Question #1 of 150 Question ID: 1646119

An investor has a two-stock portfolio (Stocks A and B) with the following characteristics:

σA = 55%
σB = 85%
CovarianceA,B = 0.09
WA = 70%
WB = 30%

The variance of the portfolio is closest to:

A) 0.54.
B) 0.25.
C) 0.39.

Explanation

The formula for the variance of a 2-stock portfolio is:

s2 = [WA2σA2 + WB2σB2 + 2WAWBσAσBrA,B]

Since σAσBrA,B = CovA,B, then

s2 = [(0.72 × 0.552) + (0.32 × 0.852) + (2 × 0.7 × 0.3 × 0.09)] = [0.1482 + 0.0650 + 0.0378] = 0.2511.

(Module 83.3, LOS 83.e)

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Question #2 of 150 Question ID: 1646156

Which of the following is the vertical axis intercept for the Capital Market Line (CML)?

A) Expected return on the market.

B) Risk-free rate.
C) Expected return on the portfolio.

Explanation

The CML originates on the vertical axis from the point of the risk-free rate.

(Module 84.1, LOS 84.b)

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Question #3 of 150 Question ID: 1646182

In the market model, beta measures the sensitivity of an asset's rate of return to the market's:

A) excess return.
B) rate of return.
C) risk-adjusted return.

Explanation
The market model is expressed as: Ri = αi + βiRm + εi. In this model, beta (βi) measures the sensitivity of the rate of return on an
asset (Ri) to the market rate of return (Rm).

(Module 84.1, LOS 84.d)

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Question #4 of 150 Question ID: 1646220

A stock that plots below the Security Market Line most likely:

A) is overvalued.
B) has a beta less than one.
C) is below the efficient frontier.

Explanation

Since the equation of the SML is the capital asset pricing model, you can determine if a stock is over- or underpriced graphically or
mathematically. Your answers will always be the same.

Graphically: If you plot a stock's expected return on the SML and it falls below the line, it indicates that the stock is currently
overpriced, causing its expected return to be too low. If the plot is above the line, it indicates that the stock is underpriced. If the
plot falls on the SML, it indicates the stock is properly priced.

Mathematically: In the context of the SML, a security is underpriced if the required return is less than the holding period (or
expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the
required return equals the holding period (or expected) return.

(Module 84.2, LOS 84.h)

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Question #5 of 150 Question ID: 1646194

If a stock's beta is equal to 1.2, its standard deviation of returns is 28%, and the standard deviation of the returns on the market
portfolio is 14%, the covariance of the stock's returns with the returns on the market portfolio is closest to:

A) 0.168.
B) 0.024.
C) 0.600.

Explanation

From the fact that betai = Covi,mkt / Varmkt, we have Covi,mkt = betai × varmkt.

Covi,mkt = 1.2 × 0.142 = 0.02352.

(Module 84.1, LOS 84.e)

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Question #6 of 150 Question ID: 1646123

A portfolio manager invests 40% of a portfolio in Asset X, which has an expected standard deviation of returns of 15%, and the
remainder in Asset Y, which has an expected standard deviation of returns of 25%. If the covariance of returns between assets X and Y
is 0.0158, the expected standard deviation of portfolio returns is closest to:

A) 2.7%.
B) 18.4%.
C) 16.3%.

Explanation

The expected standard deviation of portfolio returns is:

[0.402 × 0.152 + 0.602 × 0.252 + 2(0.40 × 0.60 × 0.0158)]1/2 = 18.35%.

(Module 83.3, LOS 83.e)

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Question #7 of 150 Question ID: 1574625

Value-at-Risk (VaR) and Conditional VaR are best described as measures of:

A) liquidity risk.
B) model risk.
C) tail risk.

Explanation

VaR and Conditional VaR are measures of tail risk, the probability of or magnitude of extreme negative outcomes in the tail of a
distribution.

(Module 88.1, LOS 88.g)

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Question #8 of 150 Question ID: 1646173

Which of the following statements about risk is NOT correct?

A) The market portfolio has only systematic risk.

B) Total risk = systematic risk - unsystematic risk.
C) Unsystematic risk is diversifiable risk.

Explanation

Total risk = systematic risk + unsystematic risk

(Module 84.1, LOS 84.c)

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Question #9 of 150 Question ID: 1574572

Which of the following statements about the importance of risk and return in the investment objective is least accurate?

A) The return objective may be stated in dollar amounts even if the risk objective is stated in percentages.
B) Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return.
C) The investor’s risk tolerance is likely to determine what level of return will be feasible.

Explanation
Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment
objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is
feasible.

(Module 86.1, LOS 86.c)

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Question #10 of 150 Question ID: 1646197

Which of the following is an assumption of capital market theory? All investors:

A) have multiple-period time horizons.

B) see the same risk/return distribution for a given stock.
C) select portfolios that lie above the efficient frontier to optimize the risk-return relationship.

Explanation

All investors select portfolios that lie along the efficient frontier, based on their utility functions. All investors have the same one-
period time horizon, and have the same risk/return expectations.

(Module 84.2, LOS 84.f)

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Question #11 of 150 Question ID: 1646136

The efficient frontier is best described as the set of attainable portfolios that gives investors:

A) the highest expected return for any given level of risk.

B) the lowest risk for any given level of risk tolerance.
C) the highest diversification ratio for any given level of expected return.

Explanation

The efficient frontier is the set of efficient portfolios that gives investors the highest expected return for any given level of risk, or
the lowest risk for any given level of expected return. Efficient portfolios have low diversification ratios.

(Module 83.4, LOS 83.g)

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Question #12 of 150 Question ID: 1646201

One of the assumptions underlying the capital asset pricing model is that:

A) only whole shares or whole bonds are available.

B) each investor has a unique time horizon.
C) there are no transactions costs or taxes.

Explanation

The CAPM assumes frictionless markets, i.e., no taxes or transactions costs. Among the other assumptions of the CAPM are that all
investors have the same one-period time horizon and that all investments are infinitely divisible.

(Module 84.2, LOS 84.f)

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Question #13 of 150 Question ID: 1646112

If the standard deviation of stock X is 7.2%, the standard deviation of stock Y is 5.4%, and the covariance between the two is –0.0031,
their correlation coefficient is closest to:

A) -0.64.
B) -0.19.
C) -0.80.

Explanation

Correlation = (covariance of X and Y) / [(standard deviation of X)(standard deviation of Y)]

= –0.0031 / [(0.072)(0.054)] = –0.797.

(Module 83.3, LOS 83.d)

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Question #14 of 150 Question ID: 1646126

A portfolio manager adds a new stock that has the same standard deviation of returns as the existing portfolio but has a correlation
coefficient with the existing portfolio that is less than +1. Adding this stock will have what effect on the standard deviation of the
revised portfolio's returns? The standard deviation will:

A) decrease only if the correlation is negative.

B) decrease.
C) increase.

Explanation

If the correlation coefficient is less than 1, there are benefits to diversification. Thus, adding the stock will reduce the portfolio's
standard deviation.

(Module 83.4, LOS 83.f)

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Question #15 of 150 Question ID: 1574542

The portfolio approach to investing is best described as evaluating each potential investment based on its:

A) fundamentals such as the financial performance of the security issuer.

B) potential to generate excess return for the investor.
C) contribution to the investor’s overall risk and return.

Explanation

The portfolio approach to investing refers to evaluating individual investments based on their contribution to the overall risk and
return of the investor's portfolio. Evaluating potential investments on a standalone basis, such as by analyzing their fundamentals or
their potential to generate excess return, does not describe the portfolio approach to investing.

(Module 85.1, LOS 85.a)

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Question #16 of 150 Question ID: 1574563

A mutual fund that invests in short-term debt securities and maintains a net asset value of $1.00 per share is best described as a:

A) balanced fund.
B) bond mutual fund.
C) money market fund.

Explanation

Money market funds invest primarily in short-term debt securities and are managed to maintain a constant net asset value, typically
one unit of currency per share. A bond mutual fund typically invests in longer-maturity securities than a money market fund. A
balanced fund invests in both debt and equity securities.

(Module 85.2, LOS 85.f)

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Question #17 of 150 Question ID: 1574592

When developing the strategic asset allocation in an IPS, the correlations of returns:

A) among asset classes should be relatively high.

B) within an asset class should be relatively high.
C) within an asset class should be relatively low.

Explanation
Asset classes are defined such that correlations of returns within an asset class are relatively high. Low correlations of returns
among asset classes increase the benefits of diversification across asset classes.

(Module 86.1, LOS 86.f)

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Question #18 of 150 Question ID: 1646171

In the context of the capital market line (CML), which of the following statements is CORRECT?

A) Firm-specific risk can be reduced through diversification.

B) Market risk can be reduced through diversification.
C) The two classes of risk are market risk and systematic risk.

Explanation

The other statements are false. Market risk cannot be reduced through diversification; market risk = systematic risk. The two classes
of risk are unsystematic risk and systematic risk.

(Module 84.1, LOS 84.c)

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Question #19 of 150 Question ID: 1646200

When the market is in equilibrium, all:

A) assets plot on the CML.

B) assets plot on the SML.
C) investors hold the market portfolio.

Explanation

When the market is in equilibrium, expected returns equal required returns. Since this means that all assets are correctly priced, all
assets plot on the SML.

By definition, all stocks and portfolios other than the market portfolio fall below the CML. (Only the market portfolio is efficient.)

(Module 84.2, LOS 84.f)

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Question #20 of 150 Question ID: 1574581

If an investor's ability to bear risk is low and willingness to bear risk is high, an investment manager should most appropriately consider
the investor's overall financial risk tolerance to be:

A) high.
B) low.
C) moderate.

Explanation
In general, an advisor should consider an investor's risk tolerance to be the lower of the investor's ability and willingness to bear
risk.

(Module 86.1, LOS 86.d)

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Question #21 of 150 Question ID: 1646121

An investor calculates the following statistics on her two-stock (A and B) portfolio.

σA = 20%
σB = 15%
rA,B = 0.32
WA = 70%
WB = 30%

The portfolio's standard deviation is closest to:

A) 0.0256.
B) 0.1832.
C) 0.1600.

Explanation
The formula for the standard deviation of a 2-stock portfolio is:

σ = [WA2σA2 + WB2σB2 + 2WAWBσAσBρA,B]1/2

σ = [(0.72 × 0.22) + (0.32 × 0.152) + ( 2 × 0.7 × 0.3 × 0.2 × 0.15 × 0.32)]1/2 = [0.0196 + 0.002025 + 0.004032]1/2 = 0.02565701/2
= 0.1602, or approximately 16.0%.

(Module 83.3, LOS 83.e)

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Question #22 of 150 Question ID: 1574597

An investment manager is most likely to be engaging in tactical asset allocation if she:

allocates 5% to cash, 20% to fixed income, and 75% to equities based on the investor’s long time horizon and high risk
A)
tolerance.
B) allocates more than the targeted 10% to emerging market bonds because the sector appears to be undervalued.
C) increases the allocation to tax-free bonds because the investor’s effective tax rate has increased.

Explanation

Tactical asset allocation is deviating from a portfolio's strategic asset allocation because an asset class or sector is perceived to be
mispriced in the short term. Establishing and updating target weights for asset classes based on the investor's objectives and
constraints is strategic asset allocation.

(Module 86.1, LOS 86.g)

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Question #23 of 150 Question ID: 1646134

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.

Explanation

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

rBridgeport, Rockaway = covBridgeport, Rockaway / [( σBridgeport) × (σRockaway) ] = 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.

(Module 83.4, LOS 83.g)

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Question #24 of 150 Question ID: 1646149

In the Markowitz framework, risk is defined as the:

A) variance of returns.
B) probability of a loss.
C) beta of an investment.

Explanation

The Markowitz framework assumes that all investors view risk as the variability of returns. The variability of returns is measured as
the variance (or equivalently standard deviation) of returns. The capital asset pricing model (CAPM) employs beta as the measure of
an investment's systematic risk.

(Module 83.4, LOS 83.g)

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Question #25 of 150 Question ID: 1574586

An individual investor specifies to her investment advisor that her portfolio must produce a minimum amount of cash each period. This
investment constraint is best classified as:

A) legal and regulatory.

B) liquidity.
C) unique circumstances.

Explanation
Liquidity constraints arise from an investor's need for spendable cash.

(Module 86.1, LOS 86.e)

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Question #26 of 150 Question ID: 1574559

MAL Investments is an asset management company that consists of three subsidiaries: one that focuses on mid-cap value stocks, one
that focuses on alternative assets, and one that focuses on long-term emerging market sovereign debt. MAL is most accurately
described as a:

A) full-service asset manager.

B) multi-boutique firm.
C) specialist asset manager.

Explanation

A multi-boutique firm is a holding company that includes a number of different specialist asset managers.

(Module 85.2, LOS 85.e)

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Question #27 of 150 Question ID: 1574553

Endowments and foundations typically have investment needs that can be characterized as:

A) long time horizon, high risk tolerance, and low liquidity needs.
B) long time horizon, low risk tolerance, and high liquidity needs.
C) short time horizon, low risk tolerance, and low liquidity needs.

Explanation

Endowments and foundations invest for the long term to provide ongoing funding for a specific purpose or charitable cause. They
typically have relatively low cash payout rates as a percentage of total assets. Their investment needs are best characterized as long
time horizons, low liquidity needs, and high risk tolerance.

(Module 85.1, LOS 85.c)

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Question #28 of 150 Question ID: 1646184

Beta is a measure of:

A) company-specific risk.
B) systematic risk.
C) total risk.

Explanation
Beta is a measure of systematic risk.

(Module 84.1, LOS 84.e)

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Question #29 of 150 Question ID: 1646169

Which of the following is the risk that disappears in the portfolio construction process?

A) Unsystematic risk.
B) Systematic risk.
C) Interest rate risk.

Explanation

Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio.

(Module 84.1, LOS 84.c)

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Question #30 of 150 Question ID: 1646207

Which of the following is least likely an assumption underlying the capital asset pricing model?

A) Investors are rational.

B) Tax rates are constant over the investment horizon.
C) All investors have the same expectations of return and risk for each security.

Explanation

Both taxes and transactions costs are assumed to be zero in deriving the CAPM.

(Module 84.2, LOS 84.f)

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Question #31 of 150 Question ID: 1574596

A firm that invests the majority of a portfolio to track a benchmark index, and uses active investment strategies for the remaining
portion, is said to be using:

A) a core-satellite approach.
B) risk budgeting.
C) strategic asset allocation.

Explanation

With a core-satellite approach, a firm invests the majority of a portfolio passively and uses active strategies for the remaining
portion. Strategic asset allocation refers to specifying the percentages of a portfolio's value to allocate to specific asset classes. Risk
budgeting refers to allocating a portfolio's overall permitted risk among strategic asset allocation, tactical asset allocation, and
security selection.

(Module 86.1, LOS 86.g)

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Question #32 of 150 Question ID: 1646133

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

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

Explanation

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.

(Module 83.4, LOS 83.f)

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Question #33 of 150 Question ID: 1646158

Portfolios on the capital market line:

A) each contain different risky assets.

B) include some positive allocation to the risk-free asset.
C) are perfectly positively correlated with each other.

Explanation

The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is
called the capital market line (CML). Since the line is straight, the math implies that the returns on any two portfolios on this line will
be perfectly, positively correlated with each other. Note: When ρa,b = 1, then the equation for risk changes to sport = WAsA + WBsB,
which is a straight line. The risky assets for each portfolio on the CML are the same, the tangency (or market) portfolio of risky
assets. The CML includes lending portfolios with positive allocations to the risk-free asset, the market portfolio with no allocation to
the risk-free asset, and borrowing portfolios with negative allocations to the risk-free asset.

(Module 84.1, LOS 84.b)

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Question #34 of 150 Question ID: 1646120

What is the variance of a two-stock portfolio if 15% is invested in stock A (variance of 0.0071) and 85% in stock B (variance of 0.0008)
and the correlation coefficient between the stocks is –0.04?

A) 0.0007.
B) 0.0020.
C) 0.0026.

Explanation

The variance of the portfolio is found by:

[W12 σ12 + W22 σ22 + 2W1W2σ1σ2r1,2], or [(0.15)2(0.0071) + (0.85)2(0.0008) + (2)(0.15)(0.85)(0.0843)(0.0283)(–0.04)] = 0.0007.

(Module 83.3, LOS 83.e)

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Question #35 of 150 Question ID: 1574587

An endowment is required by statute to pay out a minimum percentage of its asset value each period to its beneficiaries. This
investment constraint is best classified as:

A) legal and regulatory.

B) liquidity.
C) unique circumstances.

Explanation

Legal and regulatory constraints are those that apply to an investor by law.

(Module 86.1, LOS 86.e)

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Question #36 of 150 Question ID: 1646099

Which of the following statements about the efficient frontier is least accurate?

A) Investors will want to invest in the portfolio on the efficient frontier that offers the highest rate of return.
B) Portfolios falling on the efficient frontier are fully diversified.
The efficient frontier shows the relationship that exists between expected return and total risk in the absence of a risk-
C)
free asset.

Explanation

The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier.

(Module 83.2, LOS 83.c)

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Question #37 of 150 Question ID: 1646145

An investor has identified the following possible portfolios. Which portfolio cannot be on the efficient frontier?

Portfolio Expected Return Standard Deviation

V 18% 35%

W 12% 16%

X 10% 10%

Y 14% 20%

Z 13% 24%

A) Y.
B) X.
C) Z.
Explanation

Portfolio Z must be inefficient because its risk is higher than Portfolio Y and its expected return is lower than Portfolio Y.

(Module 83.4, LOS 83.g)

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Question #38 of 150 Question ID: 1646091

The basic premise of the risk-return trade-off suggests that risk-averse individuals purchasing investments with higher non-diversifiable
risk should expect to earn:

A) higher rates of return.

B) rates of return equal to the market.
C) lower rates of return.

Explanation

Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with
the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk (Eσ)
and the risk return line (capital market line [CML] and security market line [SML]) is upward sweeping.

(Module 83.2, LOS 83.c)

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Question #39 of 150 Question ID: 1646172

Which of the following is least likely considered a source of systematic risk for bonds?

A) Purchasing power risk.

B) Market risk.
C) Default risk.

Explanation

Default risk is based on company-specific or unsystematic risk.

(Module 84.1, LOS 84.c)

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Question #40 of 150 Question ID: 1574565

Which of the following pooled investment shares is least likely to trade at a price different from its NAV?

A) Closed-end mutual fund shares.

B) Open-end mutual fund shares.
C) Exchange-traded fund shares.

Explanation

Shares of open-end mutual funds trade at NAV. The others may deviate from NAV.

(Module 85.2, LOS 85.f)

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Question #41 of 150 Question ID: 1646127

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

A) greater.
B) decreased by the same level.
C) smaller.

Explanation

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.

(Module 83.4, LOS 83.f)

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Question #42 of 150 Question ID: 1646229

A stock's abnormal rate of return is defined as the:

A) rate of return during abnormal price movements.

B) actual rate of return less the expected risk-adjusted rate of return.
C) expected risk-adjusted rate of return minus the market rate of return.

Explanation

Abnormal return = Actual return – expected risk-adjusted return

(Module 84.2, LOS 84.h)

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Question #43 of 150 Question ID: 1646221

Mason Snow, CFA, is considering two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected
return of 15% and a beta of 2.0). Snow uses a risk-free of 7% and estimates that the market risk premium is 4%. Based on capital
market theory, Snow should conclude that:

A) only Cubb is underpriced.

B) neither security is underpriced.
C) only Bahre is underpriced.

Explanation

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is
overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return
equals the holding period (or expected) return.

Bahre: Expected return = 10% < CAPM Required return R = 0.07 + (1.4)(0.11-0.07) = 12.6% and is overpriced.

For Cubb: Expected return = 15% = CAPM Required return = 0.07 + (2.0)(0.11-0.07) = 15%.

(Module 84.2, LOS 84.h)

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Question #44 of 150 Question ID: 1646105

Stock 1 has a standard deviation of 10. Stock 2 also has a standard deviation of 10. If the correlation coefficient between these stocks is
–1, what is the covariance between these two stocks?

A) 0.00.
B) 1.00.
C) –100.00.

Explanation

Covariance = correlation coefficient × standard deviationStock 1 × standard deviationStock 2 = (–1.00) (10.00)(10.00) = –100.00.

(Module 83.3, LOS 83.d)

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Question #45 of 150 Question ID: 1646185

Beta is least accurately described as:

A) a measure of the sensitivity of a security’s return to the market return.

B) a standardized measure of the total risk of a security.
C) the covariance of a security’s returns with the market return, divided by the variance of market returns.

Explanation

Beta is a standardized measure of the systematic risk of a security. β = Covr,mkt / σ2mkt. Beta is multiplied by the market risk
premium in the CAPM: E(Ri) = RFR + β[E(Rmkt) – RFR].

(Module 84.1, LOS 84.e)

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Question #46 of 150 Question ID: 1646180

The market model of the expected return on a risky security is best described as a(n):

A) two-factor model.
B) arbitrage-based model.
C) single-factor model.

Explanation

The market model is a single-factor model. The single factor is the expected excess return on the market portfolio, or [E(Rm) – RFR].

(Module 84.1, LOS 84.d)

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Question #47 of 150 Question ID: 1646118

Assets A (with a variance of 0.25) and B (with a variance of 0.40) are perfectly positively correlated. If an investor creates a portfolio
using only these two assets with 40% invested in A, the portfolio standard deviation is closest to:

A) 0.3742.
B) 0.5795.
C) 0.3400.

Explanation
The portfolio standard deviation = [(0.4)2(0.25) + (0.6)2(0.4) + 2(0.4)(0.6)1(0.25)0.5(0.4)0.5]0.5 = 0.5795

(Module 83.3, LOS 83.e)

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Question #48 of 150 Question ID: 1574595

A portfolio manager who believes equity securities are overvalued in the short term reduces the weight of equities in her portfolio to
35% from its longer-term target weight of 40%. This decision is best described as an example of:

A) rebalancing.
B) strategic asset allocation.
C) tactical asset allocation.

Explanation

Tactical asset allocation refers to deviating from a portfolio's target asset allocation weights in the short term to take advantage of
perceived opportunities in specific asset classes. Strategic asset allocation is determining the target asset allocation percentages for
a portfolio. Rebalancing is periodically adjusting a portfolio back to its target asset allocation.

(Module 86.1, LOS 86.g)

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Question #49 of 150 Question ID: 1574567

Which of the following is NOT a rationale for the importance of the policy statement in investing? It:

A) identifies specific stocks the investor may wish to purchase.

B) forces investors to understand their needs and constraints.
C) helps investors understand the risks and costs of investing.

Explanation

The policy statement outlines broad objectives and constraints but does not get into the details of specific stocks for investment.

(Module 86.1, LOS 86.a)

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Question #50 of 150 Question ID: 1646196

Which of the following is NOT an assumption of capital market theory?

A) All assets are infinitely divisible.

B) The capital markets are in equilibrium.
C) Investors can lend at the risk-free rate, but borrow at a higher rate.

Explanation

Capital market theory assumes that investors can borrow or lend at the risk-free rate. The other statements are basic assumptions
of capital market theory.

(Module 84.2, LOS 84.f)

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Question #51 of 150 Question ID: 1646238

A portfolio of options had a return of 22% with a standard deviation of 20%. If the risk-free rate is 7.5%, what is the Sharpe ratio for the
portfolio?

A) 0.568.
B) 0.725.
C) 0.147.

Explanation

Sharpe ratio = (22% – 7.50%) / 20% = 0.725.

(Module 84.2, LOS 84.i)

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Question #52 of 150 Question ID: 1574579

All of the following affect an investor's risk tolerance EXCEPT:

A) tax bracket.
B) family situation.
C) years of experience with investing in the markets.

Explanation
Tax concerns play an important role in investment planning. However, these constitute an investment constraint, not an investment
objective (i.e. risk tolerance).

(Module 86.1, LOS 86.d)

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Question #53 of 150 Question ID: 1574546

Which of the following actions is best described as taking place in the execution step of the portfolio management process?

A) Developing an investment policy statement.

B) Rebalancing the portfolio.
C) Choosing a target asset allocation.

Explanation

The three major steps in the portfolio management process are (1) planning, (2) execution, and (3) feedback. The planning step
includes evaluating the investor's needs and preparing an investment policy statement. The execution step includes choosing a
target asset allocation, evaluating potential investments based on top-down or bottom-up analysis, and constructing the portfolio.
The feedback step includes measuring and reporting performance and monitoring and rebalancing the portfolio.

(Module 85.1, LOS 85.b)

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Question #54 of 150 Question ID: 1574619

Risk management within an organization should most appropriately consider:

A) internal risks independently of external risks.

B) financial risks independently of non-financial risks.
C) interactions among different risks.

Explanation

The various financial and non-financial risks interact in many ways. A risk management process should consider these interactions
among risks rather than treating them each in isolation.

(Module 88.1, LOS 88.f)

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Question #55 of 150 Question ID: 1574574

A return objective is said to be relative if the objective is:

A) based on a benchmark index or portfolio.

B) stated in terms of probability.
C) compared to a specific numerical outcome.

Explanation

Relative return objectives are stated relative to specified benchmarks, such as LIBOR or the return on a stock index. Absolute return
objectives are stated in terms of specific numerical outcomes, such as a 5% return. Risk objectives (either absolute or relative) may
be stated in terms of probability, such as "no more than a 5% probability of a negative return."

(Module 86.1, LOS 86.c)

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Question #56 of 150 Question ID: 1646086

Historically, which of the following asset classes has exhibited the smallest standard deviation of monthly returns?

A) Large-capitalization stocks.
B) Long-term corporate bonds.
C) Treasury bills.

Explanation

Based on data for securities in the United States from 1926 to 2008, Treasury bills exhibited a lower standard deviation of monthly
returns than both large-cap stocks and long-term corporate bonds.

(Module 83.1, LOS 83.a)

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Question #57 of 150 Question ID: 1574604

Which of the following are considered biases due to cognitive errors?

A) Loss aversion, self-control, and regret-aversion biases.

B) Conservatism, hindsight, and framing biases.
C) Representativeness, mental accounting, and overconfidence biases.

Explanation
Conservatism, hindsight, and framing biases are examples of cognitive errors. Loss aversion, self-control, regret-aversion, and
overconfidence are all emotional biases.

(Module 87.1, LOS 87.b)

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Question #58 of 150 Question ID: 1646093

The particular portfolio on the efficient frontier that best suits an individual investor is determined by:

A) the current market risk-free rate as compared to the current market return rate.
B) the individual's asset allocation plan.
C) the individual's utility curve.

Explanation

The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. The optimal portfolio
is the portfolio that gives the investor the greatest possible utility.

(Module 83.2, LOS 83.c)

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Question #59 of 150 Question ID: 1574603

Which of the following cognitive errors are best described as belief persistence biases?
A) Illusion of control, confirmation, and anchoring and adjustment biases.
B) Mental accounting, framing, and availability biases.
C) Conservatism, representativeness, and hindsight biases.

Explanation

Mental accounting, framing, anchoring and adjustment, and availability biases are information processing biases whereas
conservatism, representativeness, confirmation, illusion of control, and hindsight biases are belief persistence biases.

(Module 87.1, LOS 87.b)

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Question #60 of 150 Question ID: 1646187

If the standard deviation of the market's returns is 5.8%, the standard deviation of a stock's returns is 8.2%, and the covariance of the
market's returns with the stock's returns is 0.003, what is the beta of the stock?

A) 0.05.
B) 0.89.
C) 1.07.

Explanation

The formula for beta is: (Covstock,market)/(Varmarket), or (0.003)/(0.058)2 = 0.89.

(Module 84.1, LOS 84.e)

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Question #61 of 150 Question ID: 1646211

The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return is 6%, what is the expected return
of Stock A?

A) 13.8%.
B) 15.6%.
C) 14.2%.

Explanation

RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate

Here, RRStock = 6 + (12 - 6) × 1.3 = 6 + 7.8 = 13.8%.

(Module 84.2, LOS 84.g)

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Question #62 of 150 Question ID: 1646094

Investors who are less risk averse will have what type of indifference curves for risk and expected return?

A) Flatter.
B) Inverted.
C) Steeper.
Explanation

Investors who are less risk averse will have flatter indifference curves, meaning they are willing to take on more risk for a slightly
higher return. Investors who are more risk averse require a much higher return to accept more risk, producing steeper indifference
curves.

(Module 83.2, LOS 83.c)

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Question #63 of 150 Question ID: 1646097

The optimal portfolio in the Markowitz framework occurs when an investor achieves the diversified portfolio with the:

A) highest return.
B) highest utility.
C) lowest risk.

Explanation

The optimal portfolio in the Markowitz framework occurs when the investor achieves the diversified portfolio with the highest utility.

(Module 83.2, LOS 83.c)

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Question #64 of 150 Question ID: 1646084

Over the long term, the annual returns and standard deviations of returns for major asset classes have shown:
A) a negative relationship.
B) a positive relationship.
C) no clear relationship.

Explanation

In most markets and for most asset classes, higher average returns have historically been associated with higher risk (standard
deviation of returns).

(Module 83.1, LOS 83.a)

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Question #65 of 150 Question ID: 1646155

The slope of the capital market line (CML) is a measure of the level of:

A) excess return per unit of risk.

B) expected return over the level of inflation.
C) risk over the level of excess return.

Explanation

The slope of the CML indicates the excess return (expected return less the risk-free rate) per unit of risk.

(Module 84.1, LOS 84.b)

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Question #66 of 150 Question ID: 1574550

High risk tolerance, a long investment horizon, and low liquidity needs are most likely to characterize the investment needs of a(n):

A) defined benefit pension plan.

B) insurance company.
C) bank.

Explanation

A defined benefit pension plan typically has a long investment time horizon, low liquidity needs, and high risk tolerance. Insurance
companies and banks typically have low risk tolerance and high liquidity needs. Banks and property and casualty insurers typically
have short investment horizons.

(Module 85.1, LOS 85.c)

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Question #67 of 150 Question ID: 1574558

In a defined contribution pension plan, investment risk is borne by the:

A) employee.
B) plan sponsor.
C) fund manager.

Explanation
Defined contribution pension plans require the plan sponsor (the employer) to make payments to the employees' retirement
accounts throughout the duration of their employment. Once payments are made by the sponsor, the sponsor's obligation is
fulfilled and the investment risk is borne by the employees.

(Module 85.1, LOS 85.d)

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Question #68 of 150 Question ID: 1646226

Consider the following graph of the Security Market Line (SML). The letters X, Y, and Z represent risky asset portfolios and an analyst's
forecast for their returns over the next period. The SML crosses the y-axis at 0.07.

The expected market return is 13.0%.

Using the graph above and the information provided, the analyst most likely believes that:

A) Portfolio X's required return is greater than its forecast return.

B) Portfolio Y is undervalued.
C) the expected return for Portfolio Z is 14.8%.
Explanation

Portfolio Z has a beta of 1.3 and its required return can be calculated as 7.0% + 1.3 × (13.0% − 7.0%) = 14.8%. Because it plots on the
SML, its expected (forecast) return and required return are equal.

The SML plots beta (systematic risk) versus expected equilibrium (required) return. The analyst believes that Portfolio Y is
overvalued – any portfolio located below the SML has a forecast return less than its required return and is overpriced in the market.
Since Portfolio X plots above the SML, it is undervalued and the statement should read, "Portfolio X's required return is less than its
forecast return."

(Module 84.2, LOS 84.h)

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Question #69 of 150 Question ID: 1574568

Which of the following is not necessarily included in an investment policy statement?

A) An investment strategy based on the investor’s objectives and constraints.

B) Procedures to update the IPS when circumstances change.
C) A benchmark against which to judge performance.

Explanation

At a minimum an IPS should contain a clear statement of client circumstances and constraints, an investment strategy based on
these, and some benchmark against which to evaluate the account performance. The investment must periodically update the IPS as
circumstances change, but explicit procedures for these updates are not necessarily included in the IPS itself.

(Module 86.1, LOS 86.a)

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Question #70 of 150 Question ID: 1646195

Which of the following statements about the security market line (SML) and capital market line (CML) is most accurate?

A) The SML involves the concept of a risk-free asset, but the CML does not.
B) The SML uses beta, but the CML uses standard deviation as the risk measure.
C) Both the SML and CML can be used to explain a stock’s expected return.

Explanation

The SML and CML both intersect the vertical axis at the risk-free rate. The SML describes the risk/return tradeoff for individual
securities or portfolios, whereas the CML describes the risk/return tradeoff of various combinations of the market portfolio and a
riskless asset.

(Module 84.2, LOS 84.f)

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Question #71 of 150 Question ID: 1646206

Which of the following is an assumption of the Capital Asset Pricing Model (CAPM)?

A) No investor is large enough to influence market prices.

B) There are no margin transactions or short sales.
C) Investors with shorter time horizons exhibit greater risk aversion.
Explanation

The CAPM assumes all investors are price takers and no single investor can influence prices. The CAPM also assumes markets are
free of impediments to trading and that all investors are risk averse and have the same one-period time horizon.

(Module 84.2, LOS 84.f)

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Question #72 of 150 Question ID: 1574545

In the top-down approach to asset allocation, industry analysis should be conducted before company analysis because:

an industry's prospects within the global business environment are a major determinant of how well individual firms in
A)
the industry perform.
B) the goal of the top-down approach is to identify those companies in non-cyclical industries with the lowest P/E ratios.
C) most valuation models recommend the use of industry-wide average required returns, rather than individual returns.

Explanation

In general, an industry's prospects within the global business environment determine how well or poorly individual firms in the
industry do. Thus, industry analysis should precede company analysis. The goal is to find the best companies in the most promising
industries; even the best company in a weak industry is not likely to perform well.

(Module 85.1, LOS 85.b)

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Question #73 of 150 Question ID: 1646113

If the standard deviation of returns for stock X is 0.60 and for stock Y is 0.40 and the covariance between the returns of the two stocks
is 0.009, the correlation between stocks X and Y is closest to:

A) 26.6670.
B) 0.0020.
C) 0.0375.

Explanation

CovX,Y = (rX,Y)(sX)(sY), where r = correlation coefficient, sx = standard deviation of stock X , and sY = standard deviation of stock Y

Then, (rX,Y) = CovX,Y / (SDX × SDY) = 0.009 / (0.600 × 0.400) = 0.0375

(Module 83.3, LOS 83.d)

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Question #74 of 150 Question ID: 1574598

Which of the following statements is most accurate about integrating ESG considerations into portfolio planning and construction?

A broad market index is an inappropriate benchmark for a portfolio that uses negative screening to address the
A)
investor’s ESG concerns.
Investors who engage in active ownership to pursue their ESG considerations should vote their shares themselves rather
B)
than delegating share voting to an investment manager.
C) Integrating ESG considerations into portfolio planning and construction is likely to decrease portfolio returns.
Explanation

If a portfolio's investment universe is constrained by negative screening, an appropriate benchmark is an index that excludes
companies or industries that investors with ESG concerns commonly avoid.

Investors engaging in active ownership to pursue their ESG considerations may choose to vote their shares themselves or instruct
an investment manager to vote the shares.

The effect of integrating ESG considerations on portfolio returns is uncertain. While limiting the universe of investment choices and
incurring the costs involved in considering ESG factors may decrease returns, investing in companies with good corporate
governance practices and avoiding those that face ESG-related risks may increase returns.

(Module 86.1, LOS 86.g)

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Question #75 of 150 Question ID: 1574566

Open-end mutual funds differ from closed-end funds in that:

A) open-end funds stand ready to redeem their shares, while closed-end funds do not.
B) closed-end funds require active management, while open-end funds do not.
C) open-end funds issue shares that are then traded in secondary markets, while closed-end funds do not.

Explanation

Open-end funds redeem existing shares or issue new shares in accordance with investor demand. Closed-end fund shares are fixed
in number and trade on exchanges as though they were common stock.

(Module 85.2, LOS 85.f)

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Question #76 of 150 Question ID: 1646190

Given the following data, what is the correlation coefficient between the two stocks and the Beta of stock A?

standard deviation of returns of Stock A is 10.04%

standard deviation of returns of Stock B is 2.05%
standard deviation of the market is 3.01%
covariance between the two stocks is 0.00109
covariance between the market and stock A is 0.002

Correlation Coefficient Beta (stock A)

A) 0.5296 0.06

B) 0.5296 2.20

C) 0.6556 2.20

Explanation

correlation coefficient = 0.00109 / (0.0205)(0.1004) = 0.5296.

beta of stock A = covariance between stock and the market / variance of the market

Beta = 0.002 / 0.03012 = 2.2

(Module 84.1, LOS 84.e)

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Question #77 of 150 Question ID: 1646141

On a graph of risk, measured by standard deviation and expected return, the efficient frontier represents:

A) the group of portfolios that have extreme values and therefore are “efficient” in their allocation.
B) all portfolios plotted in the northeast quadrant that maximize return.
C) the set of portfolios that dominate all others as to risk and return.

Explanation

The efficient set is the set of portfolios that dominate all other portfolios as to risk and return. That is, they have highest expected
return at each level of risk.

(Module 83.4, LOS 83.g)

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Question #78 of 150 Question ID: 1646203

According to the capital asset pricing model (CAPM):

A) an investor who is risk averse should hold at least some of the risk-free asset in his portfolio.
B) a stock with high risk, measured as standard deviation of returns, will have high expected returns in equilibrium.
C) all investors who take on risk will hold the same risky-asset portfolio.

Explanation
One of the assumptions of the CAPM is that all investors who hold risky assets will hold the same portfolio of risky assets (the
market portfolio). Risk aversion means an investor will accept more risk only if compensated with a higher expected return. In
capital market theory, all investors exhibit risk aversion, even an investor who is short the risk-free asset. In the CAPM, a stock's risk
is measured as its beta, not its standard deviation of returns.

(Module 84.2, LOS 84.f)

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Question #79 of 150 Question ID: 1646103

If the standard deviation of returns for stock A is 0.40 and for stock B is 0.30 and the covariance between the returns of the two stocks
is 0.007 what is the correlation between stocks A and B?

A) 0.00084.
B) 17.14300.
C) 0.05830.

Explanation

CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x

Then, (rA,B) = CovA,B / (SDA × SDB) = 0.007 / (0.400 × 0.300) = 0.0583

(Module 83.3, LOS 83.d)

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Question #80 of 150 Question ID: 1646210

What is the required rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the market risk premium is 12%?

A) 13.2%.
B) 15.4%.
C) 20.4%.

Explanation

RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate.

Here, RRStock = 6 + (12) × 1.2 = 6 + 14.4 = 20.4%. We are given the market risk premium E(Rmkt) – Rf, not the expected return on the
market.

(Module 84.2, LOS 84.g)

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Question #81 of 150 Question ID: 1646116

Using the following correlation matrix, which two stocks would combine to make the lowest-risk portfolio? (Assume the stocks have
equal risk and returns.)

Stock A B C

A +1 -- --

B - 0.2 + 1 --

C + 0.6 - 0.1 + 1

A) A and C.
B) C and B.
C) A and B.

Explanation

Portfolios A and B have the lowest correlation coefficient and will thus create the lowest-risk portfolio.

The standard deviation of a portfolio = [W12σ12 + W22σ22 + 2W1W2σ1σ2r1,2]1/2

The correlation coefficient, r1,2, varies from + 1 to - 1. The smaller the correlation coefficient, the smaller σportfolio can be. If the
correlation coefficient were - 1, it would be possible to make σportfolio go to zero by picking the proper weightings of W1 and W2.

(Module 83.3, LOS 83.e)

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Question #82 of 150 Question ID: 1646138

Which one of the following portfolios cannot lie on the efficient frontier?

Portfolio Expected Return Standard Deviation

A 20% 35%

B 11% 13%

C 8% 10%

D 8% 9%

A) Portfolio D.
B) Portfolio A.
C) Portfolio C.

Explanation

Portfolio C cannot lie on the frontier because it has the same return as Portfolio D, but has more risk.

(Module 83.4, LOS 83.g)

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Question #83 of 150 Question ID: 1646227

Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-diversified portfolios with approximately equal
market values. He expects Portfolio X to return 13% and Portfolio Y to return 14% over the upcoming year. Because of an unexpected
need for cash, Smith is forced to sell at least one of the portfolios. He uses the security market line to determine whether his portfolios
are undervalued or overvalued. Portfolio X's beta is 0.9 and Portfolio Y's beta is 1.1. The expected return on the market is 12% and the
risk-free rate is 5%. Smith should sell:

A) portfolio Y only.
B) both portfolios X and Y because they are both overvalued.
C) either portfolio X or Y because they are both properly valued.

Explanation

Portfolio X's required return is 0.05 + 0.9 × (0.12-0.05) = 11.3%. It is expected to return 13%. The portfolio has an expected excess
return of 1.7%

Portfolio Y's required return is 0.05 + 1.1 × (0.12-0.05) = 12.7%. It is expected to return 14%. The portfolio has an expected excess
return of 1.3%.

Since both portfolios are undervalued, the investor should sell the portfolio that offers less excess return. Sell Portfolio Y because its
excess return is less than that of Portfolio X.

(Module 84.2, LOS 84.h)

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Question #84 of 150 Question ID: 1574626

Measures of interest rate sensitivity least likely include:

A) beta.
B) duration.
C) rho.

Explanation

Beta measures the market risk of an asset or portfolio. Duration measures the interest rate sensitivity of the value of a fixed-income
security or portfolio. Rho measures the interest rate sensitivity of the value of a derivative.

(Module 88.1, LOS 88.g)

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Question #85 of 150 Question ID: 1646102

A bond analyst is looking at historical returns for two bonds, Bond 1 and Bond 2. Bond 2's returns are much more volatile than Bond 1.
The variance of returns for Bond 1 is 0.012 and the variance of returns of Bond 2 is 0.308. The correlation between the returns of the
two bonds is 0.79, and the covariance is 0.048. If the variance of Bond 1 increases to 0.026 while the variance of Bond 2 decreases to
0.188 and the covariance remains the same, the correlation between the two bonds will:

A) decrease.
B) increase.
C) remain the same.

Explanation
P1,2 = 0.048/(0.0260.5 × 0.1880.5) = 0.69 which is lower than the original 0.79.

(Module 83.3, LOS 83.d)

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Question #86 of 150 Question ID: 1646178

Which of the following terms refer to the same type of risk?

A) Systematic risk and firm-specific risk.

B) Total risk and the variance of returns.
C) Undiversifiable risk and unsystematic risk.

Explanation

Variance is a measure of total risk.

(Module 84.1, LOS 84.c)

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Question #87 of 150 Question ID: 1574569

Brian Nebrik, CFA, meets with a new investment management client. They compose a statement that defines each of their
responsibilities concerning this account and choose a benchmark index with which to evaluate the account's performance. Which of
these items should be included in the client's Investment Policy Statement (IPS)?

A) Neither of these items.

B) Both of these items.
C) Only one of these items.

Explanation

Two of the major components of an IPS should be a statement of the responsibilities of the investment manager and the client, and
a performance evaluation benchmark.

(Module 86.1, LOS 86.b)

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Question #88 of 150 Question ID: 1646236

An active manager will most likely short a security with an expected Jensen's alpha that is:

A) negative.
B) positive.
C) zero.

Explanation
A security's expected Jensen's alpha is the difference between an active manager's estimate of a security's expected return and the
CAPM expected return. A security that is expected to have a negative alpha will plot below the SML (i.e., the security is overvalued
and should be sold or sold short).

(Module 84.2, LOS 84.i)

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Question #89 of 150 Question ID: 1646198

Which is NOT an assumption of capital market theory?

A) Investments are not divisible.

B) There is no inflation.
C) There are no taxes or transaction costs.

Explanation

Capital market theory assumes that all investments are infinitely divisible. The other statements are basic assumptions of capital
market theory.

(Module 84.2, LOS 84.f)

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Question #90 of 150 Question ID: 1646104

If the standard deviation of asset A is 12.2%, the standard deviation of asset B is 8.9%, and the correlation coefficient is 0.20, what is
the covariance between A and B?

A) 0.0001.
B) 0.0022.
C) 0.0031.

Explanation

The formula is: (correlation)(standard deviation of A)(standard deviation of B) = (0.20)(0.122)(0.089) = 0.0022.

(Module 83.3, LOS 83.d)

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Question #91 of 150 Question ID: 1574617

Risk governance is best described as:

A) determining an organization’s risk tolerance.

B) allocating an organization’s resources by considering their risk characteristics.
C) senior management’s oversight of the organization’s risk management.

Explanation
Risk governance is a general term that encompasses multiple functions of senior management. Determining the risk tolerance of the
organization and allocating the organization's resources by considering their risk characteristics (risk budgeting) are elements of
management's risk governance responsibility.

(Module 88.1, LOS 88.c)

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Question #92 of 150 Question ID: 1646166

Based on Capital Market Theory, an investor should choose the:

A) market portfolio on the Capital Market Line.

B) portfolio that maximizes his utility on the Capital Market Line.
C) portfolio with the highest return on the Capital Market Line.

Explanation

Given the Capital Market Line, the investor chooses the portfolio that maximizes his utility. That portfolio may be exactly the market
portfolio or it may be some combination of the risk-free asset and the market portfolio.

(Module 84.1, LOS 84.b)

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Question #93 of 150 Question ID: 1574564

Which of the following pooled investments is least likely to employ large amounts of leverage?

A) Global macro hedge fund.

B) Venture capital fund.
C) Private equity buyout fund.

Explanation

Hedge funds and buyout firms typically employ high leverage to acquire assets. Venture capital typically involves an equity interest.

(Module 85.2, LOS 85.f)

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Question #94 of 150 Question ID: 1646162

Portfolios that represent combinations of the risk-free asset and the market portfolio are plotted on the:

A) capital market line.

B) capital asset pricing line.
C) utility curve.

Explanation
The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is
called the capital market line (CML). Investors at point Rf have 100% of their funds invested in the risk-free asset. Investors at point
M have 100% of their funds invested in market portfolio M. Between Rf and M, investors hold both the risk-free asset and portfolio
M. To the right of M, investors hold more than 100% of portfolio M. All investors have to do to get the risk and return combination
that suits them is to simply vary the proportion of their investment in the risky portfolio M and the risk-free asset.
Utility curves reflect individual preferences.

(Module 84.1, LOS 84.b)

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Question #95 of 150 Question ID: 1574541

The ratio of an equally weighted portfolio's standard deviation of return to the average standard deviation of the securities in the
portfolio is known as the:

A) diversification ratio.
B) relative risk ratio.
C) Sharpe ratio.

Explanation

The diversification ratio is calculated by dividing a portfolio's standard deviation of returns by the average standard deviation of
returns of the individual securities in the portfolio (sometimes calculated as the average annualized standard deviation of portfolio
securities selected at random over the historical measurement period).

(Module 85.1, LOS 85.a)

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Question #96 of 150 Question ID: 1574577

Which of the following statements is NOT consistent with the assumption that individuals are risk averse with their investment
portfolios?

A) Many individuals purchase lottery tickets.

B) Higher betas are associated with higher expected returns.
C) There is a positive relationship between expected returns and expected risk.

Explanation

Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with
the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk and the risk
return line (capital market line [CML] and security market line [SML]) is upward sweeping. However, investors can be risk averse in
one area and not others, as evidenced by their purchase of lottery tickets.

(Module 86.1, LOS 86.d)

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Question #97 of 150 Question ID: 1646188

An analyst has estimated the following:

Correlation of Bahr Industries returns with market returns = 0.8

Variance of the market returns = 0.0441
Variance of Bahr returns = 0.0225

The beta of Bahr Industries stock is closest to:

A) 0.77.
B) 0.57.
C) 0.67.

Explanation

Covariance of Bahr and the market = 0.8 × √0.0225 × √0.0441 = 0.0252

Bahr beta = 0.0252/0.0441= 0.57

(Module 84.1, LOS 84.e)

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Question #98 of 150 Question ID: 1646157

According to capital market theory, which of the following represents the risky portfolio that should be held by all investors who desire
to hold risky assets?

A) Any point on the efficient frontier and to the left of the point of tangency between the CML and the efficient frontier.
B) Any point on the efficient frontier and to the right of the point of tangency between the CML and the efficient frontier.
C) The point of tangency between the capital market line (CML) and the efficient frontier.
Explanation

Capital market theory suggests that all investors should invest in the same portfolio of risky assets, and this portfolio is located at
the point of tangency of the CML and the efficient frontier of risky assets. Any point below the CML is suboptimal, and points above
the CML are not feasible.

(Module 84.1, LOS 84.b)

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Question #99 of 150 Question ID: 1646143

Which of the following statements about the efficient frontier is least accurate?

A portfolio that plots above efficient frontier is not attainable, while a portfolio that plots below the efficient frontier is
A)
inefficient.
B) The efficient frontier is the set of portfolios with the greatest expected return for a given level of risk.
C) The slope of the efficient frontier increases steadily as risk increases.

Explanation

The slope of the efficient frontier decreases steadily as risk and return increase.

The efficient frontier is the set of portfolios with the greatest expected return for a given level of risk as measured by standard
deviation of returns. That is, for a given level of risk, an expected return greater than that of the portfolio on the efficient frontier is
not attainable, and a portfolio with a lower expected return is inefficient.

(Module 83.4, LOS 83.g)

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Question #100 of 150 Question ID: 1574578

While assessing an investor's risk tolerance, a financial adviser is least likely to ask which of the following questions?

A) “How much insurance coverage do you have?”

B) “Is your home life stable?”
C) “What rate of investment return do you expect?”

Explanation

While the degree of risk tolerance will have an effect on expected returns, assessing the risk tolerance comes first, and the resulting
set of feasible returns follows. The other questions address risk tolerance.

(Module 86.1, LOS 86.d)

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Question #101 of 150 Question ID: 1646110

Which of the following statements regarding the covariance of rates of return is least accurate?

If the covariance is negative, the rates of return on two investments will always move in different directions relative to
A)
their means.
B) Covariance is not a very useful measure of the strength of the relationship between rates of return.
C) Covariance is positive if two variables tend to both be above their mean values in the same time periods.
Explanation

Negative covariance means rates of return for one security will tend to be above its mean return in periods when the other is below
its mean return, and vice versa. Positive covariance means that returns on both securities will tend to be above (or below) their
mean returns in the same time periods. For the returns to always move in opposite directions, they would have to be perfectly
negatively correlated. Negative covariance by itself does not imply anything about the strength of the negative correlation, it must
be standardized by dividing by the product of the securities' standard deviations of return.

(Module 83.3, LOS 83.d)

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Question #102 of 150 Question ID: 1574583

Which of the following should least likely be included as a constraint in an investment policy statement (IPS)?

A) Any unique needs or preferences an investor may have.

B) How funds are spent after being withdrawn from the portfolio.
C) Constraints put on investment activities by regulatory agencies.

Explanation

How funds are spent after withdrawal would not be a constraint of an IPS.

(Module 86.1, LOS 86.e)

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Question #103 of 150 Question ID: 1646132

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) 100% in Stock B.
B) 30% in Stock A and 70% in Stock B.
C) 50% in Stock A and 50% in Stock B.

Explanation

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

(Module 83.4, LOS 83.f)

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Question #104 of 150 Question ID: 1574562

A pooled investment fund buys all the shares of a publicly traded company. The fund reorganizes the company and replaces its
management team. Three years later, the fund exits the investment through an initial public offering of the company's shares. This
pooled investment fund is best described as a(n):

A) event-driven fund.
B) private equity fund.
C) venture capital fund.

Explanation
A private equity fund or buyout fund is one that acquires entire public companies, takes them private, and reorganizes the
companies to increase their value. An event-driven fund is a hedge fund that invests in response to corporate events such as
mergers or acquisitions. Venture capital funds invest in start-up companies.

(Module 85.2, LOS 85.f)

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Question #105 of 150 Question ID: 1646216

Given the following information, what is the required rate of return on Bin Co?

inflation premium = 3%
real risk-free rate = 2%
Bin Co. beta = 1.3
market risk premium = 4%

A) 10.2%.
B) 7.6%.
C) 16.7%.

Explanation

Use the capital asset pricing model (CAPM) to find the required rate of return. The approximate risk-free rate of interest is 5% (2%
real risk-free rate + 3% inflation premium).

k = 5% + 1.3(4%) = 10.2%.

(Module 84.2, LOS 84.g)

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Question #106 of 150 Question ID: 1646230

An analyst estimated the following for three possible investments.

Security Current Price Forecast Price in One Year Annual Dividend Beta

Alpha Inc. 25.00 31.00 2.00 1.6

Lambda Inc. 10.00 10.80 0 0.5

Omega Inc. 105.00 110.00 1.00 1.2

Given an expected return on the market of 12% and a risk-free rate of 4%, which of the three securities is correctly priced based on the
analyst's estimates?

A) Lambda.
B) Alpha.
C) Omega.

Explanation

In the context of the SML, a security is underpriced if its required return is less than its estimated holding period return, is
overpriced if its required return is greater than its estimated holding period return, and is correctly priced if its required return is
equal to its estimated holding period return.

Here, estimated holding period return is calculated as: (ending price – beginning price + cash flows) / beginning price. The required
return based on the CAPM is: risk free rate + Beta × (expected market rate − risk free rate).

For Alpha: ER = (31 – 25 + 2) / 25 = 32%, RR = 4 + 1.6 × (12 – 4) = 16.8%. Stock is underpriced.

For Omega: ER = (110 – 105 + 1) / 105 = 5.7%, RR = 4 + 1.2 × (12 – 4) = 13.6%. Stock is overpriced.
For Lambda, ER = (10.8 – 10) / 10 = 8%, RR = 4 + 0.5 × (12 – 4) = 8%. Stock is correctly priced.

(Module 84.2, LOS 84.h)

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Question #107 of 150 Question ID: 1646139

Which one of the following portfolios does not lie on the efficient frontier?

Portfolio Expected Return Standard Deviation

A 7 5

B 9 12

C 11 10

D 15 15

A) A.
B) B.
C) C.

Explanation

Portfolio B has a lower expected return than Portfolio C with a higher standard deviation.

(Module 83.4, LOS 83.g)

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Question #108 of 150 Question ID: 1574609

Greg Brown receives new information regarding one of his stocks. This information appears to be reliable and conflicts with Brown's
earlier forecast of what the stock should be trading for at this time. However, Brown does not revise his estimate of the stock's value.
Brown is most likely exhibiting:

A) hindsight bias.
B) conservatism bias.
C) confirmation bias.

Explanation

Conservatism bias refers to failing to change a view as new information becomes available, and may result in investors keeping
assets too long because they are slow to update a view or forecast. Confirmation bias refers to when investors seek out information
that supports their beliefs, while avoiding conflicting views. Hindsight bias refers to selective memory of past events resulting in
individuals believing these events were more predictable than they seemed before they happened.

(Module 87.1, LOS 87.b)

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Question #109 of 150 Question ID: 1646087

An analyst gathers the following data about the returns for two stocks.

Stock A Stock B

E(R) 0.04 0.09

σ2 0.0025 0.0064

CovA,B= 0.001

The correlation between the returns of Stock A and Stock B is closest to:

A) 0.25.
B) 0.50.
C) 0.63.

Explanation

The correlation between the two stocks is:

ρA,B = COVA,B / (σA × σB) = 0.001 / (0.05 × 0.08) = 0.001 / (0.004) = 0.25

Note that the formula uses the standard deviations, not the variances, of the returns on the two securities.

(Module 83.1, LOS 83.a)

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Question #110 of 150 Question ID: 1574620

Operational risk is most accurately described as the risk that:

A) human error or faulty processes will cause losses.

B) the organization will run out of operating cash.
C) extreme events are more likely than managers have assumed.

Explanation

Operational risk arises from faulty processes or human error within the organization. Solvency risk is the risk that the organization
will run out of cash and therefore be unable to continue operating. Tail risk is the risk that extreme events are more likely than the
organization's managers have assumed.

(Module 88.1, LOS 88.f)

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Question #111 of 150 Question ID: 1646168

All portfolios that lie on the capital market line:

A) contain the same mix of risky assets unless only the risk-free asset is held.
B) contain at least some positive allocation to the risk-free asset.
C) have some unsystematic risk unless only the risk-free asset is held.

Explanation

All portfolios on the CML include the same tangency portfolio of risky assets, except the intercept (all invested in risk-free asset). The
tangency portfolio contains none of the risk-free asset and "borrowing portfolios" can be constructed with a negative allocation to
the risk-free asset. Portfolios on the CML are efficient (well-diversified) and have no unsystematic risk.

(Module 84.1, LOS 84.c)

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Question #112 of 150 Question ID: 1646177

A portfolio manager is constructing a new equity portfolio consisting of a large number of randomly chosen domestic stocks. As the
number of stocks in the portfolio increases, what happens to the expected levels of systematic and unsystematic risk?

Systematic risk Unsystematic risk

A) Remains the same Decreases

B) Decreases Increases

C) Increases Remains the same

Explanation

As randomly selected securities are added to a portfolio, the diversifiable (unsystematic) risk decreases, and the expected level of
nondiversifiable (systematic) risk remains the same.

(Module 84.1, LOS 84.c)

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Question #113 of 150 Question ID: 1646175

In equilibrium, investors should only expect to be compensated for bearing systematic risk because:
A) individual securities in equilibrium only have systematic risk.
B) nonsystematic risk can be eliminated by diversification.
C) systematic risk is specific to the securities the investor selects.

Explanation

In equilibrium, investors should not expect to earn additional return for bearing nonsystematic risk because this risk can be
eliminated by diversification. Individual securities have both systematic and nonsystematic risk. Systematic risk is market risk;
nonsystematic risk is specific to individual securities.

(Module 84.1, LOS 84.c)

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Question #114 of 150 Question ID: 1574571

Which of the following would least likely be considered a minimum requirement of an IPS? A(n):

A) target return figure.

B) investment strategy based on client circumstances and constraints.
C) benchmark portfolio.

Explanation

An IPS does not necessarily, or even typically, require a target return because future market movements are either difficult or
impossible to predict with any degree of accuracy. At a minimum the IPS should contain a clear statement of client circumstances
and constraints, and investment strategy consistent with these, and a benchmark portfolio or instrument against which to evaluate
portfolio returns.

(Module 86.1, LOS 86.b)

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Question #115 of 150 Question ID: 1646213

What is the expected rate of return on a stock that has a beta of 1.4 if the market risk premium is 9% and the risk-free rate is 4%?

A) 13.0%.
B) 11.0%.
C) 16.6%.

Explanation

Using the security market line (SML) equation:

4% + 1.4(9%) = 16.6%.

(Module 84.2, LOS 84.g)

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Question #116 of 150 Question ID: 1574576

Which of the following statements about risk is NOT correct? Generally, greater:

A) existing wealth allows for greater risk.

B) insurance coverage allows for greater risk.
C) spending needs allows for greater risk.
Explanation

Greater spending needs usually allow for lower risk because there is a definite need to ensure that the return may adequately fund
the spending needs (a "fixed" cost).

(Module 86.1, LOS 86.d)

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Question #117 of 150 Question ID: 1646163

For an investor to move further up the Capital Market Line than the market portfolio, the investor must:

A) borrow and invest in the market portfolio.

B) reduce the portfolio's risk below that of the market.
C) diversify the portfolio even more.

Explanation

Portfolios that lie to the right of the market portfolio on the capital market line ("up" the capital market line) are created by
borrowing funds to own more than 100% of the market portfolio (M).

The statement, "diversify the portfolio even more" is incorrect because the market portfolio is fully diversified.

(Module 84.1, LOS 84.b)

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Question #118 of 150 Question ID: 1646128

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) +1.00.
B) 0.00.
C) +0.50.

Explanation

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

(Module 83.4, LOS 83.f)

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Question #119 of 150 Question ID: 1646159

The market portfolio in Capital Market Theory is determined by:

A) a line tangent to the efficient frontier, drawn from any point on the expected return axis.
B) a line tangent to the efficient frontier, drawn from the risk-free rate of return.
C) the intersection of the efficient frontier and the investor's highest utility curve.

Explanation

The Capital Market Line is a straight line drawn from the risk-free rate of return (on the Y axis) through the market portfolio. The
market portfolio is determined as where that straight line is exactly tangent to the efficient frontier.

(Module 84.1, LOS 84.b)

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Question #120 of 150 Question ID: 1574549

The execution step in the portfolio management process is most likely to include:

A) asset allocation and security analysis.

B) performance measurement and portfolio rebalancing.
C) preparation of an investment policy statement.

Explanation

The three major steps in the portfolio management process are planning, execution, and feedback. Asset allocation and security
analysis are components of the execution step, as is portfolio construction. Preparation of an investment policy statement is a
component of the planning step. Portfolio monitoring and rebalancing, as well as performance measurement and reporting, are part
of the feedback step.

(Module 85.1, LOS 85.b)

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Question #121 of 150 Question ID: 1646181

In Fama and French's multifactor model, the expected return on a stock is explained by:

A) excess return on the market portfolio, book-to-market ratio, and price momentum.
B) firm size, book-to-market ratio, and excess return on the market portfolio.
C) firm size, book-to-market ratio, and price momentum.
Explanation

In the Fama and French model, the three factors that explain individual stock returns are firm size, the firm's book value-to-market
value ratio, and the excess return on the market portfolio. The Carhart model added price momentum as a fourth factor.

(Module 84.1, LOS 84.d)

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Question #122 of 150 Question ID: 1574599

Which of the following statements would most likely be classified as a cognitive error? The investor:

A) tends to take more risk rather than sell a stock at a loss.

B) has a tendency to place information into categories.
C) acts defensively when asked why he made a poor investment decision.

Explanation

This describes the cognitive error of "representativeness bias" where investors classify information into the most appropriate
subjective category based on "if-then" heuristics. The other two answer choices describe "loss aversion" and "regret aversion."

(Module 87.1, LOS 87.a)

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Question #123 of 150 Question ID: 1646214

If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on
the stock according to the capital asset pricing model?

A) 11.3%.
B) 12.4%.
C) 7.8%.

Explanation

The formula for the required return is: ERstock = Rf + (ERM – Rf) × Betastock

or 0.035 + 1.3 × (0.095 - 0.035) = 0.113, or 11.3%.

(Module 84.2, LOS 84.g)

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Question #124 of 150 Question ID: 1646165

What is the risk measure associated with the CML?

A) Beta.
B) Market risk.
C) Standard deviation.

Explanation
In the context of the CML, the measure of risk (x-axis) is total risk, or standard deviation. Beta (systematic risk) is used to measure
risk for the security market line (SML).

(Module 84.1, LOS 84.b)

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Question #125 of 150 Question ID: 1646233

The risk-free rate is 5% and the expected market return is 15%. A portfolio manager is estimating a return of 20% on a stock with a beta
of 1.5. Based on the SML and the analyst's estimate, this stock is:

A) properly valued.
B) undervalued.
C) overvalued.

Explanation

Based on the CAPM, the portfolio should earn: E(R) = 0.05 + 1.5(0.15 − 0.05) = 0.20 or 20%. On a risk-adjusted basis, this portfolio lies
on the SML and is, thus, properly valued.

(Module 84.2, LOS 84.h)

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Question #126 of 150 Question ID: 1646193

The slope of the characteristic line is used to estimate:

A) beta.
B) risk aversion.
C) a risk premium.

Explanation

Beta for an individual security can be estimated by the slope of its characteristic line, a least-squares regression of the security's
excess returns against the market's excess returns.

(Module 84.1, LOS 84.e)

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Question #127 of 150 Question ID: 1646111

If the standard deviation of stock A is 10.6%, the standard deviation of stock B is 14.6%, and the covariance between the two is
0.015476, what is the correlation coefficient?

A) +1.
B) 0.
C) 0.0002.

Explanation

The formula is: (Covariance of A and B) / [(Standard deviation of A)(Standard Deviation of B)] = (Correlation Coefficient of A and B) =
(0.015476) / [(0.106)(0.146)] = 1.

(Module 83.3, LOS 83.d)

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Question #128 of 150 Question ID: 1646228

An investor believes Stock M will rise from a current price of $20 per share to a price of $26 per share over the next year. The company
is not expected to pay a dividend. The following information pertains:

RF = 8%
ERM = 16%
Beta = 1.7

Should the investor purchase the stock?

A) No, because it is overvalued.

B) No, because it is undervalued.
C) Yes, because it is undervalued.

Explanation

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is
overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return
equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows/dividends) / beginning
price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate − risk free rate).

ER = (26 – 20) / 20 = 0.30 or 30%, RR = 8 + (16 – 8) × 1.7 = 21.6%. The stock is underpriced therefore purchase.

(Module 84.2, LOS 84.h)

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Question #129 of 150 Question ID: 1646095

The graph below combines the efficient frontier with the indifference curves for two different investors, X and Y.

Which of the following statements about the above graph is least accurate?

A) Investor X is less risk-averse than Investor Y.

B) The efficient frontier line represents the portfolios that provide the highest return at each risk level.
C) Investor X's expected return is likely to be less than that of Investor Y.

Explanation

Investor X has a steep indifference curve, indicating that he is risk-averse. Flatter indifference curves, such as those for Investor Y,
indicate a less risk-averse investor. The other choices are true. A more risk-averse investor will likely obtain lower returns than a less
risk-averse investor.

(Module 83.2, LOS 83.c)

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Question #130 of 150 Question ID: 1646092

A line that represents the possible portfolios that combine a risky asset and a risk free asset is most accurately described as a:

A) capital allocation line.

B) capital market line.
C) characteristic line.

Explanation

The line that represents possible combinations of a risky asset and the risk-free asset is referred to as a capital allocation line (CAL).
The capital market line (CML) represents possible combinations of the market portfolio with the risk-free asset. A characteristic line
is the best fitting linear relationship between excess returns on an asset and excess returns on the market and is used to estimate
an asset's beta.

(Module 83.2, LOS 83.c)

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Question #131 of 150 Question ID: 1574588

Davis Samuel, CFA, is meeting with one of his portfolio management clients, Joseph Pope, to discuss Pope's investment constraints.
Samuel has established that:

Pope plans to retire from his job as a bond salesman in 17 years, after which this portfolio will be his primary source of income.
Pope has sufficient cash available that he will not need this portfolio to generate cash outflows until he retires.
Pope, as a registered securities representative, is required to have Samuel send a copy of his account statements to the
compliance officer at Pope's employer.
Pope opposes certain policies of the government of Lower Pannonia and does not wish to own any securities of companies that
do business with its regime.

To complete his assessment of Pope's investment constraints, Samuel still needs to inquire about Pope's:

A) tax concerns.
B) unique circumstances.
C) liquidity needs.

Explanation

Of the five categories of investment constraints, the four matters listed are related to Pope's time horizon (years to retirement),
liquidity needs (available cash), legal and regulatory factors (required copies of account statements to Pope's compliance officer),
and unique needs and preferences (no investments in Lower Pannonia). None of these constraints address Pope's tax situation or
the taxable status of the investment account.

(Module 86.1, LOS 86.e)

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Question #132 of 150 Question ID: 1646117

Calculating the variance of a two-asset portfolio least likely requires inputs for each asset's:

A) standard deviation.
B) beta.
C) weight in the portfolio.

Explanation

Beta is not an input to calculate the variance of a two-asset portfolio. The formula for calculating the variance of a two-asset
portfolio is:

σ2P = w2A σ2A + w2B σ2B + 2wA wB CovAB

(Module 83.3, LOS 83.e)

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Question #133 of 150 Question ID: 1646144

Which of the following portfolios falls below the Markowitz efficient frontier?

Portfolio Expected Return Expected Standard Deviation

A 7% 14%

B 9% 26%

C 15% 30%

D 12% 22%

A) B.
B) C.
C) D.

Explanation

Portfolio B is not on the efficient frontier because it has a lower return, but higher risk, than Portfolio D.

(Module 83.4, LOS 83.g)

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Question #134 of 150 Question ID: 1574614

With respect to asset "bubbles":

A) anchoring may cause investors to mitigate bubbles by reducing their market exposure.
B) hindsight bias can fuel overconfidence.
C) behavioral finance provides an overall explanation.

Explanation

With hindsight bias, investors may give themselves credit for recent market advances, fueling overconfidence bias. Behavioral
finance has not supplied an overall explanation for the existence of market bubbles. Anchoring may cause investors to believe
recent market highs are rational and keep them in the market even as market prices or company fundamentals have started to
decline.

(Module 87.2, LOS 87.c)

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Question #135 of 150 Question ID: 1646122

Two assets are perfectly positively correlated. If 30% of an investor's funds were put in the asset with a standard deviation of 0.3 and
70% were invested in an asset with a standard deviation of 0.4, what is the standard deviation of the portfolio?

A) 0.370.
B) 0.151.
C) 0.426.

Explanation
σ portfolio = [W12σ12 + W22σ22 + 2W1W2σ1σ2r1,2]1/2 given r1,2 = +1

σ = [W12σ12 + W22σ22 + 2W1W2σ1σ2]1/2 = (W1σ1 + W2σ2)2]1/2

σ = (W1σ1 + W2σ2) = (0.3)(0.3) + (0.7)(0.4) = 0.09 + 0.28 = 0.37

(Module 83.3, LOS 83.e)

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Question #136 of 150 Question ID: 1646125

A portfolio currently holds Randy Co. and the portfolio manager is thinking of adding either XYZ Co. or Branton Co. to the portfolio. All
three stocks offer the same expected return and total risk. The covariance of returns between Randy Co. and XYZ is +0.5 and the
covariance between Randy Co. and Branton Co. is -0.5. The portfolio's risk would decrease:

A) more if she bought Branton Co.

B) more if she bought XYZ Co.
C) most if she put half your money in XYZ Co. and half in Branton Co.

Explanation
In portfolio composition questions, return and standard deviation are the key variables. Here you are told that both returns and
standard deviations are equal. Thus, you just want to pick the companies with the lowest covariance, because that would mean you
picked the ones with the lowest correlation coefficient.

σportfolio = [W12 σ12 + W22 σ22 + 2W1 W2 σ1 σ2 r1,2]½ where σRandy =YBranton = σXYZ so you want to pick the lowest
covariance which is between Randy and Branton.

(Module 83.4, LOS 83.f)

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Question #137 of 150 Question ID: 1646096

According to Markowitz, an investor's optimal portfolio is determined where the:

A) investor's highest utility curve is tangent to the efficient frontier.

B) investor's utility curve meets the efficient frontier.
C) investor's lowest utility curve is tangent to the efficient frontier.

Explanation

The optimal portfolio for an investor is determined as the point where the investor's highest utility curve is tangent to the efficient
frontier.

(Module 83.2, LOS 83.c)

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Question #138 of 150 Question ID: 1574590

When preparing a strategic asset allocation, how should asset classes be defined with respect to the correlations of returns among the
securities in each asset class?

A) High correlation within asset classes and low correlation between asset classes.
B) Low correlation within asset classes and low correlation between asset classes.
C) Low correlation within asset classes and high correlation between asset classes.

Explanation

The portfolio diversification benefits from strategic asset allocation result from low correlations of returns between asset classes.
Asset classes should consist of assets with similar characteristics and investment performance, which means correlations within an
asset class are relatively high.

(Module 86.1, LOS 86.f)

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Question #139 of 150 Question ID: 1646089

A stock has an expected return of 4% with a standard deviation of returns of 6%. A bond has an expected return of 4% with a standard
deviation of 7%. An investor who prefers to invest in the stock rather than the bond is best described as:

A) risk averse.
B) risk neutral.
C) risk seeking.

Explanation
Given two investments with the same expected return, a risk averse investor will prefer the investment with less risk. A risk neutral
investor will be indifferent between the two investments. A risk seeking investor will prefer the investment with more risk.

(Module 83.2, LOS 83.b)

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Question #140 of 150 Question ID: 1646222

Level I CFA candidate Adeline Bass is a member of an investment club. At the next meeting, she is to recommend whether or not the
club should purchase the stocks of CS Industries and MG Consolidated. The risk-free rate is at 6% and the expected return on the
market is 15%. Prior to the meeting, Bass gathers the following information on the two stocks:

CS Industries MG Consolidated

Current Market Value $25 $50

Expected Market Value in One Year $30 $55

Expected Dividend $1 $1

Beta 1.2 0.80

Bass should recommend that the club:

A) purchase both stocks.

B) purchase CS only.
C) purchase MG only.
Explanation

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is
overpriced if the required return is greater than the holding period (or expected) return, and is correctly priced if the required
return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows / dividends) /
beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate − risk-free rate).

For CS Industries: ER = (30 – 25 + 1) / 25 = 24%, RR = 6 + 1.2 × (15 – 6) = 16.8%. Stock is underpriced - purchase.
For MG Consolidated: ER = (55 – 50 + 1) / 50 = 12%, RR = 6 + 0.80 × (15 – 6) = 13.2%. Stock is overpriced - do not purchase.

(Module 84.2, LOS 84.h)

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Question #141 of 150 Question ID: 1646115

Betsy Minor is considering the diversification benefits of a two stock portfolio. The expected return of stock A is 14 percent with a
standard deviation of 18 percent and the expected return of stock B is 18 percent with a standard deviation of 24 percent. Minor
intends to invest 40 percent of her money in stock A, and 60 percent in stock B. The correlation coefficient between the two stocks is
0.6. What is the variance and standard deviation of the two stock portfolio?

A) Variance = 0.02206; Standard Deviation = 14.85%.

B) Variance = 0.03836; Standard Deviation = 19.59%.
C) Variance = 0.04666; Standard Deviation = 21.60%.

Explanation
(0.40)2(0.18)2 + (0.60)2(0.24)2 + 2(0.4)(0.6)(0.18)(0.24)(0.6) = 0.03836.

0.038360.5 = 0.1959 or 19.59%.

(Module 83.3, LOS 83.e)

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Question #142 of 150 Question ID: 1646135

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 return for the same risk.
B) There is a portfolio that has a lower risk for the same return.
C) The portfolio has a very high return.

Explanation

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.

(Module 83.4, LOS 83.g)

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Question #143 of 150 Question ID: 1646124

An investor's portfolio currently has an expected return of 11% with a variance of 0.0081. She is considering replacing 20% of the
portfolio with a security that has an expected return of 12% and a standard deviation of 0.07. If the covariance between the returns on
the existing portfolio and the returns on the added security is 0.0058, the variance of returns on the new portfolio will be closest to:

A) 0.00545.
B) 0.00724.
C) 0.00984.

Explanation

0.82(0.0081) + 0.22 (0.072) + 2(0.8)(0.2)(0.0058) = 0.00724.

(Module 83.3, LOS 83.e)

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Question #144 of 150 Question ID: 1646212

The beta of stock D is -0.5. If the expected return of Stock D is 8%, and the risk-free rate of return is 5%, what is the expected return of
the market?

A) +3.0%.
B) +3.5%.
C) -1.0%.

Explanation
RRStock = Rf + (RMarket – Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate

A bit of algebraic manipulation results in:

RMarket = [RRStock – Rf + (BetaStock × Rf)] / BetaStock = [8 – 5 + (-0.5 × 5)] / -0.5 = 0.5 / -0.5 = -1%

(Module 84.2, LOS 84.g)

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Question #145 of 150 Question ID: 1646109

The covariance of the market's returns with the stock's returns is 0.008. The standard deviation of the market's returns is 0.1 and the
standard deviation of the stock's returns is 0.2. What is the correlation coefficient between the stock and market returns?

A) 0.00016.
B) 0.40.
C) 0.91.

Explanation

CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x

Then, (rA,B) = CovA,B / (SDA × SDB) = 0.008 / (0.100 × 0.200) = 0.40

Remember: The correlation coefficient must be between -1 and 1.

(Module 83.3, LOS 83.d)

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Question #146 of 150 Question ID: 1646152

A plot of the expected returns and standard deviations of each possible portfolio that combines a risky asset and a risk-free asset will
be:

A) a curve that approaches an upper limit.

B) convex to the origin.
C) a straight line.

Explanation

The possible portfolios of a risky asset and a risk-free asset have a linear relationship between expected return and standard
deviation.

(Module 84.1, LOS 84.a)

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Question #147 of 150 Question ID: 1574543

Which of the following is typically the first general step in the portfolio management process?

A) Specify capital market expectations.

B) Write a policy statement.
C) Develop an investment strategy.

Explanation
The policy statement is the foundation of the entire portfolio management process. Here, both risk and return are integrated to
determine the investor's goals and constraints.

(Module 85.1, LOS 85.b)

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Question #148 of 150 Question ID: 1574600

Which of the following most accurately describes cognitive errors?

A) They are not related to conscious thought.

B) They are due primarily to faulty reasoning.
C) They stem from feelings, impulses, or intuition.

Explanation

Cognitive errors are due primarily to faulty reasoning or irrationality. Emotional biases are not related to conscious thought and
stem from feelings, impulses, or intuition.

(Module 87.1, LOS 87.a)

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Question #149 of 150 Question ID: 1646223

Consider a stock selling for $23 that is expected to increase in price to $27 by the end of the year and pay a $0.50 dividend. If the risk-
free rate is 4%, the expected return on the market is 8.5%, and the stock's beta is 1.9, what is the current valuation of the stock? The
stock:

A) is correctly valued.
B) is overvalued.
C) is undervalued.

Explanation

The required return based on systematic risk is computed as: ERstock = Rf + (ERM – Rf) × Betastock, or 0.04 + (0.085 – 0.04) × 1.9 =
0.1255, or 12.6%. The expected return is computed as: (P1 – P0 + D1) / P0, or ($27 – $23 + $0.50) / $23 = 0.1957, or 19.6%. The stock is
above the security market line ER > RR, so it is undervalued.

(Module 84.2, LOS 84.h)

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Question #150 of 150 Question ID: 1574612

Steven Murphy has a tendency of overreacting to current events and trading too much based on news or anecdotes. Which of the
following biases does Murphy most likely exhibit?

A) Overconfidence bias.
B) Loss-aversion bias.
C) Availability bias.

Explanation
Availability bias is putting undue emphasis on information that is readily available, easy to recall, or based narrowly on personal
experience or knowledge. Loss aversion arises from feeling more pain from a loss than pleasure from an equal gain. Overconfidence
bias occurs when market participants overestimate their own intuitive ability.

(Module 87.1, LOS 87.b)

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