Series 7: Chapter 10 Practice Question Answers

Chapter 10 Practice Question Answers

1. 1. Answer: B. The alpha of the portfolio is equal to the actual return minus the expected return. Using CAPM, the expected return of the portfolio is 2% + (1.0 x (8% – 2%)) = 8%. Note that because the beta is equal to 1.0, the risk-free rate is irrelevant here and the expected return is simply equal to the performance of the market. Alpha = 6% – 8% = -2%.
2. 2. Answer: C. The formula for the capital asset pricing model (CAPM) is given by the following: return on stock = risk-free rate + beta of stock x (return of broad market – risk-free rate). Plugging in for Stock ABC gives: return on Stock ABC = 3% + (1.2 x (11% – 3%)) = 12.6%. Note that the standard deviation is not used in the CAPM formula.
3. 3. Answer: C. Investment strategies can be broadly categorized into two types: active strategies and passive strategies. Investors who use active strategies play an active role in choosing the specific securities in their portfolio. In contrast, passive investors do not play an active role in managing their portfolio. Instead, they often rely on investment vehicles that are managed by others, such as mutual funds. They also invest in vehicles that mimic the performance of a market index. Index funds, exchange-traded funds (ETFs), and unit investment trusts (UITs) are passively managed investment vehicles. Other passive strategies include dollar cost averaging, bond laddering, and hedging. If investing in individual securities, passive investors often employ a buy and hold strategy.
4. 4. Answer: C. Broad-based index funds and ETFs have low costs because they employ a passive investing approach and, therefore, do not need to hire a traditional portfolio manager or a team of research analysts to select securities on a routine basis. Broad-based index funds and ETFs are also more tax-efficient because fewer transactions take place in the fund, le