Practice Questions for Midterm, FIN 623

1.

Consider the following probability distribution for some stock:

State
Good
Bad

E(r)
10
4

prob.
0.40
0.60

If you are risk averse, what would a reasonable certainty equivalent be?
a. 14.0 %
b. 10.0
c. 8.0
d. 6.4
e. None of the above are possible.
3.

A set of convex indifference curves indicates which one of the following about an investor's
tradeoff between risk and expected returns?
a. An investor requires an increasingly larger increment of expected return for each additional
unit of risk incurred.
b. An investor derives less additional satisfaction from each extra dollar earned.
c. Portfolios on two separate indifference curves would be equally attractive to the investor.
d. Risk averse investors require higher expected returns.

4.

A T-bill pays 6 percent rate of return. Would risk averse investors invest in a risky portfolio that
pays 12 percent with a probability of 40 percent or 2 percent with a probability of 60 percent?
a. Yes, because they are rewarded with a risk premium.
b. No, because they are not rewarded with a risk premium.
c. No, because the risk premium is small.
d. Cannot be determined.
e. None of the above.

5.

If an investor's portfolio is composed of an investment in the Magellan fund (with 14% expected
return and a 25% standard deviation) and a risk free asset with a 5% return, what is the expected
return if the total portfolio has a standard deviation of 20%?
a. 12.2%
b. 11.9%
c. 13.1%
d. 14%

6.

The exact location of the investor's portfolio on the extended efficient frontier that results from a
combination of the risk free asset and a risky asset depends upon
a. the location of the investor's indifference curve
b. the risk free rate
c. the expected risk and return tradeoff
d. the relative proportions invested in the two assets

7.

When risk free borrowing or lending is included, what is the difference between the efficient set for
the risk seeking and risk averse investors?
a. the difference between the risky asset return and risk free rate
b. the efficient set will be the same for both investors
c. the more risk averse will lie to the southwest of the tangency portfolio
d. the more risk averse investor's indifference curves will be more steeply sloped

Use the following to answer question 8:

You have been given this probability distribution for the holding period return for XYZ stock:
State of the economy
Boom
Normal growth
Recession
8.
a.
b.
c.
d.
e.

Probability
.30
.50
.20

HPR
18%
12%
- 5%

What is the expected standard deviation for XYZ stock?

2.07%
9.96%
7.04%
1.44%
8.13%

Use the following to answer question 9:

Assume an investor with the following utility function: U = E(r) - 3/2(2).
9.

To maximize her expected utility, which one of the following investment alternatives would she
choose?
a.
A portfolio that pays 10 percent with a 60 percent probability or 5 percent with
40 percent probability.
b.
A portfolio that pays 10 percent with 40 percent probability or 5 percent with a
60 percent probability.
c.
A portfolio that pays 12 percent with 60 percent probability or 5 percent with 40
percent probability.
d.
A portfolio that pays 12 percent with 40 percent probability or 5 percent with 60
percent probability.
e.
none of the above.

Use the following to answer questions 10-11:

Investment
1
2
3
4

Expected Return E(r)

0.12
0.15
0.21
0.24

Standard Deviation
0.3
0.5
0.16
0.21

U = E(r) - (A/2) 2, where A = 4.0.

10.
a.
b.
c.
d.
e.

Based on the utility function above, which investment would you select?
1
2
3
4
cannot tell from the information given

11.

Which investment would you select if you were risk neutral?

a.
1
b.
2
c.
3
d.
4
e.
cannot tell from the information given

12.

A portfolio has an expected rate of return of 0.15 and a standard deviation of 0.15. The risk-free
rate is 6 percent. An investor has the following utility function: U = E(r) - (A/2)2. Which value
of A makes this investor indifferent between the risky portfolio and the risk-free asset?
a.
5
b.
6
c.
7
d.
8
e.
none of the above

13.

According to the mean-variance criterion, which one of the following investments dominates all
others?
a.
E(r) = 0.15; Variance = 0.20
b.
E(r) = 0.10; Variance = 0.20
c.
E(r) = 0.10; Variance = 0.25
d.
E(r) = 0.15; Variance = 0.25
f.
none of these is dominates the other alternatives.

14.

Consider a T-bill with a rate of return of 5 percent and the following risky securities:
Security A: E(r) = 0.15; Variance = 0.04
Security B: E(r) = 0.10; Variance = 0.0225
Security C: E(r) = 0.12; Variance = 0.01
Security D: E(r) = 0.13; Variance = 0.0625

a.
b.
c.
d.
e.
15.

From which set of portfolios, formed with the T-bill and any one of the 4 risky securities, would a
risk averse investor always choose his portfolio?
The set of portfolios formed with the T-bill and security A.
The set of portfolios formed with the T-bill and security B.
The set of portfolios formed with the T-bill and security C.
The set of portfolios formed with the T-bill and security D.
Cannot be determined.

The Capital Allocation Line can be described as the

investment opportunity set formed with a risky asset and a risk-free asset.
investment opportunity set formed with two risky assets.
line on which lie all portfolios that offer the same utility to a particular investor.
line on which lie all portfolios with the same expected rate of return and different
standard deviations.
e.
none of the above.

a.
b.
c.
d.

16.

Which of the following statements regarding the Capital Allocation Line (CAL) is false?
The CAL shows risk-return combinations.
The slope of the CAL equals the increase in the expected return of a risky portfolio per
unit of additional standard deviation.
c.
The slope of the CAL is also called the reward-to-variability ratio.
d.
The CAL is also called the efficient frontier of risky assets.
a.
b.

17.
a.
b.
c.
d.
e.

An investor invests 20 percent of his wealth in a risky asset with an expected rate of return of
0.20 and a variance of 0.04 and 80 percent in a T-bill that pays 5 percent. Her portfolio's
expected return and standard deviation are __________ and __________, respectively.
0.114; 0.12
0.087;0.06
0.080; 0.04
0.087; 0.12
none of the above

Use the following to answer question 18:

You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15
and a T-bill with a rate of return of 0.05.
18.
a.
b.
c.
d.
e.

The slope of the Capital Allocation Line formed with the risky asset and the risk-free asset is
equal to
0.4667
0.8000
2.14
0.41667
Cannot be determined.

Use the following to answer questions 19-20:

Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of return of
10% and a standard deviation of 16%. B has an expected rate of return of 8% and a standard deviation of
12%.
19.
a.
b.
c.
d.
e.

The weights of A and B in the portfolio with the lowest possible variance are
respectively.
0.24; 0.76
0.50; 0.50
0.57; 0.43
0.43; 0.57
0.76; 0.24

20.

The risk-free portfolio that can be formed with the two securities will earn _
a.
8.5%
b.
9.0%
c.
8.9%
d.
9.9%
e.
none of the above
Use the following to answer Question 21:

and

rate of return.

Consider a portfolio of Microsoft and General Electric stock with the following characteristics:
Stock
Microsoft
G.E.

E(r)
8%
12

Weight in portfolio
0.20
0.80

18%
25

21. For varying levels of correlation, what is the maximum level of standard deviation for the portfolio?
a.
b.
c.
d.
e.

11.2 %
18.0
23.6
25.0
Not enough information to tell.

22.

a.
b.
c.
d.
e.
23.

24.

25.

You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation
of 0.15 and a T-bill with a rate of return of 0.05.
What percentages of your money must be invested in the risky asset and the risk-free asset,
respectively, to form a portfolio with an expected return of 0.09?
85% and 15%
75% and 25%
67% and 33%
57% and 43%
cannot be determined

Suppose that asset A has a 0.45 chance of tripling its value in one year and a 0.55 chance of going
to half its value in one year. What is asset As expected return?
a. 0.355
b. 0.500
c. 0.625
d. 0.790
a. Impossible to answer.
Which of the following statements regarding risk averse investors is true?
a.
They only care about the rate of return.
b.
They accept investments that offer a weighted average of expected outcomes.
c.
They only accept risky investments that offer a risk premium.
d.
They are willing to accept lower returns and high risk.
e.
a and b.
Assume there are two assets to invest in: An S&P600 Index Fund (with 10% expected return and a
15% standard deviation) and a risk-free asset (with 5% expected return). What is the slope of the
capital asset line (CAL) of an investor who invests 50% of his/her funds in each asset?
a. 0.50
b. 0.165
c. 0.33
d. Need more information.