First: Summary of Rules and Equations

Chapter (3): Securities Markets

Element Margin Trading Short Sale
Investor's
Buy low, then, sell high Sell high, then, buy low
Philosophy
Profitable
Price increases Price decreases
when:
Percentage
𝐸𝑞𝑢𝑖𝑡𝑦 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑜𝑎𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑆𝑡𝑜𝑐𝑘𝑠 𝑂𝑤𝑒𝑑
Margin = =
𝐴𝑠𝑠𝑒𝑡𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝑆𝑡𝑜𝑐𝑘𝑠 𝑂𝑤𝑒𝑑 𝑆𝑡𝑜𝑐𝑘𝑠 𝑂𝑤𝑒𝑑

Margin call
Percentage margin < Maintenance Margin
when:
Margin Call (𝑁𝑜. 𝑥 𝑃) − 𝐿𝑜𝑎𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 − (𝑁𝑜. 𝑥 𝑃)
= 𝑀𝑀 = 𝑀𝑀
Price 𝑁𝑜. 𝑥 𝑃 𝑁𝑜. 𝑥 𝑃

Margin Call
(𝑁𝑜. 𝑥 𝑃) − (𝐿𝑜𝑎𝑛 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡) 𝐴𝑠𝑠𝑒𝑡𝑠 − (𝑁𝑜. 𝑥 𝑃) − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
Price after = 𝑀𝑀 = 𝑀𝑀
𝑁𝑜. 𝑥 𝑃 𝑁𝑜. 𝑥 𝑃
ONE year
Shares
Cash
Assets (Variable according to market
(Constant)
price)

Cash Shares
Loan (Variable according to market
(Constant) price)
Interest Paid on total Loan -----
Dividends Return (Received) Expense (obligation)
Rate of 𝑁𝑒𝑤 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦 𝑁𝑒𝑤 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
Return 𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦 𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦

Rate of 𝑁𝑒𝑤 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦

𝑁𝑒𝑤 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
Return in case 𝑂𝑙𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
Dividends are treated as debt, so,
of Dividends Assets = Shares + Dividends
New equity = Assets – Stocks owed – Dividends

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 Chapters (5) + (6): Risk and Return & Efficient Diversification
(I) Single Asset

Actual Return Expected Return

Single Period Multiple Periods

(1) Expected Return

Holding Period Return (HPR) (1) Arithmetic Average (rA)
𝑷𝟏 − 𝑷𝟎 + 𝑫𝟏 𝒓𝟏 + 𝒓𝟐 + 𝒓𝟑 + ⋯ + 𝒓𝒏 𝐄(𝐫) = ∑ 𝐏(𝐬) 𝐫(𝐬)
𝐇𝐏𝐑 𝐬𝐭𝐨𝐜𝐤 = 𝐫𝐀 =
𝑷𝟎 𝒏 𝒔
(2) Risk
𝑷𝟏 − 𝑷𝟎 + 𝑰𝟏 (2) Geometric Average (rG)
𝐇𝐏𝐑 𝐁𝐨𝐧𝐝 =
𝑷𝟎 𝐫𝐆 = [(𝟏 + 𝒓𝟏 )(𝟏 + 𝒓𝟐 )(𝟏 + 𝒓𝟑 )]𝟏/𝐧 − 𝟏 𝐕𝐚𝐫 (𝐫) = 𝛔𝟐 = ∑ 𝐏 (𝐬)[(𝐫(𝐬) − 𝐄(𝐫)]𝟐
𝐬
𝑷𝟏 − 𝑷𝟎 (3) Dollar Weighted Average
𝐇𝐏𝐑 𝐓−𝐁𝐢𝐥𝐥𝐬 = 𝟏
𝑷𝟎 𝐒𝐃 (𝐫) = 𝛔 = √𝑽𝒂𝒓 (𝒓) = (𝑽𝒂𝒓𝒊𝒂𝒏𝒄𝒆)𝟐
1. Calculate the Net Cash Flow of each
P1 = Ending Price year NB:
Po = beginning Price 2. Try at each choice to find the rate
that makes: We can use these rules if in case of any
P1-PO = Capital Gains PV of future CF = Initial Investment portfolio if he gives PROBABILITIE
D = Dividends
r1 = HPR of first period
I = Interest on bond

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 (II) Portfolio (Markowitz)

Complete Portfolio (C) Risky Portfolio (P) Optimal Risky Portfolio (O)

% in Risky Asset (Risky Portfolio)…Y % in Risky Asset (Stock)…WA % in Risk Free

% in Risk Free …(1 – Y) % in Risky Asset (Bond)…WB % in Risky Asset (Stock)
% in Risky Asset (Bond)
(1) Expected Return E(R)C
(1) Expected Return rP
𝐄(𝐫𝐜) = 𝐲 𝐄(𝐫𝐩 ) + (𝟏 − 𝐲) 𝐫𝐟 It lies on the tangency point
𝒓𝒑 = 𝑾𝑨 𝒓𝑨 + 𝑾𝑩 𝒓𝑩 between the steepest CAL with
(2) Risk σC the Efficient Frontier
(2) Risk σP
𝝈𝒄 = 𝒚 𝛔𝐩 σp2 = WA2 σA2 + WB2 σB2 + 2 WA WB COVA ,B

(3) Reward-to-Variability Ratio = WA2 σA2 + WB2 σB2 + 2 WAWB PA,B σA σB

Slope of CAL/Sharpe Measure
𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
𝑆𝑙𝑜𝑝𝑒 =
𝑆𝐷
Expected Return − Risk Free
=
SD Efficient Portfolios
Minimum Variance
(4) Required Risk Premium
Portfolio Portfolios that lie on the
𝐄(𝐫𝐏 ) − 𝐫𝐟 = 𝟎. 𝟎𝟎𝟓 𝐱 𝐀 𝐱 𝛔𝐩𝟐 % Weight of first asset = Efficient Frontier (Portfolio
𝝈𝟐 𝟐 − 𝑪𝑶𝑽(𝒓𝟏 𝒓𝟐 ) that provides higher
𝐨𝐫 ∶ 𝐄(𝐫𝐏 ) − 𝐫𝐟 = 𝟎. 𝟎𝟎𝟓 𝐱 𝐀 𝐱 𝛔𝐩𝟐 𝐖𝟏 = 𝟐
𝝈𝟏 + 𝝈𝟐 𝟐 − 𝟐 𝑪𝑶𝑽(𝒓𝟏 𝒓𝟐 ) expected return at the same
And apply the same rule of level of risk)
𝐄(𝐫𝐏 ) − 𝐫𝐟
𝐀= risky portfolio when
𝟎. 𝟎𝟎𝟓 𝐱 𝛔𝐩𝟐
calculate return and risk
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 Correlation and Covariance

(1) Covariance
1st. Way:
COV(r1 , r2) = P1,2 σ1 σ2
Where:
COV(r1 , r2) : Covariance between return of security 1 and 2.
P1,2 : Correlation coefficient between return of security 1 and 2.

2nd. Way:
COV(r1 r2) = ∑ P (Deviation of 1 x Deviation of 2)
COV(r1 r2) = ∑ P [(r1 – E(r)1) x (r2 – E(r)2)]
(2) Correlation
COV AB
PAB =
σA σB

Single Index Model 𝐑 𝐢 = 𝜶 + 𝜷𝒊 (𝐑 𝐦 ) + 𝒆

Where:
𝐑𝐢 = 𝐑𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦
𝛂 = 𝐭𝐡𝐞 𝐬𝐭𝐨𝐜𝐤 ′ 𝐬 𝐞𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐫𝐞𝐭𝐮𝐫𝐧 𝐢𝐟 𝐭𝐡𝐞 𝐦𝐚𝐫𝐤𝐞𝐭 ′ 𝐬 𝐞𝐱𝐜𝐞𝐬𝐬 𝐫𝐞𝐭𝐮𝐫𝐧 𝐢𝐬 𝐳𝐞𝐫𝐨.
Rm = Index risk premium or market risk premium.
𝛃𝐢 (𝐑 𝐦 ) = 𝐭𝐡𝐞 𝐜𝐨𝐦𝐩𝐨𝐧𝐞𝐧𝐭 𝐨𝐟 𝐫𝐞𝐭𝐮𝐫𝐧 𝐝𝐮𝐞 𝐭𝐨 𝐦𝐨𝐯𝐞𝐦𝐞𝐧𝐭𝐬 𝐢𝐧 𝐭𝐞𝐡 𝐦𝐚𝐫𝐤𝐞𝐭 𝐢𝐧𝐝𝐞𝐱

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 Second: Questions
Chapter (1): Introduction
Brief of the chapter
Investment Assets can be classified into: Real Assets and Financial Assets:
(A) Real Assets
o They are used to produce goods and services such as physical assets (buildings, machines,
computers…etc.).
o The main feature of these assets is that they are tangible. Their value appears in their physical entity.
(B) Financial Assets
They are claims (dividends or interests) to the income generated by the real assets such as:
o Equity securities (Common stocks and Preferred Stocks)
o Debt securities (Bonds)
o Derivative securities (options, futures, swaps)
The main feature of this type of asset is that they are intangible. Their value appears in their claim not in
their physical entity.

(4) The Investment Process

There are (5) sequential steps
Step (1): Asset Allocation
In this step, investor should determine:
o Investment objective in terms of risk and return
o The amount of investment wealth (investable funds)
o The potential investment categories (alternatives/securities/assets)

Step (2): Security Analysis

The main objective of security analysis is to know the mispricing securities. There are 2 types of analysis:
Fundamental or Technical
(A) Fundamental Analysis
It is used to calculate the fair value (true/present value) of a security’s future cash flows and then comparing
it with its market value.
There are 3 cases:
o If fair value = market value …..it is fairly priced security (price will not change)
o If fair value > market value…..it is undervalued (price will increase so buy)
o If fair value < market value …..it is overvalued (price will decrease so sell)
Of course, the investor will choose to invest in undervalued securities.
(B) Technical Analysis
It uses the historical market data (prices and volumes) to predict the future patterns (movements) of prices
of the securities.

Step (3): Portfolio (Security) Selection

In this step, the investor should determine:
o Assets to be purchased.
o The proportion (weight) of wealth in which to invest in each asset.
o How to deal with some issues such as selectivity, timing, and diversification.

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Step (4): Portfolio Updating and Rebalancing
In this step, the investor should:
o Periodically repeat the previous 3 steps due to the continuous change in securities’ prices.
o Therefore, updating the portfolio may lead to one of three decisions:
1. Sell existing securities and use the proceeds to buy new securities
2. Investing additional funds to increase the size of the portfolio (buy new securities)
3. Selling some securities to decrease the size of the portfolio
Step (5): Portfolio Performance Evaluation
This step involves:
o Periodic evaluation of the portfolio’s performance in terms of return and risk
o The investor to have some measures of return and risk

(5) Approaches to Portfolio Management

There are 2 approaches the investor can use to manage his portfolio:
(A) Top-Down vs. Bottom-Up
(1) Top – Down Management (following the previous 5 steps)
o The investor starts with establishing a portfolio with a level of risk appropriate to his risk tolerance
(Asset allocation).
o It represents the natural way to build a portfolio.
(2) Bottom – Up Management
o The investor starts with determining the most attractive securities (undervalued)
Meaning that the investor starts with step 2 (Security Analysis) and skip step 1 (Asset Allocation).
o It overlooks the overall composition of portfolio, which may results in a non-diversified portfolio.
Note: Top – Down Management is better than Bottom – Up Management
(B) Active vs. Passive Strategies
(1) Active Strategy
o The investor attempt to improve the performance of the portfolio by continuous identifying the
mispriced (undervalued) securities.
o Timing the market and market trends.
(2) Passive Strategy
o The investor buys and holds a well-diversified (efficient) portfolio with few changes.
o No attempts to find undervalued securities.

(6) Efficient Market Theory

o It is the market where the securities’ prices usually reflect all available information about the
corporations.
o Therefore, the market price of a security reaches to its fair value (no overvalued or undervalued).
o There are 3 forms of market efficiency:
1. Weak Efficiency: It means that NO information is available (Public or private information) which
means no transparency.
2. Semi-strong Efficiency: It means that ONLY public information is available but private information
is not.
3. Strong Efficiency: It means that both public and private information is available.

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 (7) Financial Engineering
It means repackaging services of financial intermediaries…..How?
By 2 ways:
o Bundling of Cash Flow:
Combining more than one asset into a composite security, for example securities (stock, bond and
preferred stock into one hybrid security)
o Unbundling of Cash Flows:
Breaking up and allocating cash flows of one security to create several new securities (example:
securitization in mortgage and strips in case of bonds)
MCQ
(1) Real assets in the economy include all but which one of the following?
A. Land B. Buildings C. Consumer durables D. Common stock
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(2) __________ assets generate net income to the economy and __________ assets define allocation of
income among investors.
A. Financial, financial B. Financial, real C. Real, financial D. Real, real
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(3) Real assets are ______.
A. assets used to produce goods and services B. always the same as financial assets
C. always equal to liabilities D. claims on company's income
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(4) Surf City Software Company develops new surf forecasting software. It sells the software to Microsoft in
exchange for 1000 shares of Microsoft common stock. Surf City Software has exchanged a _____ asset for a
_____ asset in this transaction.
A. real, real B. financial, financial C. real, financial D. financial, real
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(5) ____ is not a derivative security.
A. A share of common stock B. A call option
C. A futures contract D. All of the above are derivative securities.
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(6) An example of a derivative security is _________.
A. a common share of General Motors B. a call option on Intel stock
C. a Ford bond D. a U.S. Treasury bond
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(7) Which of the following are financial assets?
I. Debt securities II. Equity securities III. Derivative securities
A.I only B.I and II only C.II and III only D.I, II and III
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(8) A __________ represents an ownership share in a corporation.
A. call option B. common stock C. fixed-income security D. future
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(9) In securities markets, there should be a risk-return trade-off with higher-risk assets having _________
expected returns than lower-risk assets.
A. higher B. lower C. the same D. Can't tell from the information given
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(10) Asset allocation refers to the _________.

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A. allocation of the investment portfolio across broad asset classes
B. analysis of the value of securities C. choice of specific assets within each asset class
D. none of the answers define asset allocation
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(11) Security selection refers to the ________.
A. allocation of the investment portfolio across broad asset classes
B. analysis of the value of securities C. choice of specific securities within each asset class
D. top down method of investing
(12) __________ portfolio construction starts with selecting attractively priced securities.
A. Bottom-up B. Top-down C. Upside-down D. Side-to-side
---------------------------------------------------------------------------------------------------------------------------- -----------------------------------------------------
(13) __________ portfolio management calls for holding diversified portfolios without spending effort or
resources attempting to improve investment performance through security analysis.
A. Active B. Momentum C. Passive D. Market timing
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(14) Security selection refers to _________.
A. choosing specific securities within each asset-class
B. deciding how much to invest in each asset-class
C. deciding how much to invest in the market portfolio versus the riskless asset
D. deciding how much to hedge
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(15) __________ portfolio construction starts with asset allocation.
A. Bottom-up B. Top-down C. Upside-down D. Side-to-side
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(16) An example of a real asset is _________.
I. a college education II. customer goodwill III. a patent
A. I only B. II only C. I and III only D. I, II and III
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(17) After much investigation an investor finds that Intel stock is currently underpriced. This is an example
of……………….
A. asset allocation B. security analysis
C. top down portfolio management D. passive management
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(18) After considering current market conditions an investor decides to place 60% of their funds in equities
and the rest in bonds. This is an example of
A. asset allocation B. security analysis
C. top down portfolio management D. passive management
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(19) The efficient markets hypothesis suggests that _______.
A. active portfolio management strategies are the most appropriate investment strategies
B. passive portfolio management strategies are the most appropriate investment strategies
C. either active or passive strategies may be appropriate, depending on the expected direction of the market
D. a bottom up approach is the most appropriate investment strategy
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(20) Securitization refers to the creation of new securities by _________.
A. selling individual cash flows of a security or loan
B. repackaging individual cash flows of a security or loan into a new payment pattern

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C. taking an illiquid asset and converting it into a marketable security
D. selling financial services overseas as well as in the U.S.
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(21) An investment advisor has decided to purchase gold, real estate, stocks, and bonds in equal amounts.
This decision reflects which part of the investment process?
A. Asset allocation B. Investment analysis
C. Portfolio analysis D. Security selection
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(22) Both investors and gamblers take on risk. The difference between an investor and a gambler is that an
investor _______.
A. is normally risk neutral B. requires a risk premium to take on the risk
C. knows he or she will not lose money D. knows the outcomes at the beginning of the holding period
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Answers
No. Answer No. Answer No. Answer No. Answer
1 D 7 D 13 C 19 B
2 C 8 B 14 A 20 A
3 A 9 A 15 B 21 A
4 C 10 A 16 D 22 B
5 A 11 C 17 B
6 B 12 A 18 A
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Chapter (3): Securities Market

Brief of the theoretical part
Definition of Financial Market
Financial markets are markets where financial assets are exchanged. There are 2 forms according to
the delivery of financial assets:
1. Spot / Cash Market: The delivery of the assets occurs immediately.
2. Future / Forward Market: The delivery of the assets occurs in the future.
Types of Financial Market
There are 2 main types:
(1) Primary Markets
Definition Markets in which users of funds (corporations and government) raise funds by issuing
financial instruments (stocks and bonds) to the initial suppliers of funds (e.g. households).
How to sell financial instruments?
There are 2 ways:
(A) Initial Public Offerings (IPO) (only for new firms for the first time)
IPO means offering the securities sale to the public at large. Any investor or institution can buy the
securities once issued.
‫ممكن يشترى‬investor ‫ده بيحصل لما الشركة تكون جديدة و اول مرة تطرح اسهم او سندات و هنا اى‬
Very Important Notes:
o Most primary market transactions in the USA are arranged through financial institutions called
“Investment Banks”. They act as intermediaries between the issuing corporations (users of
funds) and the investors (suppliers of funds).
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 ‫هنا بنوك االستثمار هى اللى الشركات بتنزل عندها االسهم و السندات و هى اللى بتبيع االسهم و السندات للمستثمرين (الكالم ده‬
‫ فى مصر اللى بيعمل كده هى البنوك التجارية زى البنك االهلى‬... ) ‫فى امريكا‬
o Investment banks conduct the sale using one of the following:
1. Firm commitment underwriting
2. Best efforts underwriting
o Firm commitment underwriters perform:
1. Origination: They advise the corporation on the type, timing and pricing of the new issue.
‫ السعر‬/ ‫ توقيت الطرح‬/ ‫النوع‬
2. Risk bearing: They buy the securities from the corporation
‫بيشترى كل األوراق المالية الخاصة بالشركة بسعر اقل من سعر السوق‬
3. Distribution: They resell the issue to the public ‫اعادة البيع للجمهور‬
4. Certification: They certify quality of the issue. ‫ضمان جودة االزراق المالية‬
“Seasoned Equity Offerings (SEOs)” means that the corporation issues additional financial securities of
an already existed. ‫شركة موجودة اصال و طرحت اسهم او سندات اضافية‬
o “Shelf Registration” allow firms to register shares and sell them gradually for up to 2 years after
registration. The firm uses it to reduce the issuing cost “Flotation Costs”.
2) Best efforts underwriting: the bank does its best efforts to sell the securities and receive a
commission
‫هنا دور البنك بينحصر فى محاولة بيع االوراق المالية فقط و الحصول على عمولة مقابل ذلك‬
(B) Private Placement
A private placement is an offer of securities to an institutional buyer (e.g. mutual fund) or group of
buyers to purchase the whole issue.

‫ده مؤسسة مالية مثل صندوق استثمار او مجموعة مستثمريين هياخد الكمية كلها‬... ‫هنا مش اى حد ممكن يشترى‬
(2) Secondary Markets
Definition
Markets where financial assets are traded among investors. These securities are exchanged with the
help of a securities broker (act as intermediary between the buyer and the seller).
‫السوق الثانوية و فيها بيتم اعادة بيع و شراء االوراق المالية او تداولها و العالقة فيها بين السماسرة و المستثمرين‬
How trading happens?
There are 2 ways:
(A) Stock Exchange ‫البورصة‬
Means a physical facility where members trade securities
(B) Over the Counter Market (OTC) )‫سوق التداول االليكترونية (اونالين‬
Means an informal network of brokers and dealers that negotiate the sale of securities.
Types of Orders in Stock Exchange
There are 4 types:
(A) Market Order
An order for the broker to transact at the best price available when the order reaches the post ‫( مفيش‬
)‫مجرد افضل سعر‬... ‫سعر محدد من المستثمر للسمسار‬
(B) Limit Order
An order for the broker to transact at a specified price (limit price) ‫ و‬.....‫هناك سعر محدد للبيع عنده او اعلى منه‬
)‫سعر محدد للشراء عنده او اقل منه (السعر محدد من المستثمر للسمسار‬
(C) Stop Loss Order

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Similar to limit order, but the stock is to be sold if its price falls below a stipulated level (limit) to stop
further losses. ‫امر بالبيع لو السعر انخفض عن حد معين اليقاف الخساير‬
(D) Stop Buy Order
A stock should be bought when its price rises above a limit to stop further losses

(I) Theoretical MCQs

(1) Underwriting is one of the services provided by _____.
A. the SEC B. investment bankers C. publicly traded companies D. FDIC
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(2) Under firm commitment underwriting, the ______ assumes the full risk that the shares cannot be sold to
the public at the stipulated offering price.
A. red herring B. issuing company C. initial stockholder D. underwriter
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(3) Private placements can be advantageous rather than public issue because ______.
I. private placements are cheaper to market than public issues
II. private placements may still be sold to the general public under SEC Rule 144A
III. privately placed securities trade on secondary markets
A. I only B. I and III only C. II and III only D. I, II and III
----------------------------------------------------------------------------------------------------------------------------------------------------
(4) Transactions that do not involve the original issue of securities take place in _________.
A. primary markets B. secondary markets C. over-the-counter markets D. institutional markets
----------------------------------------------------------------------------------------------------------------------------------------------------
(5) Initial margin requirements on stocks are set by _________.
A. the Federal Deposit Insurance Corporation B. the Federal Reserve
C. the New York Stock Exchange D. the Securities and Exchange Commission
----------------------------------------------------------------------------------------------------------------------------------------------------
(6) An order to buy or sell a security at the current price is a ______________.
A. limit order B. market order C. stop loss order D. stop buy order
----------------------------------------------------------------------------------------------------------------------------------------------------
(7) If an investor places a _________ order the stock will be sold if its price falls to the stipulated level. If an
investor places a __________ order the stock will be bought if its price rises above the stipulated level.
A. stop-buy; stop-loss B. market; limit C. stop-loss; stop-buy D. limit; market
----------------------------------------------------------------------------------------------------------------------------------------------------
(8) In a __________ underwriting arrangement, the underwriter assumes the full risk that shares may not be
sold to the public at the stipulated offering price.
A. best efforts B. firm commitment C. private placement D. none of the above
----------------------------------------------------------------------------------------------------------------------------------------------------
(9) You purchased XYZ stock at $50 per share. The stock is currently selling at $65. Your gains could be
protected by placing a _________.
A. limit-buy order B. limit-sell order C. market order D. stop-loss order
----------------------------------------------------------------------------------------------------------------------------------------------------
(10) __________ often accompany short sales, and are used to limit potential losses from the short position.
A. Limit orders B. Restricted orders C. Limit-loss orders D. Stop-buy orders
----------------------------------------------------------------------------------------------------------------------------------------------------
(11) If an investor uses the full amount of margin available, the equity in a margin account used for a stock
purchase can be found as ________.
A. market value of the stock - amount owed on the margin loan
Page | 11
B. market value of the stock + amount owed on the margin loan
C. market value of the stock  margin loan
D. margin loan x market value of the stock
----------------------------------------------------------------------------------------------------------------------------------------------------
Answers
No. Answer No. Answer No. Answer
1 B 5 B 9 B
2 D 6 B 10 D
3 A 7 C 11 A
4 B 8 B
----------------------------------------------------------------------------------------------------------------------------------------------------

(II) Numerical questions

(1) Assume you purchased 500 shares of XYZ common stock on margin at $40 per share from your broker. If
the initial margin is 60%, the amount you borrowed from the broker is _________.
A. $20,000 B. $12,000 C. $8,000 D. $15,000
Solution
Amount borrowed (loan) = Value of shares x (1 - Initial Percentage Margin)
= ( 500 shares x 40) x ( 1 - 60%) = 8,000 ………(C)
---------------------------------------------------------------------------------------------------------------------
-------------------------------
(2) You sold short 300 shares of common stock at $30 per share. The initial margin is 50%. You must put up
_________.
A. $4,500 B. $6,000 C. $9,000 D. $10,000
Solution
Put up amount = Margin = Proceeds from sale x Initial Percentage Margin
= (300 shares x 30) x 50% = 4500 ………(A)
--------------------------------------------------------------------------------------------------------------------------------------------
-------------------------------------
(3) You short-sell 200 shares of Tuckerton Trading Co., now selling for $50 per share. What is your maximum
possible loss?
A. $50 B. $150 C. $10,000 D. unlimited
Solution
There is NO upper limit of the price of a share. So, loss is unlimited since we do not know the
repurchased price ……..(D)
--------------------------------------------------------------------------------------------------------------------------------------------
-------------------------------------
(4) You short-sell 200 shares of Tuckerton Trading Co., now selling for $50 per share. What is your maximum
possible gain ignoring transactions cost?
A. $50 B. $150 C. $10,000 D. unlimited
Solution
Tuckerton could go bankrupt with a share price of 0.
Maximum gain = Proceeds from the sale (–) Minimum share price
= (200 shares x 50) – ( 200 shares x 0) = 10,000 …….(C)
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-------------------------------------

Page | 12
(5) You short-sell 200 shares of Rock Creek Fly Fishing Co., now selling for $50 per share. If you wish to limit
your loss to $2,500, you should place a stop-buy order at ____.
A. $37.50 B. $62.50 C. $56.25 D. $59.75
Solution
To achieve 2,500 loss, the loss per share should be = 2,500 ÷ 200 shares = 12.5
So, the price should be increased by 12.5 to be 50 + 12.5 = 62.5 …..(B)
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(6) You purchased 200 shares of ABC common stock on margin at $50 per share. Assume the initial margin is
50% and the maintenance margin is 30%. You will get a margin call if the stock drops below ________.
(Assume the stock pays no dividends and ignore interest on the margin loan.)
A. $26.55 B. $35.71 C. $28.95 D. $30.77
Solution
Initial Position
Stocks 10,000 Loan 5,000
(200 x 50) 10,000 x ( 1 – 50%)
Equity 5,000
10,000 x 50%
Total 10,000 Total 10,000
At Margin call price (P)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑠 − 𝐴𝑚𝑜𝑢𝑛𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑
= 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑀𝑎𝑟𝑔𝑖𝑛
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑠
(200 𝑥 𝑃) − 5,000
= 30%
(200 𝑥 𝑃)

30% (200 P) = 200 P – 5,000

60 P = 200 P – 5,000
140 P = 5,000 ,P = 5,000 ÷ 140 = 35.71 ……..(B)
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
(7) You purchased 250 shares of common stock on margin for $25 per share. The initial margin is 65% and the
stock pays no dividend. Your rate of return would be __________ if you sell the stock at $32 per share.
Ignore interest on margin.
A. 35% B. 39% C. 43% D. 28%
Solution
Initial Position
Stocks 6250 Loan 2187.5
(250 x 25) 6250 x ( 1 – 65%)
Equity 4062.5
6250 x 65%
Total 6250 Total 6250
At the time of sale
Stocks 8000 Loan 2187.5
(250 x 32)
Equity (8000 – 2187.5) 5812.5
Total 8000 Total 8000
Page | 13
 New Equity − Initial Equity
Rate of Return =
Initial Equity
5812.5−4062.5
Rate of Return = = 43% …….(C)
4062.5
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
(8) An investor puts up $5,000 but borrows an equal amount of money from their broker to double the
amount invested. The broker charges 7% on the loan. The stock was originally purchased at $25 per share and
in one year the investor sells the stock for $28. The investor's rate of return was ____.
A. 17% B. 12% C. 14% D. 19%
Solution
At the time of purchase
Stocks 10,000 Loan 5,000

Equity 5,000
Total 10,000 Total 10,000
Shares = 5,000 + 5,000 = 10,000 No. of shares = 10,000 ÷ $ 25 = 400 shares
At the time of sale (after one year)
Stocks 11,200 Loan 5,350
(400 x 28) (5,000) + (5,000 x 7%)
Equity 5,850
Total 11,200 Total 11,200
New Equity − Initial Equity
Rate of Return =
Initial Equity

5850 − 5000
Rate of Return = = 𝟏𝟕% … … (𝐀)
5000
(9) An investor buys $16,000 worth of a stock priced at $20 per share using 60% initial margin. The broker
charges 8% on the margin loan and requires a 35% maintenance margin. The stock pays a $0.50 per share
dividend in one year and then the stock is sold at $23 per share. What was the investor's rate of return?
A. 17.50% B. 19.67% C. 23.83% D. 25.75%
Solution
At the time of purchase (Initial Position)
Stocks 16,000 Loan 6,400
16,000 x ( 1 – 60%)
Equity 9,600
16,000 x 60%
Total 16,000 Total 16,000

No. of shares = 16,000 ÷ $ 20 = 800 shares

At the time of sale
Stocks 18,400 Loan 6,912
(800 x 23) 6,400 + (6,400 x 8%)

Received Dividends 400

(800 x 0.50)
Equity 11,888
Page | 14
 Total 18,800 Total 18,800
New Equity − Initial Equity
Rate of Return =
Initial Equity
11,888−9,600
Rate of Return = = 23.83% ……….(C)
9600
--------------------------------------------------------------------------------------------------------------------------------------------
(10) An investor buys $8,000 worth of a stock priced at $40 per share using 50% initial margin. The broker
charges 6% on the margin loan and requires a 30% maintenance margin. In one year the investor gets a
margin call. At the time of the margin call the stock's price must have been ____.
A. $20.00 B. $29.77 C. $30.29 D. $32.45
Solution
At the time of purchase
Stocks 8,000 Loan 4,000
8,000 x ( 1 – 50%)
Equity 4,000
8,000 x 50%
Total 8,000 Total 8,000
No. of shares = 8,000 ÷ $ 40 = 200 shares
After one year
Loan = 4000 + (4,000 x 6%) = 4240
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑠 − 𝐿𝑜𝑎𝑛
= 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑀𝑎𝑟𝑔𝑖𝑛
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘𝑠
(200 𝑥 𝑃) − 4,240
= 30%
(200 𝑥 𝑃)
30% (200 P) = 200 P – 4,240 , 60 P = 200 P – 4,240
140 P = 4,240 , P = 4,240 ÷ 140 = $ 30.29 ………(C)
---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
(11) You sell short 300 shares of Microsoft which are currently selling at $30 per share. You post the 50%
margin required on the short sale. If you earn no interest on the funds in your margin account what will be
your rate of return after one year if Microsoft is selling at $27? (Ignore any dividends)
A. 10.00% B. 20.00% C. 6.67% D. 15%
Solution
Initial Position
Sales proceeds 9,000 Stocks owed 9,000
(300 x 30) (300 x 30)
Margin 4,500 Equity 4,500
(9000 x 50%)
Total 13,500 Total 13,500
At the time of purchase
Sales proceeds 9,000 Stocks owed 8,100
(300 x 30) (300 x 27)
Margin 4,500 Equity 5,400
(9000 x 50%)
Total 13,500 Total 13,500

Page | 15
 New Equity − Initial Equity
Rate of Return =
Initial Equity

5400 − 4500
Rate of Return = = 20% … … … (B)
4500
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
(12) You sell short 200 shares of Doggie Treats Inc. which are currently selling at $25 per share.
You post the 50% margin required on the short sale. If your broker requires a 30% maintenance
margin, at what stock price will you get a margin call? (You earn no interest on the funds in
your margin account and the firm does not pay any dividends).
A. $28.85 B. $35.71 C. $31.50 D. $32.25
Solution
Initial Position
Sales proceeds (200 x 25) 5,000 Stocks owed (200 x 25) 5,000
Margin 2,500 Equity 2,500
(5000 x 50%)
Total 7,500 Total 7,500

Margin call Price

𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑆𝑡𝑜𝑐𝑘𝑠 𝑜𝑤𝑒𝑑
= 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑀𝑎𝑟𝑔𝑖𝑛
𝑆𝑡𝑜𝑐𝑘𝑠 𝑜𝑤𝑒𝑑

7,500 − 200𝑃
= 30%
(200 𝑥 𝑃)
30% (200 P) = 7500 - 200 P
60 P = 7500 - 200 P
260 P = 7500
P = 7500 ÷ 260 = $28.85……….(A)
---------------------------------------------------------------------------------------------------------------------
(13) The margin requirement on a stock purchase is 25%. You fully use the margin allowed to purchase 100
shares of MSFT at $25. If the price drops to $22, what is your percentage loss?
A. 9% B. 15% C. 48% D. 57%
Solution
At the time of purchase
Stocks 2,500 Loan 1,875
(100 x 25) 2,500 x ( 1 – 25%)
Equity 625
2,500 x 25%
Total 2,500 Total 2,500
At the time of sale
Shares = 100 shares x $ 22 = 2,200 Loan = 1,875
Equity = 2,200 – 1,875 = 325
325 − 625
Rate of Return = = −48% … … (C)
625

Page | 16
 Chapter (5): Risk and Return

(I) Theoretical questions

(1) You have calculated the historical dollar weighted return, annual geometric average return and annual
arithmetic average return. If you desire to forecast performance for next year, the best forecast will be given
by the ________.
A. dollar weighted return B. geometric average return
C. arithmetic average return D. index return
---------------------------------------------------------------------------------------------------------------------
(2) You have calculated the historical dollar weighted return, annual geometric average return and annual
arithmetic average return. You always reinvest your dividends and interest earned on the portfolio. Which
method provides the best measure of the actual average historical performance of the investments you have
chosen?
A. Dollar weighted return B. Geometric average return
C. Arithmetic average return D. Index return
---------------------------------------------------------------------------------------------------------------------
(3) Your timing was good last year. You invested more in your portfolio right before prices went up and you
sold right before prices went down. In calculating historical performance measures which one of the following
will be the largest?
A. Dollar weighted return B. Geometric average return
C. Arithmetic average return D. Mean holding period return
---------------------------------------------------------------------------------------------------------------------
(4) The ______ measure of returns ignores compounding.
A. geometric average B. arithmetic average C. IRR D. dollar weighted
---------------------------------------------------------------------------------------------------------------------
(5) The rate of return on _____ is known at the beginning of the holding period while the rate of return on
____ is not known until the end of the holding period.
A. risky assets, Treasury bills B. Treasury bills, risky assets
C. excess returns, risky assets D. index assets, bonds
---------------------------------------------------------------------------------------------------------------------
(6) Which one of the following measure time weighted returns?

I. Geometric average return II. Arithmetic average return III. Dollar weighted return
A. I only B. II only C. I and II only D. I and III only

(7) If you want to measure the performance of your investment in a fund, including the timing of your
purchases and redemptions you should calculate the __________.
A. geometric average return B. arithmetic average return
C. dollar weighted return D. index return
(8) The holding period return on a stock is equal to _________.
A. the capital gain yield over the period plus the inflation rate
B. the capital gain yield over the period plus the dividend yield
C. the current yield plus the dividend yield
D. the dividend yield plus the risk premium
(9) The dollar weighted return is the _________.
A. difference between cash inflows and cash outflows B. arithmetic average return
C. geometric average return D. internal rate of return
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Page | 17
(10) The reward/variability ratio is given by _________.
A. the slope of the capital allocation line B. the second derivative of the capital allocation line
C. the point at which the second derivative of the investor's indifference curve reaches zero
D. portfolio excess return
----------------------------------------------------------------------------------------------------------------------------------------------
(11) The excess return is the _________.
A. rate of return that can be earned with certainty
B. rate of return in excess of the Treasury bill rate
C. rate of return to risk aversion D. index return
----------------------------------------------------------------------------------------------------------------------------------------------
(12) In the mean-standard deviation graph, the line that connects the risk-free rate and the optimal risky
portfolio, P, is called _________.
A. the capital allocation line B. the indifference curve
C. the investor's utility line D. the security market line
----------------------------------------------------------------------------------------------------------------------------------------------
(13) Most studies indicate that investors' risk aversion is in the range _____.
A. 1-3 B. 2-4 C. 3-5 D. 4-6
----------------------------------------------------------------------------------------------------------------------------------------------
(14) Security A has a higher standard deviation of returns than Security B. We would expect that
I. Security A would have a higher risk premium than Security B
II. the likely range of returns for Security A in any given year would be higher than the likely range of returns for
Security B
III. the Sharpe measure of A will be higher than the Sharpe measure of B.
A. I only B. I and II only C. II and III only D. I, II and III
----------------------------------------------------------------------------------------------------------------------------------------------------
(15) The complete portfolio refers to the investment in _________.
A. the risk-free asset B. the risky portfolio
C. the risk-free asset and the risky portfolio combined D. the risky portfolio and the index
-----------------------------------------------------------------------------------------------------------------------------------------------
(16) The term "complete portfolio" refers to a portfolio consisting of _________________.
A. the risk-free asset combined with at least one risky asset
B. the market portfolio combined with the minimum variance portfolio
C. securities from domestic markets combined with securities from foreign markets
D. common stocks combined with bonds
----------------------------------------------------------------------------------------------------------------------------------------------
Answers
No. Answer No. Answer No. Answer No. Answer
1 C 5 B 9 D 13 B
2 B 6 C 10 A 14 B
3 A 7 C 11 B 15 C
4 B 8 B 12 A 16 B

Page | 18
 (II) Numerical questions
(1) You put up $50 at the beginning of the year for an investment. The value of the investment grows 4% and
you earn a dividend of $3.50. Your HPR was ____.
A. 4.00% B. 3.50% C. 7.00% D. 11.00%
Solution
HPR = Capital Gain Yield + Dividends Yield
= 4% + ( 3.5 ÷ 50) = 4% + 7% = 11% ........(D)
----------------------------------------------------------------------------------------------------------------------------------------------------
(2) Suppose you pay $9,700 for a $10,000 par Treasury bill maturing in three months. What is the holding
period return for this investment?
A. 3.01% B. 3.09% C. 12.42% D. 16.71%
Solution
𝑃1 − 𝑃0 10,000 − 9,700
HPR T−bills = = = 3.09% … … . . (B)
𝑃0 9,700
---------------------------------------------------------------------------------------------------------------------------------------------------
(3) Your investment has a 20% chance of earning a 30% rate of return, a 50% chance of earning a 10% rate of
return and a 30% chance of losing 6%. What is your expected return on this investment?
A. 12.8% B. 11.0% C. 8.9% D. 9.2%
Solution

E(r) = ∑ P(s) r(s) = (0.20)(30%) + (0.50)(10%) + (0.30)(−6%) = 9.2% … … … (D)

𝑠
---------------------------------------------------------------------------------------------------------------------------------------------------
(4) Your investment has a 40% chance of earning a 15% rate of return, a 50% chance of earning a 10% rate of
return and a 10% chance of losing 3%. What is the standard deviation of this investment?
A. 5.14% B. 7.59% C. 9.29% D. 8.43%
Solution

E(r) = ∑ P(s) r(s) = (0.40)(15%) + (0.50)(10%) + (0.10)(−3%) = 10.7%

𝑠

σ2 = ∑ P (s)[(r(s) − E(r)]2
s
𝜎 = √0.40 (15% − 10.7%)2 + 0.50 (10% − 10.7%)2 + 0.10 (−3% − 10.7%)2 = 5.14% … . (𝐴)
-----------------------------------------------------------------------------------------------------------------------------------------------------------------
(5) The holding period return on a stock was 25%. Its ending price was $18 and its beginning price was $16.
Its cash dividend must have been _________.
A. $0.25 B. $1.00 C. $2.00 D. $4.00
Solution
𝑃1 − 𝑃0 + 𝐷1
HPR Stock =
𝑃0

Page | 19
 18 − 16 + 𝐷1
25% =
16
D1 = 2……..(C)
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(6) An investor invests 70% of her wealth in a risky asset with an expected rate of return of 15% and a
variance of 5% and she puts 30% in a Treasury bill that pays 5%. Her portfolio's expected rate of return and
standard deviation are __________ and __________ respectively.
A. 10.0%, 6.7% B. 12.0%, 22.4% C. 12.0%, 15.7% D. 10.0%, 35.0%
Solution
E(rc ) = y E(rp ) + (1 − y) rf = (0.70)(15%) + (1 − 0.70)(5%) = 12%
σc = y σp = (0.70)(√5%) = 15.7% … … . . (C)
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(7) The arithmetic average of -11%, 15% and 20% is ________.
A. 15.67% B. 8.00% C. 11.22% D. 6.45%
Solution
r1 + r2 + r3 −11% + 15% + 20%
ra = = = 8% … … . . (𝐵)
3 3
----------------------------------------------------------------------------------------------------------------------------------------------------
(8) The geometric average of -12%, 20% and 25% is _________.
A. 8.42% B. 11.00% C. 9.70% D. 18.88%
Solution
1
rg = [(1 + r1 ) x (1 + r2 ) x(1 + r3 )] − 1 3

1
rg = [(1 − 12%) x (1 + 20%) x(1 + 25%)]3 − 1 = 9.70% … … (𝐶)
----------------------------------------------------------------------------------------------------------------------------------------------------
(9) Consider the following two investment alternatives. First, a risky portfolio that pays 15% rate of return
with a probability of 40% or 5% with a probability of 60%. Second, a treasury bill that pays 6%. The risk
premium on the risky investment is _________.
A. 1% B. 3% C. 6% D. 9%
Solution
E(r) = ∑𝑠 P(s) r(s) = (0.40)(15%) + (0.60)(5%) = 9%
Risk Premium = E(R) – RF = 9% - 6% = 3%.........(B)
----------------------------------------------------------------------------------------------------------------------------------------------------
(10) Consider the following two investment alternatives. First, a risky portfolio that pays 20% rate of return
with a probability of 60% or 5% with a probability of 40%. Second, a treasury bill that pays 6%. If you invest
$50,000 in the risky portfolio, your expected profit would be _________.
A. $3,000 B. $7,000 C. $7,500 D. $10,000

Page | 20
 Solution

E(r) = ∑ P(s) r(s) = (0.60)(20%) + (0.40)(5%) = 14%

𝑠
Expected Profit = Amount Invested x Expected Return = 50,000 x 14% = 7,000 ……..(B)
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(11) You invest $10,000 in a complete portfolio. The complete portfolio is composed of a risky asset with an
expected rate of return of 15% and a standard deviation of 21% and a treasury bill with a rate of return of
5%. How much money should be invested in the risky asset to form a portfolio with an expected return of
11%?
A. $6,000 B. $4,000 C. $7,000 D. $3,000
E(rc ) = y E(rp ) + (1 − y) rf
Solution
11% = Y (15%) + (1-Y)(5%)
0.11 = 0.15 Y + 0.05 – 0.05Y
0.11 – 0.05 = 0.10 Y
0.06 = 0.10 Y
Y = 0.06 ÷ 0.10 = 60%
Amount invested in risky asset = 60% x 10,000 = 6,000........(A)
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You have the following rates of return for a risky portfolio for several recent years. Assume that the stock
pays no dividends

(12) What is the geometric average return for the period?

A. 2.87% B. 0.74% C. 2.60% D. 2.21%
Solution
We should first calculate HPR for each year as:
Year HPR = [P1 – P0 + D) ÷ P0
2005 – 2006 (55 – 50 + 0) ÷ 50 = 10%
2006 – 2007 (51 – 55 + 0) ÷ 55 = – 7.27%
2007 – 2008 (54 – 51 + 0) ÷ 51 = 5.88%
1 1
𝑟𝑔 = [(1 + 𝑟1 ) 𝑥 (1 + 𝑟2 ) 𝑥 (1 + 𝑟3 )]𝑛 − 1 = [(1 + 10%) 𝑥 (1 − 7.27) 𝑥 (1 + 5.88)]3 − 1 = 2.6%

(13) What is the dollar weighted return over the entire time period?
A. 0.74% B. 2.87% C. 2.60% D. 2.21%
Solution

Page | 21
We should first calculate the net cash flow as:
Year 0 Buy 100 x $50 = 5000 – VE
Year 1 (2005 – 2006) Buy 50 x $55 = 2750 – VE
Year 2 (2006 – 2007) Sell 75 x $51 = 3825 + VE
Year 3 (2007 – 2008) Sell 75 x $54 = 4050 + VE
So, applying the equation, we will find:

−2750 3825 4050

5000 = + +
(1 + 𝐼𝑅𝑅%)1 (1 + 𝐼𝑅𝑅%)2 (1 + 𝐼𝑅𝑅)3

Try at 0.74%
−2750 3825 4050
+ + = 5000
(1 + 0.74%)1 (1 + 0.74%)2 (1 + 0.74)3

IRR = 0.74% …….(B)

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(14) Treasury bills are paying a 4% rate of return. A risk averse investor with a risk aversion of A = 3 should
invest in a risky portfolio with a standard deviation of 24% only if the risky portfolio's expected return is at
least ______.
A. 8.67% B. 9.84% C. 12.64% D. 14.68%
Solution
2
Since E(rP ) − rf = 0.005 x A x σp

E(rP ) − 4% = 0.005 x 3 x (24%)2

So, E(rP ) = 12.64% … … . . (C)

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(15) Two assets have the following expected returns and standard deviations when the risk-free rate is 5%:

An investor with a risk aversion of A = 3 would find that _________________ on a risk return basis.
A. only Asset A is acceptable B. only Asset B is acceptable
C. neither Asset A nor Asset B is acceptable D. both Asset A and Asset B are acceptable
Solution
We will calculate the minimum expected risk premium (required) and comparing it with expected risk
premium for each stock:
Asset (A)
Required Risk Premium = 0.005 x 3 x (20%)2 RP = 6%
Expected risk premium = E(R) – Rf = 10% - 5% = 5%
We will reject (A) because 6% > 5%
Asset (B)
Required Risk Premium = 0.005 x 3 x (27%)2 RP = 10.94%
Expected risk premium = E(R) – Rf = 15% - 5% = 10%
We will reject (B) because 10.94 % > 10% …………………(C)
Page | 22
----------------------------------------------------------------------------------------------------------------------------------------------------
(16) A portfolio with a 25% standard deviation generated a return of 15% last year when T-bills were paying
4.5%. This portfolio had a Sharpe measure of ____.
A. 0.22 B. 0.60 C. 0.42 D. 0.25
Solution
Risk Premuim E(r) − RF 15% − 4.5%
Sharpe Measure = = = = 0.42% … … (C)
Risk σ 25%

---------------------------------------------------------------------------------------------------------------------------------------------------
(17) Consider a treasury bill with a rate of return of 5% and the following risky securities:
Security A: E(r) = .15; variance = .0400 Security B: E(r) = .10; variance = .0225
Security C: E(r) = .12; variance = .1000 Security D: E(r) = .13; variance = .0625
The investor must develop a complete portfolio by combining the risk-free asset with one of the securities
mentioned above. The security the investor should choose as part of his complete portfolio to achieve the
best CAL would be _________.
A. security A B. security B C. security C D. security D
Solution
A is better than C & D because it has higher return and lower risk. So, the choice will be between A
and B. the criterion is Sharpe measure as:
E(r) − RF 15% − 5%
Sharpe Measure of A = = = 0.5%
σ √4
E(r) − RF 10% − 5%
Sharpe Measure of B = = = 0.33%
σ √2.25

We will choose the higher value (A)

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(18) An investment earns 10% the first year, 15% the second year and loses 12% the third year. Your total
compound return over the three years was ______.
A. 41.68% B. 11.32% C. 3.64% D. 13.00%
Solution
Total compound return = [(1+r1)(1+r2)(1+r3)] - 1
(1+0.10)(1+0.15)(1+ (-0.12) - 1 = 11.32% …….(B)
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(19) Treasury bills are paying a 4% rate of return. A risk averse investor with a risk aversion of A = 3 should
invest in a risky portfolio with a standard deviation of 24% only if the risky portfolio's expected return is at
least ______.
A. 8.67% B. 9.84% C. 12.64% D. 14.68%
Solution
2
Required Risk Premium = 0.005 x A x σ
= 0.005 x 3 x (24%)2 = 8.64%
E(r) = Required risk premium + Risk free return = 8.64% + 4% = 12.64%......(C)
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You are considering investing $1,000 in a complete portfolio. The complete portfolio is composed of treasury
bills that pay 5% and a risky portfolio, P, constructed with 2 risky securities X and Y. The optimal weights of X
Page | 23
and Y in P are 60% and 40% respectively. X has an expected rate of return of 14% and Y has an expected rate
of return of 10%.

(20) To form a complete portfolio with an expected rate of return of 11%, you should invest __________ of
your complete portfolio in treasury bills.
A. 19% B. 25% C. 36% D. 50%
Solution
E(r)P = WX RX + WY RY
E(r)P = (60%)(14%) + (40%)(10%) = 12.4%
E(r)C = Y E(r)P + (1-Y) RF
11% = 12.4% Y + 5% (1-Y)
11% = 12.4% Y + 5% - 5% Y
Y = 81% So, (1-Y) = 100% - 81% = 19%.......(A)

(21) To form a complete portfolio with an expected rate of return of 8%, you should invest approximately
__________ in the risky portfolio. This will mean you will also invest approximately __________ and
__________ of your complete portfolio in security X and Y respectively.
A. 0%, 60%, 40% B. 25%, 45%, 30% C. 40%, 24%, 16% D. 50%, 30%, 20%
Solution
E(r)C = Y E(r)P + (1-Y) RF
8% = 12.4% Y + 5% (1-Y)
8% = 12.4% Y + 5% - 5% Y
Y = 40%
Weight of X = 0.40 x 0.60 = 0.24 = 24%
Weight of X = 0.40 x 0.40 = 0.16 = 16% ……..(C)
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(22) The Manhawkin Fund has an expected return of 16% and a standard deviation of 20%. The risk free rate
is 4%. What is the reward-to-volatility ratio for the Manhawkin Fund?
A. 0.8 B. 0.6 C. 9.0 D. 1.0
Solution
E(r) − RF 16% − 4%
Reward to Variability Ratio = = = 0.60 % … … (B)
σ 20%
You invest $1,000 in a complete portfolio. The complete portfolio is composed of a risky asset with an
expected rate of return of 16% and a standard deviation of 20% and a treasury bill with a rate of return of
6%.
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(23) The return on the risky portfolio is 15%. The risk-free rate is 10%. The standard deviation of return on
the risky portfolio is 20%. If the standard deviation on the complete portfolio is 14%, the expected return on
the complete portfolio is _________.
A. 6.00% B. 8.75 % C. 13.50% D. 16.25%
Solution
E(rc ) = y E(rp ) + (1 − y) rf

Page | 24
But we do not have (y), so, we can get it from the rule of standard deviation of the complete portfolio
as:
𝜎𝑐 = 𝑦 σp
14% = 𝑦 (20%)
14%
𝑦= = 70%
20%
E(rc ) = (70%)(15%) + (1 − 70%)(10%) = 13.5% … … … (C)
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Chapter (6): Efficient Diversification

(I) Theoretical MCQ

(1) Risk that can be eliminated through diversification is called ______ risk.
A. unique B. firm-specific C. diversifiable D. all of the above
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(2) Based on the outcomes in the table below choose which of the statements is/are correct:

I. The covariance of Security A and Security B is zero

II. The correlation coefficient between Security A and C is negative
III. The correlation coefficient between Security B and C is positive
A. I only B. I and II only C. II and III only D. I, II and III
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(3) Asset A has an expected return of 15% and a reward-to-variability ratio of .4. Asset B has an expected
return of 20% and a reward-to-variability ratio of .3. A risk-averse investor would prefer a portfolio using the
risk-free asset and ______.
A. asset A B. asset B C. no risky asset D. can't tell from the data given
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(4) Which of the following statistics cannot be negative?
A. Covariance B. Variance C. E[r] D. Correlation coefficient
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(5) The correlation coefficient between two assets equals to _________.
A. their covariance divided by the product of their variances
B. the product of their variances divided by their covariance
C. the sum of their expected returns divided by their covariance
D. their covariance divided by the product of their standard deviations
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(6) Diversification is most effective when security returns are _________.
A. high B. negatively correlated C. positively correlated D. uncorrelated
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(7) The expected rate of return of a portfolio of risky securities is _________.
A. the sum of the securities' covariances B. the sum of the securities' variances

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C. the weighted sum of the securities' expected returns
D. the weighted sum of the securities' variances
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(8) The risk that can be diversified away is __________.
A. beta B. firm specific risk C. market risk D. systematic risk
(9) Market risk is also called __________ and _________.
A. systematic risk, diversifiable risk B. systematic risk, nondiversifiable risk
C. unique risk, nondiversifiable risk D. unique risk, diversifiable risk
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(10) Harry Markowitz is best known for his Nobel prize winning work on _____________.
A. strategies for active securities trading
B. techniques used to identify efficient portfolios of risky assets
C. techniques used to measure the systematic risk of securities
D. techniques used in valuing securities options
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(11) Adding additional risky assets to the investment opportunity set will generally move the efficient
frontier _____ and to the ______. ( cancel A.M.T)
A. up, right B. up, left C. down, right D. down, left
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(12) Investing in two assets with a correlation coefficient of -0.5 will reduce what kind of risk?
A. Market risk B. Non-diversifiable risk C. Systematic risk D. Unique risk
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(13) Which of the following provides the best example of a systematic risk event?
A. A strike by union workers hurts a firm's quarterly earnings.
B. Mad Cow disease in Montana hurts local ranchers and buyers of beef.
C. The Federal Reserve increases interest rates 50 basis points.
D. A senior executive at a firm embezzles $10 million and escapes to South America.
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(14) If an investor does not diversify their portfolio and instead puts all of their money in one stock, the
appropriate measure of security risk for that investor is the _______(Cancel A.M.T)_.
A. stock's standard deviation B. variance of the market
C. stock's beta D. covariance with the market index
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(15) Some diversification benefits can be achieved by combining securities in a portfolio as long as the
correlation between the securities is _____________.
A. 1 B. less than 1 C. between 0 and 1 D. less than or equal to 0
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(16) In order to construct a riskless portfolio using two risky stocks, one would need to find two stocks with
a correlation coefficient of ________.
A. 1.0 B. 0.5 C. 0 D. -1.0
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(17) Diversification can reduce or eliminate __________ risk.
A. all B. systematic C. non-systematic D. only an insignificant
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(18) The term excess-return refers to ______________.
A. returns earned illegally by means of insider trading
B. the difference between the rate of return earned and the risk-free rate
C. the difference between the rate of return earned on a particular security and the rate of return earned on
other securities of equivalent risk
D. the portion of the return on a security which represents tax liability and therefore cannot be reinvested
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Page | 26
 (19) Which risk can be diversified away as additional securities are added to a portfolio?
I. Total risk II. Systematic risk III. Firm specific risk
A. I only B. I and II only C. I, II, and III D. I and III
(20) You are considering adding a new security to your portfolio. In order to decide whether you should add
the security you need to know the security's _______.
I. expected return II. standard deviation III. correlation with your portfolio
A. I only B. I and II only C. I and III only D. I, II and III
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(21) Rational risk-averse investors will always prefer portfolios ______(Cancel)_______.
A. located on the efficient frontier to those located on the capital market line
B. located on the capital market line to those located on the efficient frontier
C. at or near the minimum variance point on the efficient frontier
D. that are risk-free to all other asset choices
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(22) Which of the following correlation coefficients will produce the most diversification benefits?
A. -0.6 B. -0.9 C. 0.0 D. 0.4
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(23) Which of the following correlations coefficients will produce the least diversification benefit?
A. -0.6 B. -0.3 C. 0.0 D. 0.8
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(24) Decreasing the number of stocks in a portfolio from 50 to 10 would likely ______
A. increase the systematic risk of the portfolio
B. increase the unsystematic risk of the portfolio
C. increase the return of the portfolio
D. decrease the variation in returns the investor faces in any one year
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(25) Firm specific risk is also called __________ and __________.
A. systematic risk, diversifiable risk B. systematic risk, non-diversifiable risk
C. unique risk, non-diversifiable risk D. unique risk, diversifiable risk
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(26) Which of the following is a correct expression concerning the formula for the standard deviation of
returns of a two asset portfolio where the correlation coefficient is positive?
A. 2rp < (W1212 + W2222) B. 2rp = (W1212 + W2222)
C. 2rp = (W1212 - W2222) D. 2rp > (W1212 + W2222)
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Answers
No. Answer No. Answer No. Answer No. Answer
1 D 9 B 17 C 25 D
2 B 10 B 18 B 26 D
3 A 11 B 19 D
4 B 12 D 20 D
5 D 13 C 21 D
6 B 14 A 22 B
7 C 15 D 23 D
8 B 16 D 24 B

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 (II) Numerical questions
(1) The standard deviation of return on investment A is .10 while the standard deviation of return on
investment B is .04. If the correlation coefficient between the returns on A and B is -.50, the covariance of
returns on A and B is _________.
A. -.0447 B. -.0020 C. .0020 D. .0447
Solution
COV1,2 = P1,2 σ1 σ2
COV = (-0.50)(10%)(4%) = -0.20 % = -0.0020……..(C)
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(2) A project has a 50% chance of doubling your investment in one year and a 50% chance of losing half your
money. What is the expected return on this investment project?
A. 0% B. 25% C. 50% D. 75%
Solution
r1 = 100% 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑤𝑖𝑙𝑙 𝑏𝑒 𝑑𝑜𝑢𝑏𝑙𝑒𝑑
r2 = −50% 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑤𝑖𝑙𝑙 𝑏𝑒 𝑙𝑜𝑠𝑡 𝑏𝑦 50%
E(r) = ∑𝑠 P(s) r(s) = (0.50)(100%) + (0.50)(−50%) = 25% … … . . (B)
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(3) You put half of your money in a stock portfolio that has an expected return of 14% and a standard
deviation of 24%. You put the rest of you money in a risky bond portfolio that has an expected return of 6%
and a standard deviation of 12%. The stock and bond portfolio have a correlation 0.55. The standard
deviation of the resulting portfolio will be ________________.
A. more than 18% but less than 24% B. equal to 18%
C. more than 12% but less than 18% D. equal to 12%
Solution
σp2= W1 σ12 + W22 σ22 + 2 (W1)(W2) P12 σ1 σ2
2

σp2= (50%)2 (24%)2 + (50%)2 (12%)2 + 2 (50%)(50%)(0.55)(24%)(12%) = 2.59%

𝜎𝑃 = √2.59% = 16.1% … … … (𝐶)
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(4) A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 24% while
stock B has a standard deviation of return of 18%. Stock A comprises 60% of the portfolio while stock B
comprises 40% of the portfolio. If the variance of return on the portfolio is .0380, the correlation coefficient
between the returns on A and B is _________.
A. 0.583 B. 0.225 C. 0.327 D. 0.128
Solution
σp2= W1 σ12
2 + W2 σ22 + 2 (W1)(W2) P12 σ1 σ2
2

3.8%= (60%) (24%)2 + (40%)2 (18%)2 + 2 (60%)(40%)(P1,2)(24%)(18%)

2

P1,2 = 0.583…….(A)
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(5) The standard deviation of return on investment A is .10 while the standard deviation of return on
investment B is .04. If the correlation coefficient between the returns on A and B is -.50, the covariance of
returns on A and B is _________.
A. -.0447 B. -.0020 C. .0020 D. .0447

Page | 28
 Solution
COV1,2 = P1,2 σ1 σ2
COV = (-0.50)(10%)(4%) = -0.20 % = -0.0020……..(C)
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(6) Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of
return of 16% and a standard deviation of return of 20%. B has an expected rate of return of 10% and a
standard deviation of return of 30%. The weight of security B in the minimum variance portfolio is
_________.
A. 10% B. 20% C. 40% D. 60%
Solution
The required is WB not WA
𝜎𝐴 2 − 𝐶𝑂𝑉𝐴,𝐵
WB = 2
𝜎𝐴 + 𝜎𝐵 2 − 2 𝐶𝑂𝑉𝐴,𝐵
COVA,B = PA,B σA σB = (-1)(20%)(30%) = -6%

(20%)2 − (−6%)
WB = = 40% … … . . (C)
(20%)2 + (30%)2 − 2 (−6%)
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(7) An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on
stock A is 20% while the standard deviation on stock B is 15%. The expected return on stock A is 20% while
on stock B it is 10%. The correlation coefficient between the return on A and B is 0. The expected return on
the minimum variance portfolio is approximately _________.
A. 10.00% B. 13.60% C. 15.00% D. 19.41%
Solution
2
𝜎𝐵 − 𝐶𝑂𝑉𝐴,𝐵
WA =
𝜎𝐴 + 𝜎𝐵 2 − 2 𝐶𝑂𝑉𝐴,𝐵
2

COVA,B = PA,B σA σB = (0)(20%)(15%) = 0

(15%)2 − 0
WA = = 36%
(20%)2 + (15%)2 − 2 (0)

rp = W1 r1 + W2 r2 = (36%)(20%) + (1 − 36%)(10%) = 13.6% … … . (𝐵)

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(8) A project has a 50% chance of doubling your investment in one year and a 50% chance of losing half your
money. What is the expected return on this investment project?
A. 0% B. 25% C. 50% D. 75%
Solution
r1 = 100% 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑤𝑖𝑙𝑙 𝑏𝑒 𝑑𝑜𝑢𝑏𝑙𝑒𝑑
r2 = −50% 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑤𝑖𝑙𝑙 𝑏𝑒 𝑙𝑜𝑠𝑡 𝑏𝑦 50%
E(r) = ∑𝑠 P(s) r(s) = (0.50)(100%) + (0.50)(−50%) = 25% … … . . (B)

Page | 29
The figures below show plots of monthly excess returns for two stocks plotted against excess returns for a
market index.

9. Which stock is likely to further reduce risk for an investor currently holding his portfolio in a well-diversified
portfolio of common stock?
A. Stock A B. Stock B
C. There is no difference between A or B D. You cannot tell from the information given
(- The stock with less slope will reduce the market risk (Stock B))

10. Which stock is riskier to a non-diversified investor who puts all his money in only one of these stocks?
A. Stock A is riskier B. Stock B is riskier
C. Both stocks are equally risky D. You cannot tell from the information given.
-( The stock with more vertical distance between SCL and the actual excess return has more firm-risk (Stock
A))
10. Semitool Corp has an expected excess return of 6% for next year. However for every unexpected 1% change
in the market, Semitool's return responds by a factor of 1.2. Suppose it turns out the economy and the stock
market do better than expected by 1.5% and Semitool's products experience more rapid growth than
anticipated, pushing up the stock price by another 1%. Based on this information what was Semitool's actual
excess return?
A. 7.00% B. 8.50% C. 8.80% D. 9.25%
R i = 𝛼 + 𝛽𝑖 (R m ) + 𝑒
𝛼 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 = 6%
𝛽𝑖 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 = 1.2 (𝐸𝑣𝑒𝑟𝑦 𝑐ℎ𝑎𝑛𝑔𝑒 𝑏𝑦 1% 𝑐𝑎𝑢𝑠𝑒𝑠 𝑐ℎ𝑎𝑛𝑔𝑒 𝑏𝑦 1.2%)
R m = 𝑀𝑎𝑟𝑘𝑒𝑡 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 = +1.5% (𝐷𝑜 𝑏𝑒𝑡𝑡𝑒𝑟 𝑏𝑦 1.5%)
𝑒 = 𝐹𝑖𝑟𝑚 𝑅𝑖𝑠𝑘 = 1% (𝑇ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑒𝑥𝑝𝑒𝑟𝑖𝑒𝑛𝑐𝑒 𝑚𝑜𝑟𝑒 𝑔𝑟𝑜𝑤𝑡ℎ)
R i = 6% + (1.2)(1.5%) + 1% = 8.8%
11) Investors expect the market rate of return this year to be 10%. The expected rate of return on a
stock with a beta of 1.2 is currently 12%. If the market return this year turns out to be 8%, how would
you revise your expectation of the rate of return on the stock?
Solution: The expected return on the stock will change by:
Beta x unanticipated change in the market return
1.2 (8% - 10%) = - 2.4%
This means that the expectation will be lowered by 2.4% (to be 12% -2.4% = 9.6%)

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 1- Which stock is riskier to an investor currently holding her portfolio in a diversified
portfolio of common stock?
2- Which stock is riskier to an undiversified investor who puts all of his funds in only one of
these stocks?
Solution
1. The diversified portfolio consists mainly of systematic risk measured by beta. Therefore,
stock B is more risky because the slope of security characteristic line is higher (more
beta).
2. The undiversified investor is mainly exposed to firm specific risk, which measured by the
distance between the point and security characteristic line. Stock A has more far points.
So, it is more risky.

With My Best Wishes

Faisal El-Sadat
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