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Question 1

(5 points) According to the principle of diversification, the only way to lower the risk of a portfolio you must add assets that are negatively correlated with your existing portfolio.

Your Answer | Score | Explanation |

False | 5.00 | Correct. You understand how diversification works. |

Total | 5.00/5.00 | |

Question Explanation | ||

Simple but important question about diversification. |

Question 2

(10) You have an equally weighted portfolio that consists of equity ownership in three firms. Firm A is trading at $23 per share and has a beta of 1.15; Firm B is trading at $16 per share with a beta of 1.60; Firm C is trading at $76 per share with a beta of 0.85. Assume a risk free rate of 2% and market return of 7%. If each stock has a standard deviation of 40% and the stocks have a correlation of 0.20 with each other, your portfolio’s expected return is closest to

Your Answer | Score | Explanation |

8% | 10.00 | Correct. You appear to understand expected returns of both securities and portfolios. |

Total | 10.00/10.00 | |

Question Explanation | ||

To figure out the expected return on this, or any, portfolio. Important for making any type of investment decision. |

Question 3

(10 points) You have a portfolio that consists of equity ownership in three firms. You own 200 shares of Euro General Stores (EGS), 450 shares of Fuerte Steel (FS) and 350 shares of Bamboo Flooring (BF). Their current share prices are $62, $73, and $12, respectively. What is the weight of FS in your portfolio? (No more than two decimals in the percentage weight, but do not enter the % sign.)

Your Answer | Score | Explanation |

63.43 | 10.00 | Correct. You know how to figure out relative investments implied by your choices. |

Total | 10.00/10.00 | |

Question Explanation | ||

A simple question, but an important one to sort out as an investor. |

Question 4

(10 points) With everyone nervous about their investments after the recent financial crisis, suppose a new firm, Safety Net Insurance (SNI), emerges to sell people insurance against poorly performing markets in exchange for an annual premium. As an investor in SNI, you would expect this company’s share to have a beta that is:

Your Answer | Score | Explanation |

Close to zero. | 0.00 | Think again about what this “investment” provides you in a good versus bad state. |

Total | 0.00/0.00 | |

Question Explanation | ||

Basic intuition of beta, or systematic, risk |

Question 5

(10 points) Suppose there are three securities (A, B, and C) to choose from to create your portfolio. Next year the economy will be in an expansion, normal, or recession state with probabilities 0.30, 0.50, and 0.20, respectively. The returns (%) on the securities in these states are as follows: Security A {expansion = +8, normal = +7, recession = +2}; Security B {-1, -1, +5}; Security C {+14, +7, -8}. You are considering 4 potential portfolios of these 3 securities, with the following specific weights on each: Portfolio I (0.20, 0.40, 0.40); Portfolio II (0.34, 0.33, 0.33); Portfolio III (0.50, 0.25, 0.25); Portfolio IV (0.70, 0.15, 0.15); where the numbers in each parentheses are (weight of A, weight of B, weight of C). Which portfolio has the lowest risk?

Your Answer | Score | Explanation |

Portfolio IV. | 10.00 | Correct. You know how to calculate the risk of a portfolio and hopefully program it in a spreadsheet. |

Total | 10.00/10.00 | |

Question Explanation | ||

A question that makes you crunch the numbers so that you understand the risk of a portfolio and what it is determined by. |

Question 6

(10 points) The PSI-20 is an index of the 20 largest market capitalization stocks traded on the Euronext Lisbon Stock Exchange in Portugal. You think that 20 stocks may not give you enough diversification, so you want to expand that list to the top 60 stocks. By doing this, what is the percentage increase in the UNIQUE relations between any two stocks in your portfolio that you will have to worry about? (No more than two decimals in the percentage drop, but do not enter the % sign.)

Your Answer | Score | Explanation |

831.58 | 10.00 | |

Total | 10.00/10.00 | |

Question Explanation | ||

An important calculation to emphasize the importance of relations among stocks in a portfolio. |

Question 7

(10 points) The CAPM states that the realized/actual return on an asset in any period will be the risk free rate plus beta times the market risk premium.

Your Answer | Score | Explanation |

False | 10.00 | Correct. You understand a simple but important difference. |

Total | 10.00/10.00 | |

Question Explanation | ||

A simple, but widely misunderstood, difference between actual outcome(s) and the expected one in an uncertain word. |

Question 8

(10 points) Suppose CAPM works, and you know that the expected returns on IBM and Google are estimated to be 11% and 9.5%, respectively. You have just calculated extremely reliable estimates of the betas of IBM and Google to be 1.25 and 0.95, respectively. Given this data, what is a reasonable estimate of the market risk-premium (the average/expected difference between the market return and the risk-free rate)? (No more than two decimals in the percentage return, but do not enter the % sign.)

Your Answer | Score | Explanation |

5 | 10.00 | Correct. You understand that linear relations (like the CAPM) are easy to work with. |

Total | 10.00/10.00 | |

Question Explanation | ||

Testing your understanding of the CAPM and its key determinants. |

Question 9

(10 points) The standard deviation of a portfolio’s return is the weighted average of the standard deviations of the returns of all securities in the portfolio, where the weights are proportional to the amount of your investment in a security relative to your total investment.

Your Answer | Score | Explanation |

False | 10.00 | Correct. You have internalized diversification and the relation between the risk of a portfolio and individual securities. |

Total | 10.00/10.00 | |

Question Explanation | ||

Again, a basic but important, relation between the risks of portfolios and individual securities. Go back to basics. |

Question 10

(15 Points) Your own company has been very successful in producing and selling rocket engines. Given that airplane engines are not that cheap, and the airline industry is extremely sensitive to the market, the beta of your company is 2.50. The market risk premium (the average/expected difference between the market return and the risk-free rate) is 4.00% and the return on a long-term government bond is 2.50%. You have discovered an exciting opportunity to create a new wireless device that will cover a whole state in the U.S. with one station. This project will require a $4 billion investment, spread out equally between now (t = 0) and the end of this year (t = 1), and will produce $500 million dollars in perpetuity starting in year 2 (t = 2). Should you proceed with this project?

Your Answer | Score | Explanation |

Do not know. | 15.00 | Correct. You know that calculations without understanding the context are meaningless. |

Total | 15.00/15.00 | |

Question Explanation | ||

An issue that is more important to valuation than any other. |