio. Rebalancing is periodically adjusting a
portfolio back to its target asset allocation.

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29. Answer A
Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of
return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will
likely help determine what level of expected return is feasible.
30. Answer A
Several studies support the idea that approximately 90% of the variation in a single portfolio's returns can
be explained by its target asset allocations, with security selection and tactical variations from the target
(market timing) playing a much less significant role. In fact, for actively managed funds, actual portfolio
returns are slightly less than those that would have been achieved if the manager strictly maintained the
target allocation, thus illustrating the difficultly of improving returns through security selection or market
timing.
31. Answer C
Top-down analysis would be used to select securities in the execution step.
32. Answer A
After defining the investable asset classes and constructing an efficient frontier of possible portfolios of
these asset classes, the manager should choose the efficient portfolio that best suits the investor's
objectives as defined in the IPS. The investor's strategic asset allocation can then be defined as the asset
allocation of the chosen portfolio. Tactical asset allocation based on relative valuation of asset classes
would require the manager to deviate from the strategic asset allocation. Risk budgeting refers to the
practice of determining an overall risk limit for a portfolio and allocating the risk among strategic asset
allocation, tactical asset allocation, and security selection.
33. Answer C
The three major steps in the portfolio management process are (1) planning, (2) execution, and (3)
feedback. The planning step includes evaluating the investor's needs and preparing an investment policy
statement. The execution step includes choosing a target asset allocation, evaluating potential investments
based on top-down or bottom-up analysis, and constructing the portfolio.
The feedback step includes measuring and reporting performance and monitoring and rebalancing the
portfolio.
34. Answer C
The portfolio diversification benefits from strategic asset allocation result from low correlations of returns
between asset classes. Asset classes should consist of assets with similar characteristics and investment
performance, which means correlations within an asset class are relatively high.
35. Answer B
An asset class should be specified by type of security (e.g., stocks, bonds, alternative assets, cash) and can
then be further subdivided by region or industry classification. An asset class defined only as "emerging
markets" or "consumer discretionary firms" should identify the type of securities (e.g., equities or debt).
36. Answer B
By no means should the policy statement force the investor to take risks. The statement forces investors to
understand the risks of investing.
37. Answer B
While the degree of risk tolerance will have an effect on expected returns, assessing the risk tolerance
comes first, and the resulting set of feasible returns follows. The other questions address risk tolerance.
38. Answer A
The policy statement should state the performance standards by which the portfolio's performance will be
judged and specify the benchmark that represents the investors risk preferences.
39. Answer C
The constraints are: liquidity needs, time horizon, taxes, legal and regulatory factors, and unique needs
and preferences. Risk tolerance is included in the investment objectives of the policy statement, not in the
constraints.

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40. Answer B
How funds are spent after withdrawal would not be a constraint of an IPS.
41. Answer A
Investment constraints include: liquidity needs, time horizon, tax concerns, legal and regulatory factors
and unique needs and preferences. While employer contributions may be of interest, and an issue in some
instances, it is not classified as a specific investment constraint.
42. Answer C
Relative return objectives are stated relative to specified benchmarks, such as LIBOR or the return on a
stock index. Absolute return objectives are stated in terms of specific numerical outcomes, such as a 5%
return. Risk objectives (either absolute or relative) may be stated in terms of probability, such as "no more
than a 5% probability of a negative return."
43. Answer C
A private equity fund or buyout fund is one that acquires entire public companies, takes them private, and
reorganizes the companies to increase their value. An event-driven fund is a hedge fund that invests in
response to corporate events such as mergers or acquisitions. Venture capital funds invest in start-up
companies.
44. Answer B
Two of the major components of an IPS should be a statement of the responsibilities of the investment
manager and the client, and a performance evaluation benchmark.
45. Answer B
Legal and regulatory constraints are those that apply to an investor by law.
46. Answer A
In a defined benefit pension plan, a periodic payment, typically based on the employee's salary, is
promised to the employee upon retirement and the employer contributes to an investment trust that
generates the principal growth and income to meet the pension obligation. The employees do not direct
the investments in their accounts as they do in a defined contribution plan. Pension expense for a defined
benefit plan has several components, including service cost, prior service cost, and interest cost, and
depends on actuarial assumptions and the expected rate of return on plan assets.
47. Answer C
Hedge funds and buyout firms typically employ high leverage to acquire assets. Venture capital typically
involves an equity interest.
48. Answer: A
A portfolio’s performance should be evaluated and compared with the expectations and requirements
listed in the policy statement.
49. Answer: B
The investment policy statement does not guarantee investment success. It only provides discipline for the
investment process and reduces the possibility of making hasty, inappropriate decisions.
50. Answer: B
This is an absolute risk objective as the investor specifically states the level of risk he is willing to take.
51. Answer: C
With a high income and a long time horizon, Susan’s ability to take risk is high. However, she is only
willing to invest in government bonds and gold, investments that are considered to be relatively safe.
Therefore, her willingness to take risk is low.
52. Answer: B
Specifying a standard deviation of returns relative to that of a benchmark index is a relative risk objective.
Specifying portfolio return relative to a benchmark is a relative return objective.
53. Answer: C
Investor A’s situation provides an example of a liquidity constraint.
Investor B is legally prohibited from investing in securities regarding which he has material nonpublic
information.

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54. Answer: C
A portfolio’s allocation across various asset classes is the primary determinant of portfolio returns.
55. Answer: A
Return expectations can be developed from historical data, economic analysis, or valuation models, while
standard deviation and correlation estimates are primarily obtained from historical data.
56. Answer: B
When defining asset classes:
A. Each asset class should contain assets that carry a similar expected return and risk, and correlation
among the assets within a class should be relatively high.
B. Each asset class should provide diversification benefits. The correlation of an asset class with other
asset classes should be relatively low.
C. Asset classes should be mutually exclusive and should cover all investment alternatives.
57. Answer: A
A change in the investor’s objectives or constraints would result in a shift in her indifference curves.
A change in capital market expectations would cause a movement in the efficient frontier.
A change in either or both the efficient frontier and the investor’s indifference curve would require the
strategic asset allocation to be adjusted.
58. Answer: C
Tactical asset allocation refers to an allocation where the manager deliberately deviates from the strategic
asset allocation for the short term if she believes that another asset class will perform relatively better.
59. Answer: C
Under the core-satellite approach, investors invest most of their funds in passive investments and trade a
small proportion of assets actively.

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 PORTFOLIO MANAGEMENT: AN OVERVIEW

SUMMARY:
 In this reading we have discussed how a portfolio approach to investing could be preferable to
simply investing in individual securities.

 The problem with focusing on individual securities is that this approach may lead to the
investor “putting all her eggs in one basket.”

 Portfolios provide important diversification benefits, allowing risk to be reduced without

necessarily affecting or compromising return.

 We have outlined the differing investment needs of various types of individual and institutional
investors. Institutional clients include defined benefit pension plans, endowments and
foundations, banks, insurance companies, investment companies, and sovereign wealth funds.

 Understanding the needs of your client and creating an investment policy statement represent
the first steps of the portfolio management process. Those steps are followed by security
analysis, portfolio construction, monitoring, and performance measurement stages.

 We also discussed the different types of investment products that investors can use to create
their portfolio. These range from mutual funds, to exchange traded funds, to hedge funds, to
private equity funds.
 PORTFOLIO RISK AND RETURN: PART I

SUMMARY:
This reading provides a description and computation of investment characteristics, such as risk and
return, that investors use in evaluating assets for investment. This was followed by sections about
portfolio construction, selection of an optimal risky portfolio, and an understanding of risk aversion
and indifference curves. Finally, the tangency point of the indifference curves with the capital
allocation line allows identification of the optimal investor portfolio. Key concepts covered in the
reading include the following:

 Holding period return is most appropriate for a single, predefined holding period.

 Multiperiod returns can be aggregated in many ways. Each return computation has special
applications for evaluating investments.

 Risk-averse investors make investment decisions based on the risk–return trade-off, maximizing
return for the same risk, and minimizing risk for the same return. They may be concerned,
however, by deviations from a normal return distribution and from assumptions of financial
markets’ operational efficiency.

 Investors are risk averse, and historical data confirm that financial markets price assets for risk-
averse investors.

 The risk of a two-asset portfolio is dependent on the proportions of each asset, their standard
deviations and the correlation (or covariance) between the asset’s returns. As the number of
assets in a portfolio increases, the correlation among asset risks becomes a more important
determinate of portfolio risk.

 Combining assets with low correlations reduces portfolio risk.

 The two-fund separation theorem allows us to separate decision making into two steps. In the
first step, the optimal risky portfolio and the capital allocation line are identified, which are the
same for all investors. In the second step, investor risk preferences enable us to find a unique
optimal investor portfolio for each investor.

 The addition of a risk-free asset creates portfolios that are dominant to portfolios of risky assets
in all cases except for the optimal risky portfolio.

By successfully understanding the content of this reading, you should be comfortable calculating an
investor’s optimal portfolio given the investor’s risk preferences and universe of investable assets
available.
 PORTFOLIO RISK AND RETURN: PART II

SUMMARY:
In this reading, we discussed the capital asset pricing model in detail and covered related topics
such as the capital market line. The reading began with an interpretation of the CML, uses of the
market portfolio as a passive management strategy, and leveraging of the market portfolio to obtain
a higher expected return. Next, we discussed systematic and nonsystematic risk and why one
should not expect to be compensated for taking on nonsystematic risk. The discussion of systematic
and nonsystematic risk was followed by an introduction to beta and return-generating models. This
broad topic was then broken down into a discussion of the CAPM and, more specifically, the
relationship between beta and expected return. The final section included applications of the CAPM
to capital budgeting, portfolio performance evaluation, and security selection. The highlights of the
reading are as follows.

 The capital market line is a special case of the capital allocation line, where the efficient portfolio
is the market portfolio.

 Obtaining a unique optimal risky portfolio is not possible if investors are permitted to have
heterogeneous beliefs because such beliefs will result in heterogeneous asset prices.

 Investors can leverage their portfolios by borrowing money and investing in the market.

 Systematic risk is the risk that affects the entire market or economy and is not diversifiable.

 Nonsystematic risk is local and can be diversified away by combining assets with low
correlations.

 Beta risk, or systematic risk, is priced and earns a return, whereas nonsystematic risk is not
priced.

 The expected return of an asset depends on its beta risk and can be computed using the CAPM,
which is given by E(Ri) = Rf + βi[E(Rm) – Rf].

 The security market line is an implementation of the CAPM and applies to all securities,
whether they are efficient or not.

 Expected return from the CAPM can be used for making capital budgeting decisions.

 Portfolios can be evaluated by several CAPM-based measures, such as the Sharpe ratio, the
Treynor ratio, M2, and Jensen’s alpha.

 The SML can assist in security selection and optimal portfolio construction.
 BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION

SUMMARY:
In this reading, we have discussed construction of a client’s investment policy statement, including
discussion of risk and return objectives and the various constraints that will apply to the portfolio.
We have also discussed the portfolio construction process, with emphasis on the strategic asset
allocation decisions that must be made.

 The IPS is the starting point of the portfolio management process. Without a full understanding
of the client’s situation and requirements, it is unlikely that successful results will be achieved.

 The IPS can take a variety of forms. A typical format will include the client’s investment
objectives and also list the constraints that apply to the client’s portfolio.

 The client’s objectives are specified in terms of risk tolerance and return requirements.

 The constraints section covers factors that need to be considered when constructing a portfolio
for the client that meets the objectives. The typical constraint categories are liquidity
requirements, time horizon, regulatory requirements, tax status, and unique needs.

 Risk objectives are specifications for portfolio risk that reflect the risk tolerance of the client.
Quantitative risk objectives can be absolute or relative or a combination of the two.

 The client’s overall risk tolerance is a function of the client’s ability to accept risk and their “risk
attitude,” which can be considered the client’s willingness to take risk.

 The client’s return objectives can be stated on an absolute or a relative basis. As an example of
an absolute objective, the client may want to achieve a particular percentage rate of return.
Alternatively, the return objective can be stated on a relative basis, for example, relative to a
benchmark return.

 The liquidity section of the IPS should state what the client’s requirements are to draw cash
from the portfolio.

 The time horizon section of the IPS should state the time horizon over which the investor is
investing. This horizon may be the period during which the portfolio is accumulating before
any assets need to be withdrawn.

 Tax status varies among investors and a client’s tax status should be stated in the IPS.
 The IPS should state any legal or regulatory restrictions that constrain the investment of the
portfolio.

 The unique circumstances section of the IPS should cover any other aspect of a client’s
circumstances that is likely to have a material impact on the composition of the portfolio; for
example, any religious or ethical preferences.

 Asset classes are the building blocks of an asset allocation. An asset class is a category of assets
that have similar characteristics, attributes, and risk–return relationships. Traditionally,
investors have distinguished cash, equities, bonds, and real estate as the major asset classes.

 A strategic asset allocation results from combining the constraints and objectives articulated in
the IPS and capital market expectations regarding the asset classes.

 As time goes on, a client’s asset allocation will drift from the target allocation, and the amount of
allowable drift as well as a rebalancing policy should be formalized.

 In addition to taking systematic risk, an investment committee may choose to take tactical asset
allocation risk or security selection risk. The amount of return attributable to these decisions can
be measured.