Question

1 Risk(s) of diversifying an investment portfolio internationally may include each of the

                                                                following EXCEPT

1. possible fluctuations in the currency exchange rates.
2. political risk associated with actions the governments in other countries may take.
3. an increase in the number and variety of holdings within the investor’s portfolio.
4. the possibility that a foreign government may be overthrown.

2 Each of the following is a “systematic” risk factor that cannot be eliminated by

                                                                diversifying a portfolio EXCEPT

1. the level of interest rates in the economy.
2. a labor strike at the General Motors’ production facilities.
3. the unemployment level.
4. the annual inflation rate.

3. With regard to beta in the Security Market Line (SML) equation,

1. the beta coefficient for the entire market equals 1.0.
2. beta values higher than 1.0 are more risky than the market average.
3. beta values less than 1.0 are less risky than the market average.
4. A and B and C.
5. B and C.

4 In the Security Market Line (SML) equation, the return on the ________________

                                                                can be used as an approximation of the risk-free rate of return (R_F).

1. U.S. Treasury Bill (T-Bill).
2. Dow Jones’ Industrial Average.
3. Standard & Poor’s 500 Index.
4. Moody’s Bond Index.

5. Assume that inflation is expected to increase by 2% during the coming year. This will

1. cause the entire Security Market Line (SML) equation, when graphed, to shift downward

by 2%.

2. cause the entire Security Market Line (SML) equation, when graphed, to shift upward by 2%.
3. have no impact on the graph of the Security Market Line (SML) equation.

6. Assume that investor risk aversion decreases due to the very favorable economy. This will

1. have no impact on the graph of the Security Market Line (SML) equation.
2. cause the Y-axis intercept of the Security Market Line (SML) equation to remain constant,

when graphed, but increase the slope of the SML.

3. cause the Y-axis intercept of the SML equation to remain constant, when graphed, but

decrease the slope of the SML.

4. cause the entire SML, when graphed, to shift downward, parallel to the original SML graph.

Answer 1

1. The correct option is C

Reason: Diversifying your holdings and increasing the variety only leads to lessening the risk factor. Thus this option is odd one out. All the other options A, C & D are factors which can be considered as potentially risky for the portfolio.

2. Option B is the correct option.

The reason is that we can reduce / eliminate risk of being invested in a General Motor's company by diversifying and/or completely exiting the general motor's investment. This way we would be saved of the coutcome of the general motor's labour strike and it won't impact our portfolio negatively.

Other options such as unemployment rate, interest rate and annual inflation rate are all factors which operate at the economic level. Thus they cannot be eliminated as they have an impact which is seen across all sectors etc.

3. Option D is the correct option.

Market has Beta of 1.
If the beta is less than 1 i.e. say 0.8, then if the market falls by 1%, the stock with beta 0.8 will fall by only 0.8%. Similarly for the rise.

If the beta is more than 1 i.e. say 1.2, then if the market falls by 1%, the stock with beta 1.2 will fall by 1.2%. Similarly for the rise.

4. Option A is the correct option.

We need to assume the US Treasury Bill as an approximation for the risk free rate of return. This is because amongst all the above options i.e. Dow Jones, Standard & Poors & Moody's Bond Index, all of them are market driven forces of supply and demand. Also there may be recession in which case the entire financial system and all the stock and bond market indices may lose credibility. However we assume that the US government is the safest of all options as the government won't lose credibility and the US public can rely on these Treasury bills as the US government won't default. Thus it is considered as an approximation of the risk free rate of return.