Chapter 07 Optimal Risky Portfolios: Answer Key

Chapter 07 Optimal Risky Portfolios Answer Key
Multiple Choice Questions
1. Market risk is also referred to as

A. systematic risk, diversifiable risk.
B. systematic risk, nondiversifiable risk.
C. unique risk, nondiversifiable risk.
D. unique risk, diversifiable risk.
E. firm-specific risk.
Market, systematic, and nondiversifiable risk are synonyms referring to the risk that cannot be
eliminated from the portfolio. Diversifiable, unique, nonsystematic, and firm-specific risks are
synonyms referring to the risk that can be eliminated from the portfolio by diversification.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Diversification
2. Systematic risk is also referred to as
A. market risk, nondiversifiable risk.
B. market risk, diversifiable risk.
C. unique risk, nondiversifiable risk.
D. unique risk, diversifiable risk.
E. firm-specific risk.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
3. Nondiversifiable risk is also referred to as

A. systematic risk, unique risk.
B. systematic risk, market risk.
C. unique risk, market risk.
D. unique risk, firm-specific risk.
E. systematic risk, firm-specific risk.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
4. Diversifiable risk is also referred to as
A. systematic risk, unique risk.
C. unique risk, market risk.
D. unique risk, firm-specific risk.
E. systematic risk, firm-specific risk.
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Difficulty: Basic
5. Unique risk is also referred to as

C. diversifiable risk, market risk.
D. diversifiable risk, firm-specific risk.
E. market risk.
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Bloom's: Remember
Difficulty: Basic
6. Firm-specific risk is also referred to as
D. diversifiable risk, unique risk.
E. nondiversifiable, market risk.
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Bloom's: Remember
Difficulty: Basic
7. Non-systematic risk is also referred to as

A. market risk, diversifiable risk.
B. firm-specific risk, market risk.
D. diversifiable risk, unique risk.
E. nondiversifiable risk, unique risk.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
8. The risk that can be diversified away is
A. firm-specific risk.
B. beta.
C. systematic risk.
D. market risk.
E. non-systematic risk.
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Bloom's: Remember
Difficulty: Basic
9. The risk that cannot be diversified away is

A. firm-specific risk.
B. unique.
C. non-systematic risk.
D. market risk.
E. unique risk and non-systematic risk.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
10. The variance of a portfolio of risky securities
A. is a weighted sum of the securities' variances.
B. is the sum of the securities' variances.
C. is the weighted sum of the securities' variances and covariances.
D. is the sum of the securities' covariances.
E. is the weighted sum of the securities' covariances.
The variance of a portfolio of risky securities is a weighted sum taking into account both the
variance of the individual securities and the covariances between securities.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Portfolio Risk Allocation
11. The standard deviation of a portfolio of risky securities is

A. the square root of the weighted sum of the securities' variances.
B. the square root of the sum of the securities' variances.
C. the square root of the weighted sum of the securities' variances and covariances.
D. the square root of the sum of the securities' covariances.
The standard deviation is the square root of the variance which is a weighted sum of the variance
of the individual securities and the covariances between securities.
AACSB: Analytic
Bloom's: Remember
12. The expected return of a portfolio of risky securities
A. is a weighted average of the securities' returns.
B. is the sum of the securities' returns.
C. is the weighted sum of the securities' variances and covariances.
D. is both a weighted average of the securities' returns and a weighted sum of the securities'
variances and covariances.
The expected return of a portfolio of risky securities is a weighted average of the securities'
returns.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
13. Other things equal, diversification is most effective when

A. securities' returns are uncorrelated.
B. securities' returns are positively correlated.
C. securities' returns are high.
D. securities' returns are negatively correlated.
E. both securities' returns are positively correlated and securities' returns are high.
Negative correlation among securities results in the greatest reduction of portfolio risk, which is
the goal of diversification.
AACSB: Analytic
Bloom's: Remember
14. The efficient frontier of risky assets is
A. the portion of the investment opportunity set that lies above the global minimum variance
portfolio.
B. the portion of the investment opportunity set that represents the highest standard deviations.
C. the portion of the investment opportunity set which includes the portfolios with the lowest
standard deviation.
D. the set of portfolios that have zero standard deviation.
E. both the portion of the investment opportunity set that lies above the global minimum variance
portfolio and the portion of the investment opportunity set that represents the highest standard
deviations.
Portfolios on the efficient frontier are those providing the greatest expected return for a given
amount of risk. Only those portfolios above the global minimum variance portfolio meet this
criterion.
AACSB: Analytic
Bloom's: Understand
Topic: Markowitz Model
15. The Capital Allocation Line provided by a risk-free security and N risky securities is
A. the line that connects the risk-free rate and the global minimum-variance portfolio of the risky
securities.
B. the line that connects the risk-free rate and the portfolio of the risky securities that has the
highest expected return on the efficient frontier.
C. the line tangent to the efficient frontier of risky securities drawn from the risk-free rate.
D. the horizontal line drawn from the risk-free rate.
E. the line that connects the risk-free rate and the global maximum-variance portfolio of the risky
securities.
The Capital Allocation Line represents the most efficient combinations of the risk-free asset and
risky securities. Only C meets that definition.
AACSB: Analytic
Bloom's: Remember
Topic: Capital Allocation
16. Consider an investment opportunity set formed with two securities that are perfectly
negatively correlated. The global minimum variance portfolio has a standard deviation that is
always
A. greater than zero.
B. equal to zero.
C. equal to the sum of the securities' standard deviations.
D. equal to -1.
E. between zero and -1.
If two securities were perfectly negatively correlated, the weights for the minimum variance
portfolio for those securities could be calculated, and the standard deviation of the resulting
portfolio would be zero.
AACSB: Analytic
Bloom's: Understand
Difficulty: Challenge
17. Which of the following statements is (are) true regarding the variance of a portfolio of two
risky securities?
A. The higher the coefficient of correlation between securities, the greater the reduction in the
portfolio variance.
B. There is a linear relationship between the securities' coefficient of correlation and the portfolio
variance.
C. The degree to which the portfolio variance is reduced depends on the degree of correlation
between securities.
D. The higher the coefficient of correlation between securities, the greater the reduction in the
portfolio variance and there is a linear relationship between the securities' coefficient of
correlation and the portfolio variance.
E. The higher the coefficient of correlation between securities, the greater the reduction in the
portfolio variance and the degree to which the portfolio variance is reduced depends on the
degree of correlation between securities.
The lower the correlation between the returns of the securities, the more portfolio risk is reduced.
AACSB: Analytic
Bloom's: Understand
18. Which of the following statements is (are) false regarding the variance of a portfolio of two
risky securities?
A. The higher the coefficient of correlation between securities, the greater the reduction in the
portfolio variance.
B. There is a linear relationship between the securities' coefficient of correlation and the portfolio
variance.
C. The degree to which the portfolio variance is reduced depends on the degree of correlation
between securities.
D. The higher the coefficient of correlation between securities, the greater the reduction in the
portfolio variance and there is a linear relationship between the securities' coefficient of
correlation and the portfolio variance.
E. The higher the coefficient of correlation between securities, the greater the reduction in the
portfolio variance and the degree to which the portfolio variance is reduced depends on the
degree of correlation between securities.
The lower the correlation between the returns of the securities, the more portfolio risk is reduced.
AACSB: Analytic
Bloom's: Understand
19. Efficient portfolios of N risky securities are portfolios that

A. are formed with the securities that have the highest rates of return regardless of their standard
deviations.
B. have the highest rates of return for a given level of risk.
C. are selected from those securities with the lowest standard deviations regardless of their
returns.
D. have the highest risk and rates of return and the highest standard deviations.
E. have the lowest standard deviations and the lowest rates of return.
Portfolios that are efficient are those that provide the highest expected return for a given level of
risk.
AACSB: Analytic
Bloom's: Remember
Topic: Optimal Portfolios
20. Which of the following statement(s) is (are) true regarding the selection of a portfolio from
those that lie on the Capital Allocation Line?
A. Less risk-averse investors will invest more in the risk-free security and less in the optimal
risky portfolio than more risk-averse investors.
B. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-
free security than less risk-averse investors.
C. Investors choose the portfolio that maximizes their expected utility.
D. Less risk-averse investors will invest more in the risk-free security and less in the optimal
risky portfolio than more risk-averse investors and investors will choose the portfolio that
maximizes their expected utility.
E. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-
free security than less risk-averse investors and investors will choose the portfolio that
maximizes their expected utility.
All rational investors select the portfolio that maximizes their expected utility; for investors who
are relatively more risk-averse, doing so means investing less in the optimal risky portfolio and
more in the risk-free asset.
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21. Which of the following statement(s) is (are) false regarding the selection of a portfolio from
those that lie on the Capital Allocation Line?
A. Less risk-averse investors will invest more in the risk-free security and less in the optimal
risky portfolio than more risk-averse investors.
B. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-
free security than less risk-averse investors.
C. Investors choose the portfolio that maximizes their expected utility.
D. Less risk-averse investors will invest more in the risk-free security and less in the optimal
risky portfolio than more risk-averse investors and more risk-averse investors will invest less in
the optimal risky portfolio and more in the risk-free security than less risk-averse investors.
E. Less risk-averse investors will invest more in the risk-free security and less in the optimal
risky portfolio than more risk-averse investors and investors choose the portfolio that maximizes
their expected utility.
All rational investors select the portfolio that maximizes their expected utility; for investors who
are relatively more risk-averse, doing so means investing less in the optimal risky portfolio and
more in the risk-free asset.
AACSB: Analytic
Bloom's: Understand
Consider the following probability distribution for stocks A and B:

22. The expected rates of return of stocks A and B are _____ and _____, respectively.
A. 13.2%; 9%
B. 14%; 10%
C. 13.2%; 7.7%
D. 7.7%; 13.2%
E. 13.8%; 9.3%
E(RA) = 0.1(10%) + 0.2(13%) + 0.2(12%) + 0.3(14%) + 0.2(15%) = 13.2%; E(RB) = 0.1(8%) +

0.2(7%) + 0.2(6%) + 0.3(9%) + 0.2(8%) = 7.7%.
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Difficulty: Basic
23. The standard deviations of stocks A and B are _____ and _____, respectively.
A. 1.5%; 1.9%
B. 2.5%; 1.1%
C. 3.2%; 2.0%
D. 1.5%; 1.1%
E. 1.8%; 1.6%
sA = [0.1(10% − 13.2%)2 + 0.2(13% − 13.2%)2 + 0.2(12% − 13.2%)2 + 0.3(14% − 13.2%)2 +

0.2(15% − 13.2%)2]1/2 = 1.5%; sB = [0.1(8% − 7.7%)2 + 0.2(7% − 7.7%)2 + 0.2(6% − 7.7%)2 +
0.3(9% − 7.7%)2 + 0.2(8% − 7.7%)2]1/2 = 1.1%.
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24. The variances of stocks A and B are _____ and _____, respectively.
A. 1.5%; 1.9%
B. 2.2%; 1.2%
C. 3.2%; 2.0%
D. 1.5%; 1.1%
E. 1.4%; 2.1%
varA = [0.1(10% − 13.2%)2 + 0.2(13% − 13.2%)2 + 0.2(12% − 13.2%)2 + 0.3(14% − 13.2%)2 +

0.2(15% − 13.2%)2] = 2.16%; varB = [0.1(8% − 7.7%)2 + 0.2(7% − 7.7%)2 + 0.2(6% − 7.7%)2 +
0.3(9% − 7.7%)2 + 0.2(8% − 7.7%)2] = 1.21%.
AACSB: Analytic
Bloom's: Apply
25. The coefficient of correlation between A and B is

A. 0.46.
B. 0.60.
C. 0.58.
D. 1.20.
E. 0.73.
covA,B = 0.1(10% − 13.2%)(8% − 7.7%) + 0.2(13% − 13.2%)(7% − 7.7%) + 0.2(12% −

13.2%)(6% − 7.7%) + 0.3(14% − 13.2%)(9% − 7.7%) + 0.2(15% − 13.2%)(8% − 7.7%) = 0.76;
rA,B = 0.76/[(1.1)(1.5)] = 0.46.
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26. If you invest 40% of your money in A and 60% in B, what would be your portfolio's
expected rate of return and standard deviation?
A. 9.9%; 3%
B. 9.9%; 1.1%
C. 11%; 1.1%
D. 11%; 3%
E. 10.6%; 2.1%
E(RP) = 0.4(13.2%) + 0.6(7.7%) = 9.9%; sP = [(0.4)2(1.5)2 + (0.6)2(1.1)2 +

2(0.4)(0.6)(1.5)(1.1)(0.46)]1/2 = 1.1%.
AACSB: Analytic
Bloom's: Apply
27. Let G be the global minimum variance portfolio. The weights of A and B in G are
__________ and __________, respectively.
A. 0.40; 0.60
B. 0.66; 0.34
C. 0.34; 0.66
D. 0.77; 0.23
E. 0.23; 0.77
wA = [(1.1)2 − (1.5)(1.1)(0.46)]/[(1.5)2 + (1.1)2 − (2)(1.5)(1.1)(0.46) = 0.23; wB = 1 − 0.23 = 0.77.

Note that the above solution assumes the solutions obtained in question 13 and 14.
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28. The expected rate of return and standard deviation of the global minimum variance portfolio,
G, are __________ and __________, respectively.
A. 10.07%; 1.05%
B. 8.97%; 2.03%
C. 10.07%; 3.01%
D. 8.97%; 1.05%
E. 7.56%; 0.83%
E(RG) = 0.23(13.2%) + 0.77(7.7%) = 8.965%; sG = [(0.23)2(1.5)2 + (0.77)2(1.1)2 +

(2)(0.23)(0.77)(1.5)(1.1)(0.46)]1/2 = 1.05%.
AACSB: Analytic
Bloom's: Apply
29. Which of the following portfolio(s) is (are) on the efficient frontier?

A. The portfolio with 20 percent in A and 80 percent in B.
B. The portfolio with 15 percent in A and 85 percent in B.
C. The portfolio with 26 percent in A and 74 percent in B.
D. The portfolio with 10 percent in A and 90 percent in B.
E. The portfolio with 20 percent in A and 80 percent in B, and the portfolio with 15 percent in A
and 85 percent in B are both on the efficient frontier.
The Portfolio's E(Rp), sp, Reward/volatility ratios are 20A/80B: 8.8%, 1.05%, 8.38; 15A/85B:
8.53%, 1.06%, 8.07; 26A/74B: 9.13%, 1.05%, 8.70; 10A/90B: 8.25%, 1.07%, 7.73. The portfolio
with 26% in A and 74% in B dominates all of the other portfolios by the mean-variance criterion.
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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%.
30. The weights of A and B in the global minimum variance portfolio are _____ and _____,
respectively.
A. 0.24; 0.76
B. 0.50; 0.50
C. 0.57; 0.43
D. 0.43; 0.57
E. 0.76; 0.24
wA = 12/(16 + 12) = 0.4286; wB = 1 − 0.4286 = 0.5714.
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31. The risk-free portfolio that can be formed with the two securities will earn _____ rate of
return.
A. 8.5%
B. 9.0%
C. 8.9%
D. 9.9%
E. 6.2%
E(RP) = 0.43(10%) + 0.57(8%) = 8.86%.
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32. Given an optimal risky portfolio with expected return of 12% and standard deviation of 23%
and a risk free rate of 3%, what is the slope of the best feasible CAL?
A. 0.64
B. 0.39
C. 0.08
D. 0.35
E. 0.36
Slope = (12 − 3)/23 = .391
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33. An investor who wishes to form a portfolio that lies to the right of the optimal risky portfolio
on the Capital Allocation Line must:
A. lend some of her money at the risk-free rate and invest the remainder in the optimal risky
portfolio.
B. borrow some money at the risk-free rate and invest in the optimal risky portfolio.
C. invest only in risky securities.
D. such a portfolio cannot be formed.
E. both borrow some money at the risk-free rate and invest in the optimal risky portfolio and
invest only in risky securities
The only way that an investor can create a portfolio that lies to the right of the Capital Allocation
Line is to create a borrowing portfolio (buy stocks on margin). In this case, the investor will not
hold any of the risk-free security, but will hold only risky securities.
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34. Which one of the following portfolios cannot lie on the efficient frontier as described by
Markowitz?
A. Only portfolio W cannot lie on the efficient frontier.

B. Only portfolio X cannot lie on the efficient frontier.
C. Only portfolio Y cannot lie on the efficient frontier.
D. Only portfolio Z cannot lie on the efficient frontier.
E. Cannot tell from the information given.
When plotting the above portfolios, only W lies below the efficient frontier as described by
Markowitz. It has a higher standard deviation than Z with a lower expected return.
AACSB: Analytic
Bloom's: Understand
35. Which one of the following portfolios cannot lie on the efficient frontier as described by
Markowitz?
A. Only portfolio A cannot lie on the efficient frontier.

B. Only portfolio B cannot lie on the efficient frontier.
C. Only portfolio C cannot lie on the efficient frontier.
D. Only portfolio D cannot lie on the efficient frontier.
E. Cannot tell from the information given.
When plotting the above portfolios, only D lies below the efficient frontier as described by
Markowitz. It has a higher standard deviation than C with a lower expected return.
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36. Portfolio theory as described by Markowitz is most concerned with:
A. the elimination of systematic risk.
B. the effect of diversification on portfolio risk.
C. the identification of unsystematic risk.
D. active portfolio management to enhance returns.
E. the elimination of unsystematic risk.
Markowitz was concerned with reducing portfolio risk by combining risky securities with
differing return patterns.
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37. The measure of risk in a Markowitz efficient frontier is:

A. specific risk.
B. standard deviation of returns.
C. reinvestment risk.
D. beta.
E. unique risk.
Markowitz was interested in eliminating diversifiable risk (and thus lessening total risk) and thus
was interested in decreasing the standard deviation of the returns of the portfolio.
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38. A statistic(s) that measures how the returns of two risky assets move together is:
A. variance.
B. standard deviation.
C. covariance.
D. correlation.
E. both covariance and correlation.
Covariance measures whether security returns move together or in opposition; however, only the
sign, not the magnitude, of covariance may be interpreted. Correlation, which is covariance
standardized by the product of the standard deviations of the two securities, may assume values
only between +1 and -1; thus, both the sign and the magnitude may be interpreted regarding the
movement of one security's return relative to that of another security.
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39. The unsystematic risk of a specific security

A. is likely to be higher in an increasing market.
B. results from factors unique to the firm.
C. depends on market volatility.
D. cannot be diversified away.
E. is likely to be lower in a decreasing market.
Unsystematic (or diversifiable or firm-specific) risk refers to factors unique to the firm. Such risk
may be diversified away; however, market risk will remain.
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40. Which statement about portfolio diversification is correct?
A. Proper diversification can eliminate systematic risk.
B. The risk-reducing benefits of diversification do not occur meaningfully until at least 50-60
individual securities have been purchased.
C. Because diversification reduces a portfolio's total risk, it necessarily reduces the portfolio's
expected return.
D. Typically, as more securities are added to a portfolio, total risk would be expected to decrease
at a decreasing rate.
E. Proper diversification can eliminate systematic risk and increases return.
Diversification can eliminate only nonsystematic risk; relatively few securities are required to
reduce this risk, thus diminishing returns result quickly.
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41. The individual investor's optimal portfolio is designated by:

A. The point of tangency with the indifference curve and the capital allocation line.
B. The point of highest reward to variability ratio in the opportunity set.
C. The point of tangency with the opportunity set and the capital allocation line.
D. The point of the highest reward to variability ratio in the indifference curve.
E. None of these is correct.
The indifference curve represents what is acceptable to the investor; the capital allocation line
represents what is available in the market. The point of tangency represents where the investor
can obtain the greatest utility from what is available.
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42. For a two-stock portfolio, what would be the preferred correlation coefficient between the
two stocks?
A. +1.00.
B. +0.50.
C. 0.00.
D. -1.00.
E. -0.65.
The correlation coefficient of −1.00 provides the greatest diversification benefits.
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43. In a two-security minimum variance portfolio where the correlation between securities is
greater than -1.0
A. the security with the higher standard deviation will be weighted more heavily.
B. the security with the higher standard deviation will be weighted less heavily.
C. the two securities will be equally weighted.
D. the risk will be zero.
E. the return will be zero.
The security with the higher standard deviation will be weighted less heavily to produce
minimum variance. The return will not be zero; the risk will not be zero unless the correlation
coefficient is −1.
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44. Which of the following is not a source of systematic risk?
A. The business cycle.
B. Interest rates.
C. Personnel changes.
D. The inflation rate.
E. Exchange rates.
Personnel changes are a firm-specific event that is a component of non-systematic risk. The
others are all sources of systematic risk.
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Difficulty: Basic
45. The global minimum variance portfolio formed from two risky securities will be riskless
when the correlation coefficient between the two securities is
A. 0.0
B. 1.0
C. 0.5
D. -1.0
E. negative
The global minimum variance portfolio will have a standard deviation of zero whenever the two
securities are perfectly negatively correlated.
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46. Security X has expected return of 12% and standard deviation of 20%. Security Y has
expected return of 15% and standard deviation of 27%. If the two securities have a correlation
coefficient of 0.7, what is their covariance?
A. 0.038
B. 0.070
C. 0.018
D. 0.013
E. 0.054
Cov(rX, rY) = (.7)(.20)(.27) = .0378
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47. When two risky securities that are positively correlated but not perfectly correlated are held
in a portfolio,
A. the portfolio standard deviation will be greater than the weighted average of the individual
security standard deviations.
B. the portfolio standard deviation will be less than the weighted average of the individual
C. the portfolio standard deviation will be equal to the weighted average of the individual
D. the portfolio standard deviation will always be equal to the securities' covariance.
E. both the portfolio standard deviation will be greater than the weighted average of the
individual security standard deviations and it will always be equal to the securities' covariance .
Whenever two securities are less than perfectly positively correlated, the standard deviation of
the portfolio of the two assets will be less than the weighted average of the two securities'
standard deviations. There is some benefit to diversification in this case.
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48. The line representing all combinations of portfolio expected returns and standard deviations
that can be constructed from two available assets is called the
A. risk/reward tradeoff line
B. Capital Allocation Line
C. efficient frontier
D. portfolio opportunity set
E. Security Market Line
The portfolio opportunity set is the line describing all combinations of expected returns and
standard deviations that can be achieved by a portfolio of risky assets.
AACSB: Analytic
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Difficulty: Basic
A. 0.64
B. 0.14
C. 0.08
D. 0.33
E. 0.36
Slope = (14 − 6)/22 = .3636
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A. 0.64
B. 0.14
C. 0.62
D. 0.33
E. 0.36
Slope = (18 − 5)/21 = .6190
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51. The risk that can be diversified away in a portfolio is referred to as ___________.
I) diversifiable risk
II) unique risk
III) systematic risk
IV) firm-specific risk
A. I, III, and IV
B. II, III, and IV
C. III and IV
D. I, II, and IV
E. I, II, III, and IV
All of these terms are used interchangeably to refer to the risk that can be removed from a
portfolio through diversification.
AACSB: Analytic
Bloom's: Remember
52. As the number of securities in a portfolio is increased, what happens to the average portfolio
standard deviation?
A. It increases at an increasing rate.
B. It increases at a decreasing rate.
C. It decreases at an increasing rate.
D. It decreases at a decreasing rate.
E. It first decreases, then starts to increase as more securities are added.
Statman's study, showed that the risk of the portfolio would decrease as random stocks were
added. At first the risk decreases quickly, but then the rate of decrease slows substantially, as
shown in Figure 7.2. The minimum portfolio risk in the study was 19.2%.
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53. In words, the covariance considers the probability of each scenario happening and the
interaction between
A. securities' returns relative to their variances.
B. securities' returns relative to their mean returns.
C. securities' returns relative to other securities' returns.
D. the level of return a security has in that scenario and the overall portfolio return.
E. the variance of the security's return in that scenario and the overall portfolio variance.
As written in equation 7.4, the covariance of the returns between two securities is the sum over
all scenarios of the product of three things. The first item is the probability that the scenario will
happen. The second and third terms represent the deviations of the securities' returns in that
scenario from their own expected returns.
AACSB: Analytic
Bloom's: Understand
54. The standard deviation of a two-asset portfolio is a linear function of the assets' weights
when
A. the assets have a correlation coefficient less than zero.
B. the assets have a correlation coefficient equal to zero.
C. the assets have a correlation coefficient greater than zero.
D. the assets have a correlation coefficient equal to one.
E. the assets have a correlation coefficient less than one.
When there is a perfect positive correlation (or a perfect negative correlation), the equation for
the portfolio variance simplifies to a perfect square. The result is that the portfolio's standard
deviation is linear relative to the assets' weights in the portfolio.
AACSB: Analytic
Bloom's: Understand
55. A two-asset portfolio with a standard deviation of zero can be formed when
A. the assets have a correlation coefficient less than zero.
B. the assets have a correlation coefficient equal to zero.
C. the assets have a correlation coefficient greater than zero.
D. the assets have a correlation coefficient equal to one.
E. the assets have a correlation coefficient equal to negative one.
When there is a perfect negative correlation, the equation for the portfolio variance simplifies to
a perfect square. The result is that the portfolio's standard deviation equals |wAA − wBB|, which
can be set equal to zero. The solution wA = B/(A + B) and wB = 1 − wA will yield a zero-
standard deviation portfolio.
AACSB: Analytic
Bloom's: Understand
56. When borrowing and lending at a risk-free rate are allowed, which Capital Allocation Line
(CAL) should the investor choose to combine with the efficient frontier?
I) The one with the highest reward-to-variability ratio.
II) The one that will maximize his utility.
III) The one with the steepest slope.
IV) The one with the lowest slope.
A. I and III
B. I and IV
C. II and IV
D. I only
E. I, II, and III
The optimal CAL is the one that is tangent to the efficient frontier. This CAL offers the highest
reward-to-variability ratio, which is the slope of the CAL. It will also allow the investor to reach
his highest feasible level of utility.
AACSB: Analytic
Bloom's: Understand
A. 0.60
B. 0.14
C. 0.08
D. 0.36
E. 0.31
Slope = (13 − 5)/26 = .31
AACSB: Analytic
Bloom's: Apply
58. The separation property refers to the conclusion that
A. the determination of the best risky portfolio is objective and the choice of the best complete
portfolio is subjective.
B. the choice of the best complete portfolio is objective and the determination of the best risky
portfolio is objective.
C. the choice of inputs to be used to determine the efficient frontier is objective and the choice of
the best CAL is subjective.
D. the determination of the best CAL is objective and the choice of the inputs to be used to
determine the efficient frontier is subjective.
E. investors are separate beings and will therefore have different preferences regarding the risk-
return tradeoff.
The determination of the optimal risky portfolio is purely technical and can be done by a
manager. The complete portfolio, which consists of the optimal risky portfolio and the risk-free
asset, must be chosen by each investor based on preferences.
AACSB: Analytic
Bloom's: Understand
Topic: Separation Strategy
Consider the following probability distribution for stocks A and B:

59. The expected rates of return of stocks A and B are _____ and _____, respectively.
A. 13.2%; 9%
B. 13%; 8.4%
C. 13.2%; 7.7%
D. 7.7%; 13.2%
E. 12.7%; 9.2%
E(RA) = 0.15(8%) + 0.2(13%) + 0.15(12%) + 0.3(14%) + 0.2(16%) = 13%; E(RB) = 0.15(8%) +

0.2(7%) + 0.15(6%) + 0.3(9%) + 0.2(11%) = 8.4%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
60. The standard deviations of stocks A and B are _____ and _____, respectively.
A. 1.56%; 1.99%
B. 2.45%; 1.66%
C. 3.22%; 2.01%
D. 1.54%; 1.11%
E. 3.22%; 2.82%
sA = [0.15(8% − 13%)2 + 0.2(13% − 13%)2 + 0.15(12% − 13%)2 + 0.3(14% − 13%)2 + 0.2(16% −

13%)2] 1/2 = 2.449%; sB = [0.15(8% − 8.4%)2 + 0.2(7% − 8.4%)2 + 0.15(6% − 8.4%)2 + 0.3(9% −
8.4%)2 + 0.2(11% − 8.4%)2 ] 1/2= 1.655%.
AACSB: Analytic
Bloom's: Apply
61. The coefficient of correlation between A and B is
A. 0.474.
B. 0.612.
C. 0.590.
D. 1.206.
E. 0.751.
covA,B = 0.15(8% − 13%)(8% − 8.4%) + 0.2(13% − 13%)(7% − 8.4%) + 0.15(12% − 13%)(6% −

8.4%) + 0.3(14% − 13%)(9% − 8.4%) + 0.2(16% − 13%)(11% − 8.4%) = 2.40; A,B =
2.40/[(2.45)(1.66)] = 0.590.
AACSB: Analytic
Bloom's: Apply
62. If you invest 35% of your money in A and 65% in B, what would be your portfolio's
A. 9.9%; 3%
B. 9.9%; 1.1%
C. 10%; 1.7%
D. 10%; 3%
E. 11%; 2.6%
E(RP) = 0.35(13%) + 0.65(8.4%) = 10.01%; sP = [(0.35)2(2.45%)2 + (0.65)2(1.66)2 +

2(0.35)(0.65)(2.45)(1.66)(0.590)]1/2 = 1.7%.
AACSB: Analytic
Bloom's: Apply
Consider two perfectly negatively correlated risky securities A and B. A has an expected rate of
return of 12% and a standard deviation of 17%. B has an expected rate of return of 9% and a
63. The weights of A and B in the global minimum variance portfolio are _____ and _____,
respectively.
A. 0.24; 0.76
B. 0.50; 0.50
C. 0.57; 0.43
D. 0.45; 0.55
E. 0.76; 0.24
wA = 14/(17 + 14) = 0.45; wB = 1 − 0.45 = 0.55.
AACSB: Analytic
Bloom's: Apply
return.
A. 9.5%
B. 10.4%
C. 10.9%
D. 9.9%
E. 11.2%
E(RP) = 0.45(12%) + 0.55(9%) = 10.35%.
AACSB: Analytic
Bloom's: Apply
A. 0.038
B. 0.049
C. 0.018
D. 0.013
E. 0.054
Cov(rX, rY) = (.8)(.22)(.28) = .04928
AACSB: Analytic
Bloom's: Apply
A. 0.60
B. 0.14
C. 0.08
D. 0.36
E. 0.31
Slope = (16 − 4)/20 = .6
AACSB: Analytic
Bloom's: Apply
A. 0.64
B. 0.14
C. 0.08
D. 0.35
E. 0.36
Slope = (12 − 3)/26 = .346
AACSB: Analytic
Bloom's: Apply
Consider the following probability distribution for stocks C and D:
68. The expected rates of return of stocks C and D are _____ and _____, respectively.
A. 4.4%; 9.5%
B. 9.5%; 4.4%
C. 6.3%; 8.7%
D. 8.7%; 6.2%
E. 6.9%; 11.7%
E(RC) = 0.30(7%) + 0.5(11%) + 0.20(−16%) = 4.4%; E(RD) = 0.30(−9%) + 0.5(14%) +

0.20(26%) = 9.5%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
69. The standard deviations of stocks C and D are _____ and _____, respectively.
A. 7.62%; 11.24%
B. 11.24%; 7.62%
C. 10.35%; 12.93%
D. 12.93%; 10.35%
E. 12.93%; 7.35%
sC = [0.30(7% − 4.4%)2 + 0.5(11% − 4.4%)2 + 0.20(−16% − 4.4%)2 ] 1/2 = 10.35%; sD =

[0.30(−9% − 9.5%)2 + 0.50(14% − 9.5%)2 + 0.20(26% − 9.5%)2] 1/2 = 12.93%.
AACSB: Analytic
Bloom's: Apply
70. The coefficient of correlation between C and D is

A. 0.67.
B. 0.50.
C. -0.50.
D. -0.67.
E. 0.81.
CovC,D = 0.30(7% − 4.4%)(−9% − 9.5%) + 0.50(11% − 4.4%)(14% − 9.5%) + 0.20(−16% −

4.4%)(26% − 9.5%) = −66.9; A,B = −66.90/[(10.35)(12.93)] = −0.50
AACSB: Analytic
Bloom's: Apply
71. If you invest 25% of your money in C and 75% in D, what would be your portfolio's
A. 9.891%; 8.70%
B. 9.945%; 11.12%
C. 8.225%; 8.70%
D. 10.275%; 11.12%
E. 8.75%; 9.70%
E(RP) = 0.25(4.4%) + 0.75(9.5%) = 8.225%; sP = [(0.25)2(10.35)2 + (0.75)2(12.93)2 +

2(0.25)(0.75)(10.35)(12.93)( −0.50)]1/2 = 8.70%.
AACSB: Analytic
Bloom's: Apply
Consider two perfectly negatively correlated risky securities K and L. K has an expected rate of
return of 13% and a standard deviation of 19%. L has an expected rate of return of 10% and a
72. The weights of K and L in the global minimum variance portfolio are _____ and _____,
respectively.
A. 0.24; 0.76
B. 0.50; 0.50
C. 0.46; 0.54
D. 0.45; 0.55
E. 0.76; 0.24
wK = 1 − 0.54 = 0.46; wL = 19/(19 + 16) = 0.54.
AACSB: Analytic
Bloom's: Apply
return.
A. 9.5%
B. 11.4%
C. 10.9%
D. 9.9%
E. E.6.0%
E(RP) = 0.46(13%) + 0.54(10%) = 11.38%.
AACSB: Analytic
Bloom's: Apply
74. Security M has expected return of 17% and standard deviation of 32%. Security S has
A. 0.038
B. 0.049
C. 0.047
D. 0.045
E. 0.054
Cov(rX, rY) = (.78)(.32)(.19) = .0474
AACSB: Analytic
Bloom's: Apply
coefficient of -0.45, what is their covariance?
A. 0.0388
B. -0.0108
C. 0.0184
D. -0.0133
E. -0.1512
Cov(rX, rY) = (−.45)(.12)(.20) = −.0108
AACSB: Analytic
Bloom's: Apply
coefficient of -0.4, what is their covariance?
A. 0.0388
B. 0.0706
C. 0.0184
D. -0.0133
E. -0.0151
Cov(rX, rY) = (−.4)(.18)(.21) = −0.0151
AACSB: Analytic
Bloom's: Apply
Short Answer Questions
77. Theoretically, the standard deviation of a portfolio can be reduced to what level? Explain.
Realistically, is it possible to reduce the standard deviation to this level? Explain.
Theoretically, if one could find two securities with perfectly negatively correlated returns
(correlation coefficient = -1), one could solve for the weights of these securities that would
produce the minimum variance portfolio of these two securities. The standard deviation of the
resulting portfolio would be equal to zero. However, in reality, securities with perfect negative
correlations do not exist.
Feedback: The rationale for this question is to ascertain whether or not the student understands
the concept of the minimum variance portfolio, the theoretical zero risk portfolio, and the
probability of obtaining a zero risk portfolio.
AACSB: Reflective Thinking

Bloom's: Understand
78. Discuss how the investor can use the separation theorem and utility theory to produce an
efficient portfolio suitable for the investor's level of risk tolerance.
One can identify the optimum risky portfolio as the portfolio at the point of tangency between a
ray extending from the risk-free rate and the efficient frontier of risky securities. Below the point
of tangency on this ray from the risk-free rate, the efficient portfolios consist of both the
optimum risky portfolio and risk-free investments (T-bills); above the point of tangency, the
efficient portfolios consist of the optimum risky portfolio purchased on margin. If the investor's
indifference curve, which reflects that investor's preferences regarding risk and return, is
superimposed on the ray from the risk-free rate, the resulting point of tangency represents the
appropriate combination of the optimum risky portfolio and either risk-free assets or margin
buying for that investor. Thus, the separation theorem separates the investing and financing
decisions. That is, all investors will invest in the same optimal risky portfolio, and adjust the risk
level of the portfolio by either lending (investing in U.S. Treasuries, i.e., lending to the U.S.
government) or borrowing (buying risky securities on margin).
Feedback: The purpose of this question is to ascertain whether the student understands the basic
principles of utility theory, the optimal risky portfolio, and the separation theorem, as these
concepts relate to constructing the ideal portfolio for a particular investor.

Bloom's: Evaluate
Topic: Separation Strategy
79. State Markowitz's mean-variance criterion. Give some numerical examples of how the
criterion would be applied.
The mean-variance criterion states that asset A dominates asset B if and only if E(RA) is greater
than or equal to E(RB) and the standard deviation of A's returns is less than or equal to the
standard deviation of B's returns, with at least one strict inequality holding. Students can give
examples of securities dominating others on the basis of expected return or standard deviation,
and can also give examples of comparisons where neither security is inefficient.
Feedback: The mean-variance criterion is the basis of the chapter material. It is essential that
students have a firm grasp of this material.
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
80. Draw a graph of a typical efficient frontier. Explain why the efficient frontier is shaped the
way it is.
The efficient frontier has a curved appearance, as shown throughout the chapter. Figure 7-5
shows several correlation values and the corresponding shapes of the frontier. The typical shape
results from the fact that assets' returns are not perfectly (positively or negatively) correlated.
Feedback: This question relates to the fundamentals of assets' relationships and their impact on
the efficient frontier. Sometimes students get used to seeing the efficient frontier as it is depicted
in subsequent graphs and forget its origin.

Bloom's: Understand

Chapter 07 Optimal Risky Portfolios: Answer Key

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Chapter 07 Optimal Risky Portfolios Answer Key

Multiple Choice Questions

1. Market risk is also referred to as

3. Nondiversifiable risk is also referred to as

5. Unique risk is also referred to as

7. Non-systematic risk is also referred to as

9. The risk that cannot be diversified away is

11. The standard deviation of a portfolio of risky securities is

13. Other things equal, diversification is most effective when

19. Efficient portfolios of N risky securities are portfolios that

Consider the following probability distribution for stocks A and B:

E(RA) = 0.1(10%) + 0.2(13%) + 0.2(12%) + 0.3(14%) + 0.2(15%) = 13.2%; E(RB) = 0.1(8%) +

sA = [0.1(10% − 13.2%)2 + 0.2(13% − 13.2%)2 + 0.2(12% − 13.2%)2 + 0.3(14% − 13.2%)2 +

varA = [0.1(10% − 13.2%)2 + 0.2(13% − 13.2%)2 + 0.2(12% − 13.2%)2 + 0.3(14% − 13.2%)2 +

25. The coefficient of correlation between A and B is

covA,B = 0.1(10% − 13.2%)(8% − 7.7%) + 0.2(13% − 13.2%)(7% − 7.7%) + 0.2(12% −

E(RP) = 0.4(13.2%) + 0.6(7.7%) = 9.9%; sP = [(0.4)2(1.5)2 + (0.6)2(1.1)2 +

wA = [(1.1)2 − (1.5)(1.1)(0.46)]/[(1.5)2 + (1.1)2 − (2)(1.5)(1.1)(0.46) = 0.23; wB = 1 − 0.23 = 0.77.

E(RG) = 0.23(13.2%) + 0.77(7.7%) = 8.965%; sG = [(0.23)2(1.5)2 + (0.77)2(1.1)2 +

29. Which of the following portfolio(s) is (are) on the efficient frontier?

wA = 12/(16 + 12) = 0.4286; wB = 1 − 0.4286 = 0.5714.

E(RP) = 0.43(10%) + 0.57(8%) = 8.86%.

Slope = (12 − 3)/23 = .391

A. Only portfolio W cannot lie on the efficient frontier.

A. Only portfolio A cannot lie on the efficient frontier.

37. The measure of risk in a Markowitz efficient frontier is:

39. The unsystematic risk of a specific security

41. The individual investor's optimal portfolio is designated by:

The correlation coefficient of −1.00 provides the greatest diversification benefits.

Cov(rX, rY) = (.7)(.20)(.27) = .0378

Slope = (14 − 6)/22 = .3636

Slope = (18 − 5)/21 = .6190

Slope = (13 − 5)/26 = .31

Consider the following probability distribution for stocks A and B:

E(RA) = 0.15(8%) + 0.2(13%) + 0.15(12%) + 0.3(14%) + 0.2(16%) = 13%; E(RB) = 0.15(8%) +

sA = [0.15(8% − 13%)2 + 0.2(13% − 13%)2 + 0.15(12% − 13%)2 + 0.3(14% − 13%)2 + 0.2(16% −

covA,B = 0.15(8% − 13%)(8% − 8.4%) + 0.2(13% − 13%)(7% − 8.4%) + 0.15(12% − 13%)(6% −

E(RP) = 0.35(13%) + 0.65(8.4%) = 10.01%; sP = [(0.35)2(2.45%)2 + (0.65)2(1.66)2 +

wA = 14/(17 + 14) = 0.45; wB = 1 − 0.45 = 0.55.

E(RP) = 0.45(12%) + 0.55(9%) = 10.35%.

Cov(rX, rY) = (.8)(.22)(.28) = .04928

Slope = (16 − 4)/20 = .6

Slope = (12 − 3)/26 = .346

Consider the following probability distribution for stocks C and D:

E(RC) = 0.30(7%) + 0.5(11%) + 0.20(−16%) = 4.4%; E(RD) = 0.30(−9%) + 0.5(14%) +

sC = [0.30(7% − 4.4%)2 + 0.5(11% − 4.4%)2 + 0.20(−16% − 4.4%)2 ] 1/2 = 10.35%; sD =

70. The coefficient of correlation between C and D is

CovC,D = 0.30(7% − 4.4%)(−9% − 9.5%) + 0.50(11% − 4.4%)(14% − 9.5%) + 0.20(−16% −

E(RP) = 0.25(4.4%) + 0.75(9.5%) = 8.225%; sP = [(0.25)2(10.35)2 + (0.75)2(12.93)2 +

wK = 1 − 0.54 = 0.46; wL = 19/(19 + 16) = 0.54.

E(RP) = 0.46(13%) + 0.54(10%) = 11.38%.

Cov(rX, rY) = (.78)(.32)(.19) = .0474

Cov(rX, rY) = (−.45)(.12)(.20) = −.0108

Cov(rX, rY) = (−.4)(.18)(.21) = −0.0151

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

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