Chapter 5 - Modern Portfolio Theory and Capital Asset Pricing Model
Unit 12: Fundamentals of Economics, Microeconomics, Macroeconomics and types of Economics
Chapter 5 - Modern Portfolio Theory and Capital Asset Pricing Model
1. What is the primary objective of Modern Portfolio Theory (MPT)?
A. Maximizing total returns regardless of risk
B. Selecting assets with the highest individual returns
C. Optimizing portfolio risk and return through diversification
D. Eliminating market risk completely
Modern Portfolio Theory (MPT) focuses on optimizing the risk-return tradeoff by diversifying investments to minimize risk while achieving a desired return.
2. According to Markowitz's portfolio theory, which of the following is an assumption?
A. Investors are irrational and seek high risk
B. Investors are rational and risk-averse
C. Investors prefer individual stock selection over diversification
D. Investors seek to maximize volatility in portfolios
Markowitz's portfolio theory assumes that investors are rational and risk-averse, meaning they aim to maximize utility while minimizing risk.
3. What does a correlation coefficient (ρ) of -1 between two assets imply?
A. No diversification benefit
B. Portfolio variance equals the weighted average of individual variances
C. The assets are perfectly correlated
D. A risk-free portfolio can be created
A correlation coefficient of -1 implies perfect negative correlation, allowing the construction of a risk-free portfolio by combining the two assets.
4. What is the impact of holding a well-diversified portfolio?
A. It eliminates all types of risk
B. It increases exposure to company-specific risk
C. It reduces idiosyncratic risk and leaves only market risk
D. It ensures a fixed return regardless of market conditions
A well-diversified portfolio reduces company-specific (idiosyncratic) risk and primarily exposes the investor to market risk.
5. Which assumption of Modern Portfolio Theory is unrealistic in real-world markets?
A. Investors seek to maximize utility
B. Investors are rational and risk-averse
C. Portfolio variance depends on asset correlation
D. Capital markets are perfect
The assumption that capital markets are perfect is unrealistic because real-world markets involve transaction costs, taxes, and imperfect information.
6. According to Modern Portfolio Theory, what happens when assets in a portfolio have a correlation coefficient of +1?
A. No diversification benefit
B. Portfolio risk is minimized
C. Portfolio variance is zero
D. Portfolio returns are unpredictable
When the correlation coefficient between assets is +1, there is no diversification benefit, and the portfolio variance becomes a weighted average of individual variances.
7. What is the primary reason for diversification in a portfolio?
A. To increase overall portfolio volatility
B. To maximize total returns at any risk level
C. To eliminate all types of risk
D. To reduce idiosyncratic risk
Diversification reduces idiosyncratic (company-specific) risk by spreading investments across multiple assets, thereby minimizing exposure to individual asset risks.
8. In Modern Portfolio Theory, why do rational investors prefer diversification?
A. To maximize returns regardless of risk
B. To eliminate market risk completely
C. To achieve the highest possible return for a given level of risk
D. To invest only in risk-free assets
Rational investors diversify to maximize expected returns for a given level of risk, reducing unnecessary exposure to individual asset risks.
9. According to Markowitz, what is the best way to minimize portfolio risk?
A. Investing in the asset with the lowest variance
B. Holding a portfolio of assets with low or negative correlations
C. Choosing stocks with the highest expected return
D. Investing in only risk-free assets
Portfolio risk is minimized by selecting assets with low or negative correlations, reducing overall volatility through diversification.
10. What does the Efficient Frontier represent in Modern Portfolio Theory?
A. The set of portfolios with the lowest possible return
B. Portfolios with no diversification
C. The combination of portfolios with equal risk
D. The set of optimal portfolios offering the highest return for a given risk level
The Efficient Frontier represents the set of optimal portfolios that provide the highest expected return for a given level of risk.
11. Why do investors not expect compensation for idiosyncratic risk?
A. Because it is unpredictable
B. Because markets are always efficient
C. Because it can be diversified away at low or no cost
D. Because it is less important than total risk
Since idiosyncratic risk can be diversified away at little or no cost, investors do not require additional compensation for bearing this risk.
12. What is the main difference between idiosyncratic risk and market risk?
A. Idiosyncratic risk affects the entire market, while market risk affects only individual companies
B. Idiosyncratic risk is company-specific, while market risk affects all assets in the economy
C. Market risk is easily eliminated through diversification
D. Idiosyncratic risk is higher in diversified portfolios
Idiosyncratic risk is company-specific and can be reduced through diversification, while market risk affects the entire economy and cannot be diversified away.
13. What does the Efficient Frontier represent in Modern Portfolio Theory?
A. The set of all possible portfolios
B. Portfolios that minimize total risk
C. Portfolios that achieve the highest possible risk
D. The set of optimal portfolios offering the highest return for a given risk level
The Efficient Frontier is the set of portfolios that provide the highest return for a given level of risk. Any portfolio below it is inefficient, while those above are unattainable.
14. What is the significance of Point C on the Efficient Frontier?
A. It represents the highest return portfolio
B. It is the global minimum variance portfolio
C. It is an unattainable portfolio
D. It lies above the Efficient Frontier
Point C is the global minimum variance portfolio, meaning it has the least total risk among all efficient portfolios.
15. Why are portfolios below the Efficient Frontier considered inefficient?
A. They are unattainable in real-world markets
B. They have zero risk but also zero return
C. There is always another portfolio on the Efficient Frontier with a higher return for the same risk
D. They contain only risk-free assets
Portfolios below the Efficient Frontier are inefficient because they offer lower returns for the same risk compared to portfolios directly above them on the frontier.
16. What happens to portfolios above the Efficient Frontier?
A. They are unattainable
B. They represent the riskiest portfolios possible
C. They offer lower returns than the Efficient Frontier
D. They are portfolios with the lowest standard deviation
Portfolios above the Efficient Frontier are theoretically unattainable because they would provide higher returns for a given level of risk than is possible in real markets.
17. In the absence of a risk-free asset, what can be said about portfolios on the Efficient Frontier?
A. All investors should always choose Portfolio G
B. They provide the lowest risk possible
C. They contain only bonds and low-risk assets
D. They are the only efficient portfolios available
When a risk-free asset is not available, the only efficient portfolios are those that lie on the Efficient Frontier, as they maximize returns for each level of risk.
18. What determines an investor’s choice of portfolio on the Efficient Frontier?
A. The availability of risk-free assets
B. Their risk tolerance
C. The number of stocks in the market
D. Market fluctuations
An investor’s position on the Efficient Frontier depends on their risk tolerance. Risk-averse investors prefer portfolios with lower risk, while risk-seekers choose higher-risk portfolios.
19. What is the Capital Market Line (CML)?
A. A line connecting all possible efficient portfolios
B. A curve that represents the risk-return trade-off
C. A line representing the risk-free asset
D. A tangent line to the Efficient Frontier that includes the risk-free asset
The CML is a straight line that starts from the risk-free rate and is tangent to the Efficient Frontier, representing the highest Sharpe ratio portfolios.
20. What does the y-intercept of the Capital Market Line (CML) represent?
A. The risk-free rate
B. The return of the market portfolio
C. The highest expected return
D. The variance of the market portfolio
The CML starts from the risk-free rate, which is its y-intercept. This rate represents the return from a zero-risk investment such as a Treasury bill.
21. What is the significance of the tangency point where the CML touches the Efficient Frontier?
A. It represents the risk-free asset
B. It is the market portfolio
C. It is an inefficient portfolio
D. It has zero standard deviation
The tangency point represents the market portfolio, which is the optimal risky portfolio that all investors combine with the risk-free asset.
22. According to the CML, what happens when an investor moves to the right of the market portfolio?
A. The investor reduces risk exposure
B. The investor is investing in inefficient portfolios
C. The investor is using leverage (borrowing at the risk-free rate)
D. The investor is holding only the risk-free asset
Investors to the right of the market portfolio are borrowing at the risk-free rate to invest more in the market portfolio, effectively increasing risk and potential return.
23. What does the slope of the Capital Market Line (CML) represent?
A. The variance of the market portfolio
B. The market return minus the risk-free rate
C. The portfolio standard deviation
D. The Sharpe ratio
The slope of the CML is equal to the Sharpe ratio, which measures excess return per unit of risk.
24. What assumption is made about investors when deriving the Capital Market Line (CML)?
A. All investors have homogeneous expectations
B. All investors prefer higher risk
C. Investors only hold risk-free assets
D. Investors always borrow at the risk-free rate
The CML assumes that all investors have homogeneous expectations, meaning they have the same views on expected returns, risk, and correlations.
25. What happens to an investor's portfolio when they lend at the risk-free rate?
A. The portfolio becomes riskier
B. The portfolio moves left along the CML
C. The portfolio moves above the CML
D. The portfolio achieves maximum risk-adjusted return
Lending at the risk-free rate means investing a portion of capital in a risk-free asset, which moves the portfolio left along the CML, reducing risk.
26. What is the correct formula for the Capital Market Line (CML)?
The CML equation is derived from the Sharpe ratio and shows the relationship between expected return and portfolio risk.
27. In the CML equation, what does \( \sigma_P \) represent?
A. Standard deviation of the portfolio
B. Expected return of the market
C. Risk-free rate
D. Sharpe ratio
\( \sigma_P \) represents the total risk (standard deviation) of the portfolio, which determines the expected return along the CML.
28. If the risk-free rate is 3%, the expected market return is 10%, and the market standard deviation is 15%, what is the expected return of a portfolio with a standard deviation of 10%?
29. In a CML graph, what is represented on the x-axis?
A. Expected return
B. Beta
C. Portfolio risk (standard deviation)
D. Covariance of assets
The x-axis of the CML graph represents total risk (standard deviation) rather than beta, which is used in the Security Market Line (SML).
30. In a CML graph, what does the point where the line meets the Efficient Frontier represent?
A. The risk-free asset
B. The maximum Sharpe ratio
C. The minimum variance portfolio
D. The market portfolio
The market portfolio is the tangency point between the CML and the Efficient Frontier, representing the highest Sharpe ratio portfolio.
31. What happens when an investor's portfolio is on the left side of the market portfolio on the CML?
A. The investor is lending at the risk-free rate
B. The investor is borrowing money
C. The investor's portfolio has infinite risk
D. The investor is holding inefficient portfolios
Portfolios to the left of the market portfolio involve lending at the risk-free rate, reducing risk by holding some Treasury bills.
32. How does the Capital Market Line (CML) differ from the Security Market Line (SML)?
A. The CML uses beta, while the SML uses standard deviation
B. The CML measures total risk, while the SML measures systematic risk
C. The SML is tangent to the Efficient Frontier
D. The CML represents inefficient portfolios
The CML measures total risk (standard deviation), while the SML focuses only on systematic risk (beta) in the Capital Asset Pricing Model (CAPM).
33. Which of the following is NOT an assumption of the Capital Asset Pricing Model (CAPM)?
A. Investors can borrow and lend at the risk-free rate.
B. Investors have homogenous expectations.
C. There are no taxes or transaction costs.
D. Investors consider skewness and kurtosis in their decision-making.
The CAPM assumes investors only consider expected return and variance, ignoring skewness and kurtosis.
34. In the CAPM, investors are assumed to hold which of the following portfolios?
A. A portfolio consisting only of risk-free assets.
B. A combination of the risk-free asset and the market portfolio.
C. A portfolio chosen based on individual preferences.
D. A portfolio based on fundamental analysis.
According to CAPM, all investors hold a combination of the market portfolio and the risk-free asset.
35. What does the CAPM assume about market competition?
A. Large investors can influence market prices.
B. Some investors have superior information.
C. Individual investors are price takers.
D. Market prices are determined solely by fundamental analysis.
In CAPM, markets are perfectly competitive, meaning no single investor can influence prices.
36. What is the formula for the Capital Asset Pricing Model (CAPM)?
A. \( E(R_i) = R_f + \beta_i (E(R_M) - R_f) \)
B. \( E(R_i) = R_f + \sigma_i (E(R_M) - R_f) \)
C. \( E(R_i) = R_f + \rho (E(R_M) - R_f) \)
D. \( E(R_i) = R_f + \alpha_i (E(R_M) - R_f) \)
The CAPM formula calculates the expected return using the risk-free rate, beta, and market risk premium.
37. If the risk-free rate is 4%, the expected market return is 12%, and a stock has a beta of 1.5, what is the expected return of the stock using CAPM?
38. What does the Security Market Line (SML) represent in the CAPM?
A. The risk-return relationship for a diversified portfolio.
B. The relationship between total risk and expected return.
C. The relationship between systematic risk (beta) and expected return.
D. The risk-return tradeoff for an individual asset.
The SML shows the expected return for assets based on their beta, which measures systematic risk.
39. On the Security Market Line (SML), what does a stock with a beta greater than 1 indicate?
A. The stock has lower risk than the market.
B. The stock has higher systematic risk than the market.
C. The stock’s returns are negatively correlated with the market.
D. The stock has no relationship with market movements.
A beta greater than 1 means the stock is more volatile than the market and will have higher expected returns.
40. What does the beta of an asset measure?
A. The total risk of an asset
B. The unsystematic risk of an asset
C. The sensitivity of an asset’s return to the market return
D. The expected return of an asset
Beta measures the systematic risk of an asset, which represents its sensitivity to market movements.
41. How is the beta of an asset calculated?
A. Variance of the asset’s return divided by variance of market return
B. Standard deviation of the asset’s return divided by standard deviation of market return
C. Correlation of the asset’s return with market return
D. Covariance of asset return with market return divided by variance of market return
Beta is computed as the covariance of the asset’s return with the market return divided by the variance of the market return.
42. What is the beta of an asset if its standard deviation is 30%, the market standard deviation is 20%, and the correlation with the market is 0.8?
A. 0.8
B. 1.2
C. 1.5
D. 2.0
Beta is calculated as β = (Correlation × Standard deviation of asset) / Standard deviation of market = (0.8 × 0.30) / 0.20 = 1.2.
43. What is the beta of an asset if its covariance with the market is 0.048 and the market variance is 0.04?
A. 0.8
B. 1.0
C. 1.2
D. 1.5
Beta is calculated as β = (Covariance of asset and market) / (Variance of market) = 0.048 / 0.04 = 1.2.
44. What is the beta of the overall market portfolio?
A. 1
B. 0
C. -1
D. Varies over time
By definition, the beta of the overall market portfolio is always equal to 1.
45. Which type of stock is likely to have a beta greater than 1?
A. Defensive stock
B. Utility stock
C. Cyclical stock
D. Dividend-paying stock
Cyclical stocks (e.g., luxury goods companies) tend to have a beta greater than 1 because they are more sensitive to market movements.
46. How is beta estimated in practice?
A. By calculating the average returns of an asset and the market
B. By calculating the Sharpe ratio of the asset
C. By using historical standard deviations
D. By regressing the asset’s returns against market returns
Beta is estimated through a regression analysis where asset returns are the dependent variable, and market returns are the independent variable.
47. What is the primary determinant of expected return in the CAPM model?
A. Standard deviation of returns
B. Total risk of the asset
C. Beta (systematic risk)
D. Firm-specific risk
The CAPM model states that expected return only depends on beta (systematic risk), as company-specific risk can be diversified away.
48. What is the intercept of the Security Market Line (SML) in the CAPM framework?
A. Expected market return
B. Risk-free rate (RF)
C. Market risk premium
D. Beta of the market
The Security Market Line (SML) has an intercept at the risk-free rate (RF), which represents the return of an asset with zero systematic risk.
49. What is the slope of the Security Market Line (SML) in CAPM?
A. Beta of the market
B. Standard deviation of the market
C. Covariance of market returns
D. Market risk premium (RM - RF)
The slope of the Security Market Line (SML) represents the Market Risk Premium (MRP), which is calculated as (RM - RF).
50. What does the term (E(RM) − RF) in the CAPM formula represent?
A. Market risk premium
B. Systematic risk
C. Unsystematic risk
D. Equity risk premium
The term (E(RM) − RF) represents the Market Risk Premium (MRP), which measures the excess return investors expect from the market over the risk-free rate.
51. What does the beta (β) of an asset measure in the CAPM framework?
A. Total risk of the asset
B. Systematic risk relative to the market
C. Firm-specific risk
D. Standard deviation of returns
Beta (β) measures an asset’s systematic risk in relation to the market. It quantifies how much an asset's returns move in response to market movements.
52. According to CAPM, where does a mispriced security lie in relation to the Security Market Line (SML)?
A. Always on the SML
B. Only above the SML
C. Either above or below the SML
D. None of the above
A mispriced security does not lie on the SML. If it is overvalued, it lies below the SML; if it is undervalued, it lies above the SML.
53. What does it mean when a security plots below the SML?
A. The security is overvalued
B. The security is undervalued
C. The security is fairly priced
D. The security has zero risk
A security below the SML has an expected return lower than its required return, meaning it is overvalued.
54. If a security's expected return (as per an analyst) is higher than the required return (as per CAPM), what does this indicate?
A. The security is overvalued
B. The security is undervalued
C. The security is fairly valued
D. The security has no systematic risk
If the expected return is greater than the required return, the security is undervalued and should plot above the SML.
55. Why is it important for portfolio managers to analyze risk-adjusted rates of return?
A. To maximize absolute returns
B. To ignore risk and focus on returns
C. To evaluate true performance considering the risk taken
D. To reduce portfolio volatility to zero
Portfolio managers must assess risk-adjusted returns to determine how efficiently returns are generated given the level of risk taken.
56. Which of the following is NOT a traditional performance measure used for risk-adjusted return evaluation?
A. Sharpe performance index
B. Treynor performance index
C. Jensen’s performance index
D. Beta coefficient
The Beta coefficient measures systematic risk but is not a performance measure. Sharpe, Treynor, and Jensen’s indexes are used to evaluate risk-adjusted performance.
57. How do the Sharpe and Treynor performance indices primarily differ?
A. Sharpe uses total risk, while Treynor uses systematic risk
B. Treynor considers standard deviation, while Sharpe considers beta
C. Sharpe is only used for individual assets, while Treynor is for portfolios
D. Treynor index is always greater than the Sharpe index
The Sharpe ratio accounts for total risk (standard deviation), while the Treynor index considers only systematic risk (beta).
58. What is a key characteristic of Jensen’s Performance Index?
A. It compares returns to the standard deviation
B. It measures excess return over the expected return from CAPM
C. It is only used for evaluating individual stocks
D. It is identical to the Sharpe ratio
Jensen’s Performance Index, or Jensen’s Alpha, measures the excess return a portfolio earns above the expected return predicted by the CAPM.
59. If two portfolios have the same average return, which performance measure helps determine which one took less risk?
A. Absolute return
B. Market return
C. Portfolio beta
D. Sharpe ratio
The Sharpe ratio helps determine which portfolio achieved its return with less risk, as it adjusts returns for volatility.
60. What does the Sharpe Performance Index measure?
A. Portfolio return per unit of beta
B. Portfolio return per unit of alpha
C. Excess return per unit of total risk
D. Excess return per unit of systematic risk
The Sharpe Performance Index measures the excess return of a portfolio over the risk-free rate per unit of total risk (measured by standard deviation).
61. Which of the following is the correct formula for the Sharpe Performance Index?
A. \( \frac{E(R_P) - R_F}{\sigma_P} \)
B. \( \frac{E(R_P) - R_F}{\beta_P} \)
C. \( \frac{E(R_P) - \sigma_P}{R_F} \)
D. \( \frac{R_F - E(R_P)}{\sigma_P} \)
The correct formula for the Sharpe Performance Index (SPI) is:
\( \frac{E(R_P) - R_F}{\sigma_P} \)
where \( E(R_P) \) is the expected portfolio return, \( R_F \) is the risk-free rate, and \( \sigma_P \) is the standard deviation of portfolio returns.
62. What does a higher Sharpe ratio indicate?
A. Higher total risk in the portfolio
B. Higher unsystematic risk
C. Lower excess return per unit risk
D. Better risk-adjusted returns
A higher Sharpe ratio indicates that the portfolio provides a better return for the same amount of risk, implying superior risk-adjusted performance.
63. What does it mean if a portfolio’s Sharpe ratio is lower than the market’s Sharpe ratio?
A. The portfolio has lower total risk than the market
B. The portfolio has higher beta than the market
C. The portfolio has lower risk-adjusted returns than the market
D. The portfolio has outperformed the market
A portfolio with a Sharpe ratio lower than the market’s indicates that it has lower risk-adjusted returns compared to the market.
64. The slope of which financial model represents the Sharpe ratio of the market?
A. Security Market Line (SML)
B. Capital Market Line (CML)
C. Arbitrage Pricing Theory (APT) Line
D. Risk-Return Tradeoff Curve
The Sharpe ratio of the market is represented by the slope of the **Capital Market Line (CML)**, which shows the risk-return tradeoff for efficient portfolios.
65. Why is the Sharpe ratio considered more widely applicable compared to other performance measures?
A. It considers total risk rather than only systematic risk
B. It ignores the risk-free rate
C. It is not dependent on portfolio diversification
D. It is only useful for comparing portfolios with the same beta
The Sharpe ratio is widely used because it accounts for **total risk** (standard deviation) rather than just systematic risk (beta), making it applicable to all portfolios.
66. What is the key difference between the Treynor Performance Index and the Sharpe Ratio?
A. Treynor Index uses standard deviation, while Sharpe Ratio uses beta
B. Both use standard deviation in the denominator
C. Treynor Index uses beta, while Sharpe Ratio uses standard deviation
D. Treynor Index uses total risk, while Sharpe Ratio uses systematic risk
The Treynor Performance Index measures return relative to systematic risk (beta), whereas the Sharpe Ratio measures return relative to total risk (standard deviation).
67. For which type of portfolios is the Treynor measure most relevant?
A. Well-diversified portfolios
B. Poorly diversified portfolios
C. Portfolios with high idiosyncratic risk
D. Portfolios with low systematic risk
The Treynor measure is more relevant for well-diversified portfolios because it evaluates performance based on systematic risk (beta), which is the only risk remaining after diversification.
68. How is the Treynor Performance Index (TPI) calculated?
A. (E(RP) - RF) / σP
B. (E(RP) - RF) / MRP
C. (E(RP) - RF) / αP
D. (E(RP) - RF) / βP
The Treynor Performance Index is calculated as (Expected Portfolio Return - Risk-Free Rate) divided by Portfolio Beta, indicating return per unit of systematic risk.
69. What does the slope of the Security Market Line (SML) represent?
A. The Sharpe Ratio
B. The Market Risk Premium (MRP)
C. The Alpha of a portfolio
D. The Risk-Free Rate
The slope of the Security Market Line (SML) represents the Market Risk Premium (MRP), which is the excess return investors expect for taking on market risk.
70. If a portfolio has a higher Treynor Index compared to the market, what does it indicate?
A. The portfolio has generated higher returns per unit of systematic risk than the market
B. The portfolio has higher total risk than the market
C. The portfolio has a higher standard deviation than the market
D. The portfolio has lower returns than the market
A higher Treynor Index indicates that the portfolio is providing a greater return per unit of systematic risk (beta) compared to the market.
71. What does Jensen’s Performance Index (JPI) primarily measure?
A. The total risk-adjusted return of a portfolio
B. The unsystematic risk of a portfolio
C. The excess return of a portfolio over the CAPM required return
D. The deviation of a portfolio from the Treynor measure
Jensen’s Performance Index (JPI) measures the difference between the expected return of a portfolio and its CAPM required return, known as Jensen’s alpha.
72. What risk metric does Jensen’s Performance Index use?
A. Standard deviation
B. Beta
C. Sharpe ratio
D. Value at Risk (VaR)
Jensen’s Performance Index assumes investors are well-diversified and, therefore, uses beta as the relevant risk metric instead of standard deviation.
73. When is Jensen’s alpha equal to zero?
A. When the portfolio is overvalued
B. When the Treynor ratio is negative
C. When the portfolio is mispriced
D. When the portfolio expected return equals the CAPM required return
In equilibrium, the portfolio expected return must equal the CAPM required return, leading to zero alpha.
74. If a portfolio has a positive Jensen’s alpha, what does it indicate?
A. The portfolio is undervalued
B. The portfolio is overvalued
C. The portfolio has high unsystematic risk
D. The CAPM model is incorrect
A positive Jensen’s alpha implies that the portfolio is undervalued and offers a return higher than what is predicted by CAPM.
75. How are Jensen’s alpha and the Treynor measure related?
A. They always provide the same ranking of portfolios
B. They use standard deviation as the risk measure
C. A superior Treynor measure implies a superior Jensen’s alpha
D. They measure different aspects of risk-adjusted return
A superior performance implied by the Treynor measure automatically implies a superior performance according to Jensen’s alpha, although their relative rankings may differ.
76. What does tracking error measure in portfolio performance?
A. The correlation between portfolio returns and benchmark returns
B. The absolute difference between portfolio return and benchmark return
C. The standard deviation of the difference between portfolio return and benchmark return
D. The portfolio return in excess of the benchmark return
Tracking error is defined as the standard deviation of the difference between the portfolio return and the benchmark return, representing the variability in excess return.
77. What does the denominator of the Information Ratio represent?
A. Expected portfolio return
B. Benchmark return
C. Active return
D. Tracking error
The denominator of the Information Ratio is tracking error, which measures the variability of the excess return of a portfolio over its benchmark.
78. Which of the following best describes the Information Ratio?
A. The portfolio return divided by the benchmark return
B. The portfolio return in excess of the benchmark return divided by tracking error
C. The Sharpe ratio adjusted for active management
D. The difference between portfolio and benchmark returns
The Information Ratio is calculated as the portfolio return in excess of the benchmark return divided by tracking error, which measures risk-adjusted active management performance.
79. What is the key difference between the Sharpe Ratio and the Sortino Ratio?
A. The Sortino Ratio uses the risk-free rate instead of a minimum acceptable return
B. The Sharpe Ratio considers only downside risk, while the Sortino Ratio considers all risk
C. The Sortino Ratio uses a minimum acceptable return and downside deviation instead of standard deviation
D. The Sortino Ratio measures correlation instead of volatility
Unlike the Sharpe Ratio, which uses the total standard deviation of returns, the Sortino Ratio replaces the risk-free rate with a minimum acceptable return and considers only downside deviation, focusing on downside risk.
80. What is downside deviation in the Sortino Ratio?
A. The standard deviation of all portfolio returns
B. The absolute difference between portfolio return and risk-free rate
C. The standard deviation of all negative portfolio returns
D. The standard deviation of returns that fall below the minimum acceptable return
Downside deviation is the standard deviation of only those returns that fall below the minimum acceptable return (RMIN), excluding returns above this threshold.
81. What is the primary use of tracking error in portfolio management?
A. To measure the correlation between a portfolio and its benchmark
B. To assess the consistency of excess returns over a benchmark
C. To evaluate the absolute performance of a portfolio
D. To determine the expected return of a portfolio
Tracking error measures how consistently a portfolio's returns differ from its benchmark, indicating the level of active management.
82. A high tracking error suggests that a portfolio is:
A. Closely following its benchmark
B. Generating negative returns
C. Deviating significantly from its benchmark
D. More diversified than its benchmark
A high tracking error indicates that a portfolio's returns fluctuate significantly compared to its benchmark, suggesting an active management approach.
83. The Information Ratio is most useful for:
A. Measuring the risk-adjusted return relative to the risk-free rate
B. Calculating the expected return of a portfolio
C. Measuring total portfolio volatility
D. Evaluating the consistency of a manager’s excess return over a benchmark
The Information Ratio helps assess how consistently a portfolio outperforms its benchmark on a risk-adjusted basis, making it useful for evaluating fund managers.
84. A portfolio with an Information Ratio of 0 indicates that:
A. The portfolio is highly volatile
B. The portfolio’s excess return over the benchmark is zero
C. The portfolio has no active risk
D. The portfolio has a negative Sharpe ratio
An Information Ratio of 0 implies that the portfolio is not generating any excess return over the benchmark, meaning it performs similarly to the benchmark.
85. The Sortino Ratio differs from the Sharpe Ratio by:
A. Using total risk instead of downside risk
B. Ignoring benchmark performance
C. Focusing only on downside deviation
D. Considering only standard deviation
The Sortino Ratio measures risk-adjusted returns but focuses only on downside deviation, ignoring positive volatility, unlike the Sharpe Ratio, which considers total volatility.
86. If a portfolio has a high Sortino Ratio, it means:
A. The portfolio has high returns with low downside risk
B. The portfolio is highly volatile
C. The portfolio is underperforming its benchmark
D. The portfolio ignores risk
A high Sortino Ratio indicates strong returns with minimal downside risk, making it favorable for investors seeking downside protection.
87. Which of the following best defines downside deviation?
A. The standard deviation of all portfolio returns
B. The variance of returns exceeding a benchmark
C. The standard deviation of returns above the minimum acceptable return
D. The standard deviation of returns below the minimum acceptable return
Downside deviation calculates the standard deviation of returns that fall below the minimum acceptable return, helping to measure downside risk.
88. If a portfolio has a negative Information Ratio, it means:
A. The portfolio has low tracking error
B. The portfolio is outperforming the benchmark
C. The portfolio has a negative excess return compared to the benchmark
D. The portfolio has zero active risk
A negative Information Ratio indicates that the portfolio is underperforming its benchmark, as the excess return is negative.
89. According to modern portfolio theory, rational investors seek to maximize which of the following?
A. Absolute return
B. Total risk
C. Return per unit of risk
D. Company-specific risk
Rational investors aim to maximize return per unit of risk, meaning they prefer portfolios on the efficient frontier while diversifying to eliminate idiosyncratic risk.
90. What happens to company-specific risk as a portfolio becomes sufficiently diversified?
A. It remains constant
B. It is eliminated
C. It increases
D. It becomes equal to market risk
A well-diversified portfolio eliminates company-specific (idiosyncratic) risk, leaving only market risk.
91. In the Capital Asset Pricing Model (CAPM), which factor determines an asset’s expected return?
A. Beta
B. Standard deviation
C. Company-specific risk
D. Total portfolio variance
According to CAPM, expected return only depends on beta, as company-specific risk can be diversified away.
92. What is the equation for the Capital Asset Pricing Model (CAPM)?
A. E(Ri) = RF + βi
B. E(Ri) = RF + σi
C. E(Ri) = RM + RFβi
D. E(Ri) = RF + [E(RM) − RF]βi
The CAPM formula is E(Ri) = RF + [E(RM) − RF]βi, where beta represents an asset’s sensitivity to market movements.
93. Which of the following is an assumption of the Capital Asset Pricing Model (CAPM)?
A. There are taxes and commissions
B. Investors have different expectations of returns
C. Information is freely available
D. Market participants cannot borrow at the risk-free rate
CAPM assumes that information is freely available, there are no transaction costs, and investors have homogeneous expectations.
94. What is the slope of the Capital Market Line (CML)?
A. Beta
B. Sharpe performance index
C. Standard deviation of returns
D. Jensen’s alpha
The slope of the Capital Market Line (CML) represents the Sharpe performance index, measuring return per unit of risk.
95. How is beta estimated for an asset?
A. By dividing expected return by market return
B. By measuring total standard deviation of the asset
C. By computing the average return over time
D. By running a regression of stock returns against market returns
Beta is calculated as the slope in a regression of an asset’s returns against market returns, reflecting its sensitivity to market movements.
