Finance B3, Part 2

Practice exam

Welcome to the final exam. You have 120 minutes, and there are 30 multiple-choice questions.
You do not need to show your calculations. Simply put a circle around the answer you believe
to be correct on this sheet. Keep in mind that answers may be rounded. For example, if the
possible answers are A) 0%, B) 1%, C) 2%, D) 3%, and you believe the answer is 2.8%, then you
should mark D.

Note that there is exactly one correct answer for each question. For each question, you get 3
points if you answer it correctly, 0 points if you do not answer, and -1 point if you answer it
incorrectly. Therefore, it is not in your interest to guess at random. Good luck.

QUESTION 1 A B C D
QUESTION 2 A B C D
QUESTION 3 A B C D
QUESTION 4 A B C D
QUESTION 5 A B C D
QUESTION 6 A B C D
QUESTION 7 A B C D
QUESTION 8 A B C D
QUESTION 9 A B C D
QUESTION 10 A B C D
QUESTION 11 A B C D
QUESTION 12 A B C D
QUESTION 13 A B C D
QUESTION 14 A B C D
QUESTION 15 A B C D
QUESTION 16 A B C D
QUESTION 17 A B C D
QUESTION 18 A B C D
QUESTION 19 A B C D
QUESTION 20 A B C D
QUESTION 21 A B C D
QUESTION 22 A B C D
QUESTION 23 A B C D
QUESTION 24 A B C D
QUESTION 25 A B C D
QUESTION 26 A B C D
QUESTION 27 A B C D
QUESTION 28 A B C D
QUESTION 29 A B C D
QUESTION 30 A B C D
Question 1. A stock’s price increased by 30% in one year, increased by 40% in the
following year, and decreased by 50% in the third year. No dividends were paid. What is
the stock’s geometric average annual return during this three-year period?
A) -3%
B) 0%
C) 7%
D) 20%

Answer: A

[(1+0.3)*(1+0.4)*(1-0.5)]^(1/3)–1=-0.031

Question 2. At the end of the trading day on Wednesday 30th of April 2014, the share
price of Airbus was €49.49. On Thursday 29th of May 2014, Airbus paid a €0.75 dividend.
At the end of the trading day on Friday 30th of May 2014, Airbus share price was €52.61.
What was Airbus’ rate of return for the month of May 2014?
A) 5%
B) 6%
C) 7%
D) 8%

Answer: D

(52.61+0.75-49.49)/49.49=0.078

Question 3. Risk that affects the stock market as a whole is called:

A) specific
B) undiversifiable
C) unique
D) unsystematic

Answer: B

From lecture.
Question 4. Asset X has 5% expected return and Asset Y has 15% expected return. A
portfolio consisting only of assets X and Y has 12% expected return. What is the
proportion of Asset X in this portfolio?
A) 20%
B) 30%
C) 70%
D) 80%

Answer: B

12% = 5%*p+15%*(1-p) => 12 = -10p + 15 => -10p = - 3 => p=0.3

Question 5. 20% of a portfolio is invested in Treasury bills, 30% in the market index and
50% in a stock whose beta is equal to 0.8. What is the beta of the portfolio?
A) 0.7
B) 0.8
C) 0.9
D) 1.0

Answer: A

The beta of Treasury bills is 0 and the beta of the market index is 1, so the portfolio’s beta is
0.2*0+0.3*1+0.5*0.8=0.7.

Question 6. In order to optimize a portfolio of 4 risky assets, how many correlations need
to be known?
A) 4
B) 5
C) 6
D) 7

Answer: C

(4^2-4)/2=6
Question 7. If investment gain is measured in euros, then what units is the variance of
investment gain measured in?
A) Euros
B) Euros squared
C) No units
D) Percent

Answer: B

Question 8. An analyst believes that an asset has a 40% chance of experiencing a -10%
return, a 20% chance of experiencing a 0% return, and a 40% chance of experiencing a
30% return. According to the analyst, what is the asset’s expected return?
A) 7%
B) 8%
C) 9%
D) 10%

Answer: B

0.4*(-0.1)+0.2(0)+0.4(0.3)=-0.04+0.12=0.08.

Question 9. An analyst believes that an asset has a 40% chance of experiencing a -10%
return, a 20% chance of experiencing a 0% return, and a 40% chance of experiencing a
30% return. According to the analyst, what is the standard deviation of the asset’s
return?
A) 8%
B) 18%
C) 28%
D) 38%

Answer: B

p(i) r(i) r(i)*p(i) r(i)-E[r] (r(i)-E[r])^2 p(i)*(r(i)-E[r])^2

40% -10% -4% -18% 0.0324 0.01296
20% 0% 0% -8% 0.0064 0.00128
40% 30% 12% 22% 0.0484 0.01936

E[r]= 0.08 Var= 0.0336

StDev= 18.3%
Question 10. A portfolio is equally invested into three uncorrelated assets whose expected
returns are 5%, 9% and 10%, and whose standard deviations are 10%, 15% and 20%.
What is the expected return of this portfolio?
A) 6%
B) 7%
C) 8%
D) 9%

Answer: C

1/3*5%+1/3*9%+1/3*10%=8%

Question 11. A portfolio is equally invested into three uncorrelated assets whose expected
returns are 5%, 9% and 10%, and whose standard deviations are 10%, 15% and 20%.
What is the standard deviation of this portfolio?
A) 6%
B) 7%
C) 8%
D) 9%

Answer: D

Since the assets are uncorrelated, we only need to worry about adding up the variance (i.e.
diagonal) terms:

Portfolio Variance = (1/3)^2*0.1^2+(1/3)^2*0.15^2+(1/3)^2*0.2^2 = 0.008056

Portfolio Standard Deviation = 0.0898

Question 12. Which of the following portfolios is the least risky? A portfolio which is
invested:
A) Entirely in stocks
B) Entirely in Treasury bills
C) One-third in stocks and two-thirds in Treasury bills
D) Two-thirds in stocks and one-third in Treasury bills

Answer: B

According to the special case formula for investing in two assets one of which is risk-free (as
is effectively the case for Treasury bills), portfolio risk equals the proportion invested in the
risky asset times the standard deviation of the risky asset. So, if the standard deviation of the
stock portfolio is equal to s, then choices A, B, C, and D correspond to s, 0, 1/3*s and 2/3*s,
respectively.

Question 13. Over a 10-year period, a market index had one year with a -10% return, three
years with a 0% return, five years with a 10% return, and one year with a 20% return.
What was the standard deviation of returns for this market index?
A) 8%
B) 18%
C) 28%
D) 38%

Answer: A

The arithmetic average return was [-10*1+0*3+10*5+20*1]/10=6%.

The portfolio variance was [(-10-6)^2*1+(0-6)^2*3+(10-6)^2*5+(20-6)*1]/(10-1)=0.0071

The portfolio standard deviation was 0.084

Question 14. A stock has beta equal to 2. Which of the following statements is correct?
A) The stock’s standard deviation is twice as high as the standard deviation of the
market
B) The stock’s variance is twice as high as the variance of the market
C) On average, if the market goes up 2%, the stock goes up 1%
D) On average, if the market goes up 2%, the stock goes up 4%

Answer: D

Question 15. A portfolio is equally split between Treasury bills and the market index. The
portfolio’s beta is equal to:
A) 0.0
B) 0.5
C) 1.0
D) 2.0

Answer: B

The beta of Treasury bills is 0, and the beta of the market index is 1, so the portfolio’s beta
is 0.5*0+0.5*1 = 0.5.
Question 16. The expected return of a financial security is 10% and its standard deviation is
20%. Which of the following portfolios is inefficient? A portfolio which has:
A) Expected return = 5%, standard deviation = 15%
B) Expected return = 5%, standard deviation = 25%
C) Expected return = 15%, standard deviation = 15%
D) Expected return = 15%, standard deviation = 25%

Answer: B

Portfolio B has higher risk and lower return than the security, therefore it is inefficient (since
simply putting 100% of one’s money into the security results in a better risk/return profile
than Portfolio B).

Question 17. According to the CAPM, a stock’s expected return is proportional to its
A) Market capitalization
B) Previous year’s return
C) Systematic risk
D) Variance

Answer: C

Systematic risk is measured by beta.

Question 18. Which of the following are held by debtholders?

A) Bonds
B) Equities
C) Shares
D) Stocks

Answer: A

Question 19. The expected return on a firm’s debt is 4%, its debt ratio is 0.5, its equity beta
is 1, and the expected return on the market portfolio is 6%. There are no taxes. What is
the firm’s cost of capital?
A) 5%
B) 6%
C) 7%
D) 8%

Answer: A

The cost of equity is Rf+1*(6%-Rf)=6%, so COC=0.5*4%+0.5*6%=5%

Question 20. A firm’s beta is equal to 0.8, the expected return on the market portfolio is
8%, and the risk-free rate is 3%. What is this company’s cost of capital?
A) 5%
B) 6%
C) 7%
D) 8%

Answer: C

3%+0.8*(8%-3%)=7%

Question 21. Over a certain 30-year period, the arithmetic average returns on Treasury
bills, corporate bonds and stocks were 2%, 5% and 9%, respectively. What was the
market risk premium during this 30-year period?
A) 0%
B) 3%
C) 4%
D) 7%

Answer: D

9% - 2% = 7%

Question 22. A portfolio is invested equally in two stocks whose variances are equal to 0.10
and 0.20, and whose covariance is equal to 0.05. What is the variance of the portfolio?
A) 0.05
B) 0.10
C) 0.15
D) 0.20
Answer: B

Portfolio variance = 0.5*0.5*0.10 + 0.5*0.5*0.20+2*0.5*0.5*0.05

= 0.25*(0.10 + 0.20 +0.10) = 0.25*0.4 = 0.10

Question 23. What is the beta of an asset whose standard deviation is 30% and whose
correlation with the market portfolio is 0.6, given that the standard deviation of the
market is 20%?
A) 0.6
B) 0.7
C) 0.8
D) 0.9

Answer: D

30/20*0.6=1.5*0.6=0.9

Question 24. All else being equal, investors should seek portfolios which have:
A) Low expected return and low variance
B) Low expected return and high variance
C) High expected return and low variance
D) High expected return and high variance

Answer: C

From lecture

Question 25. If the risk free rate is 2%, the market risk premium is 4%, and a stock’s beta is
0.5, what is the stock’s expected return?
A) 3%
B) 4%
C) 5%
D) 6%

Answer: B

2%+0.5*4%=4%
Question 26. The risk free rate is equal to 5%. One of portfolios A, B, C and D is the
tangency portfolio. Which portfolio is it?

Portfolio Standard Deviation Expected Return

A 15% 10%
B 20% 13%
C 25% 14%
D 30% 15%
A) Portfolio A
B) Portfolio B
C) Portfolio C
D) Portfolio D

Answer: B

The Sharpe ratios for these portfolios are:

A: (10-5)/15=0.333

B: (13-5)/20=0.400

C: (14-5)/25=0.360

D: (15-5)/30=0.333

Portfolio B has the highest Sharpe ratio (i.e. the highest slope of the line passing through
the portfolio and the risk-free asset) among the four portfolios, so only B can be the
tangency portfolio. Since we are told that one of the four portfolios is, in fact, the tangency
portfolio, the answer has to be B.

Question 27. The market portfolio has expected return equal to 10%, and the risk-free rate
is equal to 4%. Stocks X and Y both betas equal to 0.5. Stock X has expected return of
8%, and Stock Y has expected return equal to 6%. According to the CAPM, which of the
following statements about stocks X and Y is correct?
A) X and Y are overvalued.
B) X and Y are undervalued.
C) X is overvalued, Y is undervalued.
D) X is undervalued, Y is overvalued.

Answer: D
According to the CAPM, the expected return on a stock with beta equal to 0.5 should be
halfway between the expected returns of the risk-free asset and the market portfolio, i.e.
(4%+10%)/2=7%. X has higher expected return that 7%, so its price must be lower than
predicted by the CAPM – i.e. it is undervalued. Analogously, Y has lower expected return
than 7%, so it is overvalued.

Question 28. With all other factors being equal, a bond with a longer maturity will have:
(A) lower price volatility
(B) greater price volatility
(C) lower coupon rate
(D) higher coupon rate

Answer: B

See lecture notes: price-yield relationship. With yield-to-maturity & coupon rate = const,
bonds with longer maturity have greater price volatility

Question 29. A four-year government bond with an annual coupon rate of 6% and par
value of $100 has just been issued. The yield to maturity is at 8%. What is the price of
this bond.
(A) $75.36
(B) $81.37
(C) $93.38
(D) $106.39

Answer: C

P = 6/(1+0.08) + 6/(1+0.08)^2 + 6/(1+0.08)^3 + 6/(1+0.08)^4 + 100/(1+0.08)^4 = $93.38

Question 30. A four-year government bond with an annual coupon rate of 6% and par
value of $100 has just been issued. The yield to maturity is at 8%. What is the duration
for this 4-year bond.
(A) 2.44
(B) 2.86
(C) 3.24
(D) 3.66

Answer: D
P = 6/(1+0.08) + 6/(1+0.08)^2 + 6/(1+0.08)^3 + 6/(1+0.08)^4 + 100/(1+0.08)^4 = $93.38

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( ( ( (
!$%.' (!$%.%')) (!$%.%'), (!$%.%')- (!$%.%')-
Duration = = 3.66
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