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Chapter 27
The Theory of Active Portfolio Management
Multiple Choice Questions
1. In the Treynor-Black model
A. portfolio weight are sensitive to large alpha values which can lead to infeasible long or
short position for many portfolio managers.
B. portfolio weight are not sensitive to large alpha values which can lead to infeasible long or
short position for many portfolio managers.
C. portfolio weight are sensitive to large alpha values which can lead to the optimal portfolio
for most portfolio managers.
D. portfolio weight are not sensitive to large alpha values which can lead to the optimal
portfolio for most portfolio managers.
E. none of the above.
In the Treynor-Black model portfolio weight are sensitive to large alpha values which can lead
to infeasible long or short position for many portfolio managers.
Difficulty: Moderate
Difficulty: Moderate
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3. If you begin with a ______ and obtain additional data from and experiment you can form a
______.
A. posterior distribution; prior distribution
B. prior distribution; posterior distribution
C. tight posterior; Bayesian analysis
D. tight prior; Bayesian analysis
E. none of the above
If you begin with a prior distribution and obtain additional data from and experiment you can
form a posterior distribution.
Difficulty: Moderate
Difficulty: Moderate
Difficulty: Moderate
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6. ____________ can be used to measure forecast quality and guide in the proper adjustment
of forecasts.
A. regression analysis
B. exponential smoothing
C. ARIMA
D. moving average models
E. GAUSS
Regression analysis can be used to measure forecast quality and guide in the proper
adjustment of forecasts.
Difficulty: Moderate
Difficulty: Moderate
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8. The ____________ model allows the private views of the portfolio manager to be
incorporated with market data in the optimization procedure.
A. Black-Litterman
B. Treynor-Black
C. Treynor-Mazuy
D. Black-Scholes
E. none of the above.
The Black-Litterman model allows the private views of the portfolio manager to be
incorporated with market data in the optimization procedure.
Difficulty: Moderate
Difficulty: Moderate
10. The Black-Litterman model is geared toward ____________ while the Treynor-Black
model is geared toward ____________.
A. security analysis; security analysis
B. asset allocation; asset allocation
C. security analysis; asset allocation
D. asset allocation; security analysis
E. none of the above
The Black-Litterman model is geared toward asset allocation while the Treynor-Black model
is geared toward security analysis.
Difficulty: Moderate
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Difficulty: Moderate
Difficulty: Moderate
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13. The tracking error of an optimized portfolio can be expressed in terms of the
____________ of the portfolio and thus reveal ____________.
A. return; portfolio performance
B. total risk; portfolio performance
C. beta; portfolio performance
D. beta; benchmark risk
E. relative return; benchmark risk
The tracking error of an optimized portfolio can be expressed in terms of the beta of the
portfolio and thus reveal benchmark risk.
Difficulty: Moderate
14. The Treynor-Black model is a model that shows how an investment manager can use
security analysis and statistics to construct __________.
A. a market portfolio
B. a passive portfolio
C. an active portfolio
D. an index portfolio
E. a balanced portfolio
The Treynor-Black model is a model that shows how an investment manager can use security
analysis and statistics to construct an active portfolio.
Difficulty: Easy
15. If a portfolio manager consistently obtains a high Sharpe measure, the manager's
forecasting ability __________.
A. is above average
B. is average
C. is below average
D. does not exist.
E. cannot be determined based on the Sharpe measure
The manager with the highest Sharpe measure presumably has true forecasting abilities.
Difficulty: Easy
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Difficulty: Easy
Difficulty: Easy
18. The critical variable in the determination of the success of the active portfolio is
________.
A. alpha/systematic risk
B. alpha/nonsystematic risk
C. gamma/systematic risk
D. gamma/nonsystematic risk
E. none of the above
A portfolio with a positive alpha is outperforming the market. If this portfolio also has a low
degree of nonsystematic risk, the portfolio is adequately diversified.
Difficulty: Moderate
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19. In the Treynor-Black model, the weight of each security in the portfolio should be
proportional to its __________.
A. alpha/beta
B. alpha/beta/residual variance
C. beta/residual variance
D. alpha/residual variance
E. none of the above
Use the estimates of alpha, beta, and residual risk to determine the optimal weight of each
security in the portfolio.
Difficulty: Moderate
20. Active portfolio managers try to construct a risky portfolio with __________.
A. a higher Sharpe measure than a passive strategy
B. a lower Sharpe measure than a passive strategy
C. the same Sharpe measure as a passive strategy
D. very few securities
E. none of the above
A higher Sharpe measure than a passive strategy is indicative of the benefits of active
management.
Difficulty: Moderate
21. The beta of an active portfolio is 1.20. The standard deviation of the returns on the market
index is 20%. The nonsystematic variance of the active portfolio is 1%. The standard
deviation of the returns on the active portfolio is __________.
A. 3.84%
B. 5.84%
C. 19.60%
D. 24.17%
E. 26.0%
s = [(1.2)2(0.2)2 + 0.01]1/2 = [0.0676]1/2 = 26.0%.
Difficulty: Difficult
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22. The beta of an active portfolio is 1.36. The standard deviation of the returns on the market
index is 22%. The nonsystematic variance of the active portfolio is 1.2%. The standard
deviation of the returns on the active portfolio is __________.
A. 3.19%
B. 31.86%
C. 42.00%
D. 27.57%
E. 2.86
s = [(1.36)2(0.22)2 + 0.012]1/2 = [0.10152]1/2 = 31.86%.
Difficulty: Difficult
23. Consider the Treynor-Black model. The alpha of an active portfolio is 2%. The expected
return on the market index is 16%. The variance of return on the market portfolio is 4%. The
nonsystematic variance of the active portfolio is 1%. The risk-free rate of return is 8%. The
beta of the active portfolio is 1. The optimal proportion to invest in the active portfolio is
__________.
A. 0%
B. 25%
C. 50%
D. 100%
E. none of the above
wO = [2%/1%]/[(16% - 8%)/4%] = 1, or 100%; w* = 1/[1 + (1 - 1)1] = 1.
Difficulty: Difficult
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24. Consider the Treynor-Black model. The alpha of an active portfolio is 1%. The expected
return on the market index is 16%. The variance of the return on the market portfolio is 4%.
The nonsystematic variance of the active portfolio is 1%. The risk-free rate of return is 8%.
The beta of the active portfolio is 1.05. The optimal proportion to invest in the active portfolio
is __________.
A. 48.7%
B. 50.0%
C. 51.3%
D. 100.0%
E. none of the above
wO = [1%/1%]/[(16% - 8%)/4%] = 0.5; w* = 0.5/[1 + (1 - 1.05)0.5] = 0.513, or 51.3%.
Difficulty: Difficult
25. There appears to be a role for a theory of active portfolio management because
A. some portfolio managers have produced sequences of abnormal returns that are difficult to
label as lucky outcomes.
B. the "noise" in the realized returns is enough to prevent the rejection of the hypothesis that
some money managers have outperformed a passive strategy by a statistically small, yet
economic, margin.
C. some anomalies in realized returns have been persistent enough to suggest that portfolio
managers who identified these anomalies in a timely fashion could have outperformed a
passive strategy over prolonged periods.
D. A and B.
E. A, B, and C.
Statements A, B, and C are true.
Difficulty: Easy
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Difficulty: Easy
27. Which of the following are not true regarding the Treynor-Black model
A. considers both macroeconomic and microeconomic risks.
B. considers security selection only.
C. is relatively easy to implement.
D. A and C.
E. B and C.
A and C are true for the model.
Difficulty: Easy
28. To improve future analyst forecasts using the statistical properties of past forecasts, a
regression model can be fitted to past forecasts. The intercept of the regression is a
__________ coefficient, and the regression beta represents a __________ coefficient.
A. bias, precision
B. bias, bias
C. precision, precision
D. precision, bias
E. none of the above
The estimated equation adjusts future forecasts for direction and magnitude of bias and degree
of imprecision in past forecasts.
Difficulty: Moderate
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Difficulty: Easy
Difficulty: Moderate
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Difficulty: Moderate
Difficulty: Moderate
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Difficulty: Moderate
34. Consider the Treynor-Black model. The alpha of an active portfolio is 3%. The expected
return on the market index is 18%. The standard deviation of the return on the market
portfolio is 25%. The nonsystematic standard deviation of the active portfolio is 15%. The
risk-free rate of return is 6%. The beta of the active portfolio is 1.2. The optimal proportion to
invest in the active portfolio is __________.
A. 50.0%
B. 69.4%
C. 72.3%
D. 80.6%
E. 100.0%
wO = [3%/2.25%]/[(18% - 6%)/6.25%] = 0.6944; w* = 0.6944/[1 + (1 - 1.2)0.6944] = 0.8064,
or 80.6%.
Difficulty: Difficult
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35. According to the Treynor-Black model, the weight of a security in the active portfolio
depends on the ratio of __________ to __________.
A. the degree of mispricing; the nonsystematic risk of the security
B. the degree of mispricing; the systematic risk of the security
C. the market sensitivity of the security; the nonsystematic risk of the security
D. the nonsystematic risk of the security; the systematic risk of the security
E. the total return on the security; the nonsystematic risk of the security
The weight of the mispriced security in the active portfolio depends on the degree of
mispricing (alpha) in proportion to the nonsystematic risk added by holding the security.
Difficulty: Moderate
36. One property of a risky portfolio that combines an active portfolio of mispriced securities
with a market portfolio is that, when optimized, its squared Sharpe measure increases by the
square of the active portfolio's
A. Sharpe ratio.
B. information ratio.
C. alpha.
D. Treynor measure.
E. none of the above.
When optimized, a property of the overall risky portfolio is that its squared Sharpe measure
increases by the square of the active portfolio's information ratio.
Difficulty: Moderate
Difficulty: Moderate
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38. A manager who uses the mean-variance theory to construct an optimal portfolio will
satisfy
A. investors with low risk-aversion coefficients.
B. investors with high risk-aversion coefficients.
C. investors with moderate risk-aversion coefficients.
D. all investors, regardless of their level of risk aversion.
E. only clients with whom she has established long-term relationships, because she knows
their personal preferences.
The optimal portfolio will be the one with the highest reward-to-variability ratio. Investors
can choose for themselves how they want to combine this portfolio with the risk-free asset to
take on more or less risk.
Difficulty: Easy
39. Ideally, clients would like to invest with the portfolio manager who has
A. a moderate personal risk-aversion coefficient.
B. a low personal risk-aversion coefficient.
C. the highest Sharpe measure.
D. the highest record of realized returns.
E. the lowest record of standard deviations.
The Sharpe measure is commonly used to measure the performance of professional managers.
A good manager has a steeper CAL than the one from following a passive strategy.
Difficulty: Easy
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Difficulty: Difficult
41. To determine the optimal risky portfolio in the Treynor-Black Model, macroeconomic
forecasts are used for the _________ and composite forecasts are used for the __________.
A. passive index portfolio; active portfolio
B. active portfolio, passive index portfolio
C. expected return; standard deviation
D. expected return ; beta coefficient
E. alpha coefficient; beta coefficient
The two factors combine to determine the optimal risky portfolio.
Difficulty: Moderate
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42. The beta of an active portfolio is 1.45. The standard deviation of the returns on the market
index is 22%. The nonsystematic variance of the active portfolio is 3%. The standard
deviation of the returns on the active portfolio is __________.
A. 36.30%
B. 5.84%
C. 19.60%
D. 24.17%
E. 26.0%
s = [(1.45)2(0.22)2 + 0.03]1/2 = [0.13176]1/2 = 36.3%.
Difficulty: Difficult
43. Consider the Treynor-Black model. The alpha of an active portfolio is 1%. The expected
return on the market index is 11%. The variance of return on the market portfolio is 6%. The
nonsystematic variance of the active portfolio is 2%. The risk-free rate of return is 4%. The
beta of the active portfolio is 1.1. The optimal proportion to invest in the active portfolio is
__________.
A. 45%
B. 25%
C. 50%
D. 100%
E. none of the above
wO = [1%/2%]/[(11% - 4%)/6%] = .4286, or 42.86%; w* = .4286/[1 + (1 - 1.1).4286] =
0.4478.
Difficulty: Difficult
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44. Consider the Treynor-Black model. The alpha of an active portfolio is 3%. The expected
return on the market index is 10%. The variance of the return on the market portfolio is 4%.
The nonsystematic variance of the active portfolio is 2%. The risk-free rate of return is 3%.
The beta of the active portfolio is 1.15. The optimal proportion to invest in the active portfolio
is __________.
A. 48.7%
B. 98.3%
C. 51.3%
D. 100.0%
E. none of the above
wO = [3%/2%]/[(10% - 3%)/4%] = 0.857; w* = 0.857/[1 + (1 - 1.15)0.857] = .983., or 98.3%.
Difficulty: Difficult
45. Consider the Treynor-Black model. The alpha of an active portfolio is 2%. The expected
return on the market index is 12%. The variance of the return on the market portfolio is 4%.
The nonsystematic variance of the active portfolio is 2%. The risk-free rate of return is 3%.
The beta of the active portfolio is 1.15. The optimal proportion to invest in the active portfolio
is __________.
A. 48.7%
B. 98.3%
C. 47.6%
D. 100.0%
E. none of the above
wO = [2%/2%]/[(12% - 3%)/4%] = 0.444; w* = 0.444/[1 + (1 - 1.15) 0.444] = .476., or 47.6%.
Difficulty: Difficult
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46. Perfect timing ability is equivalent to having __________ on the market portfolio.
A. a call option
B. a futures contract
C. a put option
D. a commodities contract
E. none of the above
Perfect foresight is equivalent to holding a call option on the equity portfolio.
Difficulty: Easy
47. Kane, Marcus, and Trippi (1999) show that the annualized fee that investor should be
willing to pay for active management, over and above the fee charged by a passive index
fund, depends on
I) the investor's coefficient of risk aversion
II) the value of at-the-money call option on the market portfolio
III) the value of out-of-the-money call option on the market portfolio
IV) the precision of the security analyst
V) the distribution of the squared information ratio of in the universe of securities
A. I, II, IV
B. I, III, V
C. II, IV, V
D. I, IV, V
E. II, IV, V
Kane, Marcus, and Trippi (1999) show that the annualized fee that investor should be willing
to pay for active management, over and above the fee charged by a passive index fund,
depends on the investor's coefficient of risk aversion, the precision of the security analyst, the
distribution of the squared information ratio of in the universe of securities.
Difficulty: Moderate
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48. Kane, Marcus, and Trippi (1999) show that the annualized fee that investor should be
willing to pay for active management, over and above the fee charged by a passive index
fund, does not depend on
I) the investor's coefficient of risk aversion
II) the value of at-the-money call option on the market portfolio
III) the value of out-of-the-money call option on the market portfolio
IV) the precision of the security analyst
V) the distribution of the squared information ratio of in the universe of securities
A. I, II, IV
B. II, III, V
C. II, III
D. I, IV, V
E. II, IV, V
Kane, Marcus, and Trippi (1999) show that the annualized fee that investor should be willing
to pay for active management, over and above the fee charged by a passive index fund,
depends on the investor's coefficient of risk aversion, the precision of the security analyst, the
distribution of the squared information ratio of in the universe of securities.
Difficulty: Moderate
Difficulty: Moderate
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50. You have a record of an analyst's past forecasts of alpha. Describe how you would use this
information within the context of the Treynor-Black model to determine the forecasting
ability of the analyst.
You can use the index model and valid estimates of beta, you can estimate the ex-post alphas
from the average realized return and the return on the market index. The equation is
.
Then you would estimate a regression of the forecasted alphas on the realized alphas as in the
equation
. The coefficients a0 and a1 reflect the bias in the forecasts. If
there is no bias a0=0 and a1=1. The forecast errors are uncorrelated with the true alpha, so the
variance of the forecast is
.
To measure the value of the forecast, you would use the squared correlation coefficient
between the forecasts and the realizations. This can also be determined by the formula
. If the analyst has perfect forecasting ability the correlation coefficient will
be 1. If the analyst has no ability then the correlation coefficient will be 0. For values in
between 0 and 1 you can adjust the forecasts by multiplying by the correlation.
Feedback: The value of active management depends on the analyst's ability to forecast
accurately. The best way to exploit analysts' forecasts is with the Treynor-Black model.
Difficulty: Difficult
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