mouse123

As the correlation between the returns of two assets becomes lower, the risk reduction potential becomes:

A) smaller.

B) greater.

C) decreased by the same level.

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Perfect positive correlation (r = +1) of the returns of two assets offers no risk reduction, whereas perfect negative correlation (r = -1) offers the greatest risk reduction.

mouse123

Adding a stock to a portfolio will reduce the risk of the portfolio if the correlation coefficient is less than which of the following?

A) 0.00.

B) +1.00.

C) +0.50.

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Adding any stock that is not perfectly correlated with the portfolio (+1) will reduce the risk of the portfolio.

mouse123

Stock A has a standard deviation of 4.1% and Stock B has a standard deviation of 5.8%. If the stocks are perfectly positively correlated, which portfolio weights minimize the portfolio’s standard deviation?

Stock A

Stock B

A) 63% 37%

B) 0% 100%

C) 100% 0%

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Because there is a perfectly positive correlation, there is no benefit to diversification. Therefore, the investor should put all his money into Stock A (with the lowest standard deviation) to minimize the risk (standard deviation) of the portfolio.

andytrader

Which one of the following statements about correlation is NOT correct?

A) Potential benefits from diversification arise when correlation is less than +1.

B) If the correlation coefficient were -1, a zero variance portfolio could be constructed.

C) If the correlation coefficient were 0, a zero variance portfolio could be constructed.

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A correlation coefficient of zero means that there is no relationship between the stock's returns. The other statements are true.

andytrader

There are benefits to diversification as long as:

A) the correlation coefficient between the assets is less than 1.

B) there is perfect positive correlation between the assets.

C) there must be perfect negative correlation between the assets.

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There are benefits to diversification as long as the correlation coefficient between the assets is less than 1.

andytrader

Stock A has a standard deviation of 0.5 and Stock B has a standard deviation of 0.3. Stock A and Stock B are perfectly positively correlated. According to Markowitz portfolio theory how much should be invested in each stock to minimize the portfolio's standard deviation?

A) 30% in Stock A and 70% in Stock B.

B) 100% in Stock B.

C) 50% in Stock A and 50% in Stock B.

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Since the stocks are perfectly correlated, there is no benefit from diversification. So, invest in the stock with the lowest risk.

andytrader

Which of the following statements about portfolio theory is least accurate?

A) Assuming that the correlation coefficient is less than one, the risk of the portfolio will always be less than the simple weighted average of individual stock risks.

B) For a two-stock portfolio, the lowest risk occurs when the correlation coefficient is close to negative one.

C) When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will not decrease the overall portfolio standard deviation.

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When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will decrease the overall portfolio standard deviation. Any time the correlation coefficient is less than one, there are benefits from diversification. The other choices are true.

andytrader

Kendra Jackson, CFA, is given the following information on two stocks, Rockaway and Bridgeport.

• Covariance between the two stocks = 0.0325
• Standard Deviation of Rockaway’s returns = 0.25
• Standard Deviation of Bridgeport’s returns = 0.13

Assuming that Jackson must construct a portfolio using only these two stocks, which of the following combinations will result in the minimum variance portfolio?

A) 100% in Bridgeport.

B) 50% in Bridgeport, 50% in Rockaway.

C) 80% in Bridgeport, 20% in Rockaway.

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First, calculate the correlation coefficient to check whether diversification will provide any benefit.

rBridgeport, Rockaway = covBridgeport, Rockaway / [( sBridgeport) × (sRockaway) ] = 0.0325 / (0.13 × 0.25) = 1.00

Since the stocks are perfectly positively correlated, there are no diversification benefits and we select the stock with the lowest risk (as measured by variance or standard deviation), which is Bridgeport.

andytrader

An investment manager is looking at ten possible stocks to include in a client’s portfolio. In order to achieve the maximum efficiency of the portfolio, the manager must:

A) find the combination of stocks that produces a portfolio with the maximum expected rate of return at a given level of risk.

B) include only the stocks that have the lowest volatility at a given expected rate of return.

C) include all ten stocks in the portfolio in equal amounts.

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The most efficient portfolio will be the one that lies on the efficient frontier. It will offer the highest expected return at a given level of risk compared to all other possible portfolios.

andytrader

Which of the following statements best describes an investment that is not on the efficient frontier?

A) There is a portfolio that has a lower risk for the same return.

B) There is a portfolio that has a lower return for the same risk.

C) The portfolio has a very high return.

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The efficient frontier outlines the set of portfolios that gives investors the highest return for a given level of risk or the lowest risk for a given level of return. Therefore, if a portfolio is not on the efficient frontier, there must be a portfolio that has lower risk for the same return. Equivalently, there must be a portfolio that produces a higher return for the same risk.