Name: _____________________

ID number: _________________

FIN 406
QUIZ 1

October 3, 2002

Instructions: Circle the best answer for each question in the exam. There are 45
questions and each question is worth 1 point. The exam is a closed book and closed notes
exam.

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1. Why are derivatives potentially dangerous?
a. They involve leverage
b. They are used to hedge
c. They are a tool for risk management
d. There are more than 1200 different derivatives on the market

2. Financial assets ___________ means by which individuals hold claims on real

assets. Financial assets ________ directly to the productive capacity of the
economy.
a. are; contribute
b. are; do not contribute
c. are not; contribute
d. are not; do not contribute

3. Asset allocation refers to the _______________.

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 above

4. _____________ portfolio management calls for holding diversified portfolios

without spending effort or resources attempting to improve investment
performance through security analysis.
a. active
b. idiotic
c. passive
d. none of the above

5. The most important feature of municipal bonds is their ____________.

a. safety
b. liquidity
c. tax-exempt status
d. convertibility

6. ____________ is not a characteristic of a money market instrument.

a. liquidity
b. marketability
c. low risk
d. long maturity

7. Financial intermediaries exist because small investors cannot efficiently

_____________.
a. diversify their portfolios
b. gather information
c. monitor their portfolios
d. all of the above

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8. When computing the bond equivalent yield in a leap year, you would use
________ days.
a. 260
b. 360
c. 365
d. 366

9. The bid price of a treasury bill is ______________.

a. the price at which the dealer in treasury bills is willing to sell the bill
b. the price at which the dealer in treasury bills is willing to buy the bill
c. greater than the ask price of the treasury bill expressed in dollar terms
d. the price at which the investor can buy the treasury bill

10. In a futures contract, the long position is taken by the person who ____________.
a. commits to delivering the commodity
b. commits to purchasing the commodity
c. plays between second base and third base
d. uses his margin

11. A __________ gives its holder the right to buy an asset for a specified exercise
price on or before a specified expiration date.
a. call option
b. futures contract
c. put option
d. none of the above

12. A treasury bill has a face value of $10,000 and is selling for $9,800. If the treasury
bill matures in 80 days, its bank discount yield is ___________.
a. 2.04%
b. 9.46%
c. 9.00%
d. 9.66%

13. The bond equivalent yield on a treasury bill is 5%. The price of the bill is
______________ if it matures in 60 days and has a face value of $1,000.
a. $950.00
b. $990.67
c. $991.85
d. none of the above

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14. If the market prices of the 30 stocks in the Dow Jones Industrial Average all
change by the same dollar amount on a given day (ignoring stock splits), which
stock will have the greatest impact on the average?
a. the one with the highest price
b. the one with the lowest price
c. all 30 stocks will have the same impact
d. the answer cannot be determined by the information given

15. Which of the following are not characteristic of common stock ownership?
a. residual claimant
b. unlimited liability
c. voting rights
d. all of the above are characteristics of stock ownership

16. Assume that you have just purchased some shares in an investment company
reporting $300 million in assets, $20 million in liabilities, and 28 million shares
outstanding. What is the net asset value of these shares?
a. $10
b. $9.33
c. $15
d. $1.50

17. Sponsors of unit investment trusts earn a profit by ______________.

a. deducting a quarterly management fee from fund assets
b. deducting a percentage of any gains in asset value
c. selling shares in the trust at a premium to the cost of acquiring the
underlying assets
d. none of the above

18. Investors who wish to liquidate their holding in a closed-end fund may
_______________.
a. sell their shares back to the trustee at a discount
b. sell their shares back to the trustee at net asset value
c. sell their shares on the open market
d. none of the above

19. ____________ is a false statement regarding open-end mutual funds.

a. they offer investors a guaranteed rate of return
b. they offer investors a well diversified portfolio
c. they redeem their shares at their net asset value
d. none of the above

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20. Mutual funds that vary the proportions of funds invested in particular market
sectors according to the fund manager’s forecast of the performance of that
market sector are called ______________.
a. asset allocation funds
b. balanced funds
c. index funds
d. income funds

21. Over the past two decades, actively managed funds have tended to ____________
index funds.
a. outperform
b. perform equivalently to
c. underperform
d. no consistent relationship between the performance of actively managed
funds and passively managed funds has been documented.

22. The stage an individual is in his/her life cycle will affect his/her _____________.
a. return requirement
b. risk tolerance
c. both a. and b.
d. neither a. nor b.

23. The ___________ average ignores compounding.

a. geometric
b. arithmetic
c. both a and b above
d. none of the above

24. Of the alternatives available, _____________ typically have the lowest standard
deviation of returns.
a. commercial paper
b. corporate bonds
c. stocks
d. treasury bills

25. If you purchase a stock for $50, receive dividends of $2, and sell the stock at the
end of the year for $55, what is your holding period return?
a. 5%
b. 10%
c. 14%
d. 18%

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26. The arithmetic average of 10%, 15%, and 20% is ________________.
a. 15.7%
b. 15%
c. 17.2
d. 20%

27. The geometric average of 10%, 20% and 30% is ____________.

a. 14.9%
b. 18.2%
c. 19.7%
d. 23%

28. The dollar weighted return is the same as the _______________.

a. difference between cash inflows and outflows
b. arithmetic average return
c. geometric average return
d. internal rate of return

29. Suppose you pay $9,750 for a Treasury bill maturing in three months. What is the
effective annual rate of return for this investment?
a. 3.1%
b. 13%
c. 8.42%
d. 10.65%

30. 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. none of the above.

31. If you require a real growth in the purchasing power of your investment of 8%,
and you expect the rate of inflation over the next year to be 3%, what is the lowest
nominal return that you would be satisfied with? (exact rate, not approximation)
a. 3%
b. 8%
c. 11%
d. 11.24%

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32. A Treasury bill pays a 6% rate of return. A risk averse investor _____________
invest in a risky portfolio that pays 12% with a probability of 40% or 2% with a
probability of 60% because ___________________.
a. might; she is rewarded a risk premium
b. would not; because she is not rewarded any risk premium
c. would not; because the risk premium is small
d. cannot be determined

33. Consider a treasury bill with a rate of return of 5% and the following risky
securities:
Expected Return Variance
A 0.15 0.0400
B 0.15 0.0225
C 0.12 0.1000
D 0.13 0.0625
The investor must develop a complete portfolio by combining the risk-free asset
with one of the securities mentioned above. The security the investor would
choose as part of his complete portfolio would be _____________.
a. security A
b. security B
c. security C
d. security D

34. An investor invests 40% of his wealth in a risky asset with an expected rate of
return of 15% and a variance of 4% and 60% in a treasury bill that pays 6%. The
portfolio’s expected rate of return and standard deviation are _____________ and
______________.
a. 8.0%; 12%
b. 9.6%; 8%
c. 9.6%; 10%
d. 11.4%; 12%

35. Consider the following two investment alternatives. First, a risky portfolio that
pays 15% rate of return with a probability of 60% or 5% with a probability of
40%. Second, a treasury bill that pays 10%. The risk premium on the risky
investment is
a. 1%
b. 5%
c. 9%
d. 7%

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36. You invest $100 in a complete portfolio. The complete portfolio is composed of a
risky asset with an expected rate of return of 12% and a standard deviation of
15% and a treasury bill with a rate of return of 5%. ______ of your money should
be invested in the risky asset to form a portfolio with an expected return of 7%.
a. 28%
b. 86%
c. 57%
d. 50%

37. A portfolio is composed to two stocks, A and B. Stock A has a standard deviation
of return of 25% while stock B has a standard deviation of return of 5%. Stock A
comprises 20% of the portfolio while stock B comprises 80% of the portfolio. If
the variance of returns on the portfolio is 0.0050, the correlation coefficient
between the returns on A and B is ____________.
a. -0.225
b. -0.474
c. 0.474
d. 0.225

38. The standard deviation of return on investment A is 0.1 while the standard
deviation of return on investment B is 0.05. If the covariance of returns on A and
B is 0.00385, the correlation coefficient between the returns A and B is
____________.
a. 0.12
b. 0.36
c. 0.60
d. 0.77

39. 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 stock B is 15%. The correlation coefficient between the return on A and B is
0.The expected return on stock A is 20% while on stock B is 10%. The proportion
of the minimum variance portfolio that would be invested in stock B is ________.
a. 6%
b. 50%
c. 64%
d. 100%
40. A portfolio is composed of two stocks, A and B. Stock A has a standard deviation
of return of 5% while stock B has a standard deviation of return of 15%. The
correlation coefficient between the returns on A and B is 0.8. Stock A comprises
40% of the portfolio while stock B comprises 60% of the portfolio. The variance
of return on the portfolio is ___________.
a. 0.0056
b. 0.0067
c. 0.0114
d. 0.0103

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41. According to Tobin’s separation property, portfolio choice can be separated into
two independent tasks consisting of ___________ and ___________.
a. identifying all investor imposed constraints; identifying the set of
securities that conform to the investor’s constraints and offer the best risk-
return tradeoff
b. identifying the investor’s degree of risk aversion; choosing securities from
industry groups that are consistent with the investor’s risk profile
c. identifying the optimal risky portfolio; constructing a complete portfolio
from the T-bills and the optimal risky portfolio based on the investor’s
degree of risk aversion
d. none of the above answers is correct.

42. The values of beta coefficients of securities are ___________.

a. always positive
b. always negative
c. always between +1 and –1
d. usually positive, but not restricted in any particular way

43. Rational risk-averse investors will always prefer portfolios ____________.

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. rational risk-averse investors prefer the risk-free asset to all others

44. Risk that can’t be eliminated through diversification is called _____________ risk
a. firm-specific
b. unique
c. both of the above
d. none of the above

45. The term excess returns 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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Answers to QUIZ 1

(Since the correct answers are circled in red pen on your returned quizzes, only the work
for computational questions are provided here.)

12. Bank discount yield = (face value – price)/face value x 360/80 = 9%

13. Bond equivalent yield = (face value – price)/price x 365/60

0.05 = (1000-P)/P x 365/60  solving for P yields $991.85

16. NAV = (assets-liabs)/shares outstanding = (300m-20m)/28m = $10

25. Return = (selling price +dividend)/purch price - 1 = (55+2)/50 - 1 = 14%

26. Arithmetric average = (0.10 + 0.15 + 0.20)/3 = 0.15 = 15%

27. Geometric average = ((1.1)(1.2)(1.30))1/3 –1 = 19.7%

29. Holding period return = (10,000-9,750)/9,750 = 0.025641

EAR = (1.025641)4 - 1 = 0.1065 = 10.65%

31. (1 + nom rate) = (1+real rate)(1+inflation rate)

= (1.08)(1.03) = 1.1124 so nominal rate = 11.24%

32. Expected return on the risky portfolio = (0.4)(0.12) + (0.6)(0.02) = 0.06

No point in investing in the risky portfolio since you can get the same rate of
return from the risk free asset (there is no risk premium)

33. Calculate the slope of the CAL between the risk free asset and each of the risky
securities. Slope of the CAL
= (Expected return on risky asset – risk free rate)/std dev of risky asset
For A: (0.15-0.05)/sqr root of 0.0400 = 0.5
For B: = 0.66
For C: = 0.22
For D: = 0.32

Security B is best since it allows for a CAL with the highest slope.

34. Expected return on portfolio = (0.4)(0.15) + (0.6)(0.06) = 0.096

Standard deviation = (0.4)(sqr root of 0.04) = 0.08

35. Expected return on risky portfolio = (0.6)(0.15)+(0.4)(0.05) = 0.11

The risk premium = 0.11 – risk free rate = 0.11-0.10 = 0.01

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36. Expected return on portfolio = x(0.12) + (1-x)(0.05)
We want the expected return to equal 0.07 so
0.07 = x(0.12) + (1-x)(0.05)  solving for x yields 28%

37. using the equation for variance of returns on a portfolio:

0.0050 = (0.2)2(0.25)2 + (0.8)2(0.05)2 + 2(0.2)(0.8)(0.25)(0.05)(corr)
solving for correlation yields 0.225

38. correlation coeff = covariance/(std dev of A x std dev of B)

= 0.00385/(0.1*0.05) = 0.77

39. using the equation for solving the weight of asset B in the minimum variance
portfolio
= (0.2)2 - (0.2)(0.15)(0)
(0.15)2 + (0.2)2 - 2(0.2)(0.15)(0)
= 0.64 = 64%

40. using the equation for variance of returns on a portfolio

= (0.4)2(0.05)2 + (0.6)2(0.15)2 + 2(0.4)(0.6)(0.05)(0.15)(0.8)
= 0.0004 + 0.0081 + (0.00288) = 0.01138

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