Finance True And False Questions! Quiz

A portfolio's alpha measures its performance relative to a benchmark. A zero alpha indicates that the portfolio's return is equal to the benchmark's return. If the expected return of the portfolio is lower than the risk-free rate, it means that the portfolio is not generating enough return to compensate for the risk taken. Since the risk-free rate is the minimum return an investor can earn without taking any risk, a portfolio with a lower expected return must have a negative beta. A negative beta implies that the portfolio's returns move in the opposite direction of the overall market, indicating a higher level of risk.

In the risk-return diagram, the efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk. Any individual asset or portfolio that plots on or inside the efficient frontier means that it is achieving a higher return for the same level of risk or a lower risk for the same level of return compared to other assets or portfolios. Therefore, it is true that individual assets or portfolios will always plot on or inside the efficient frontier in the risk-return diagram.

A portfolio with a zero alpha means that it is not outperforming or underperforming the market. If the expected return is lower than the risk-free rate, it suggests that the portfolio is not generating enough return to compensate for the risk taken. This implies that the portfolio is less risky than the market, and thus it must have a negative beta. A negative beta indicates that the portfolio's returns move in the opposite direction of the market, providing a hedge against market downturns. Therefore, the statement is true.

A well-diversified portfolio with a zero beta means that it is not correlated with the overall market. This implies that the portfolio's returns are not affected by market fluctuations. Since the risk-free asset also has a stable return and no volatility, a well-diversified portfolio with a zero beta will behave in the same way as the risk-free asset. Therefore, the statement is true.

When interest rates increase, the yield on bonds also increases. This means that the bond's value decreases because the fixed interest payments it offers become less attractive compared to other investments with higher yields. Conversely, when interest rates decrease, the yield on bonds decreases, making their fixed interest payments more attractive and increasing the bond's value. Therefore, it is true that a bond's value is inversely related to interest rates (as proxied by the yield).

The statement is true because the price of a bond and its yield-to-maturity have an inverse relationship. When the yield-to-maturity of a bond increases, it means that the bond's interest payments become less attractive compared to other investment opportunities. As a result, the demand for the bond decreases, causing its price to decrease. Conversely, when the yield-to-maturity decreases, the bond becomes more attractive, leading to an increase in demand and consequently an increase in price. Therefore, the price of a bond is inversely related to its yield-to-maturity.

The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk. Any individual asset or portfolio that plots on or inside the efficient frontier is considered to be efficient because it provides the highest return for its level of risk. Therefore, it is true that individual assets or portfolios will always plot on or inside the efficient frontier in a risk-return diagram.

This statement is true because a portfolio that does not involve borrowing or short-selling is limited to investing in its constituent assets only. The expected return of a portfolio is determined by the weighted average of the expected returns of its constituent assets. Therefore, it is not possible for the portfolio's expected return to exceed that of its constituent assets.

Bonds with longer time to maturity are more sensitive to interest rate risk because they have a longer period of time in which their coupon payments are fixed, making them more vulnerable to changes in interest rates. As interest rates rise, the value of existing bonds decreases, and longer-term bonds are affected more because their fixed coupon payments become less attractive compared to newer bonds with higher coupon rates. On the other hand, if interest rates decrease, longer-term bonds become more valuable as their fixed coupon payments become more attractive. Therefore, it is true that a bond with a longer time to maturity is more sensitive to interest rate risk than a bond with a shorter time to maturity.

A portfolio of stocks with identical betas means that the stocks in the portfolio move in tandem with the overall market. This implies that the portfolio's expected return will be the same as the individual stocks' expected returns. However, the total risk of the portfolio will be lower than that of the constituent stocks because the diversification effect reduces the impact of individual stock movements. By combining stocks with identical betas, the portfolio can achieve a similar expected return while reducing overall risk.

When adding an additional risky asset to an existing universe of risky assets in the risk-return diagram, the GMV (Global Minimum Variance) portfolio is likely to move up or to the left, or both. This is because the addition of another risky asset increases the potential for diversification and lowers the overall risk of the portfolio. The GMV portfolio represents the optimal combination of assets that minimizes risk for a given level of return. Moving to the right or downwards would imply higher risk for the same level of return, which goes against the principles of portfolio optimization. Therefore, the statement is true.

In finance, short-selling refers to the practice of selling assets that one does not currently own, with the intention of buying them back at a lower price in the future. If no short-selling is allowed, it means that an investor can only buy assets and hold them, without the ability to sell assets they do not own. In such a scenario, the expected return on any portfolio is limited to the maximum return of the constituent assets, as the investor cannot benefit from any potential decline in asset prices. Therefore, the statement is true.

This statement is true because the Sharpe ratio is a measure of risk-adjusted return, calculated by dividing the excess return of an investment by its volatility. It allows investors to compare the returns of different assets while considering the level of risk involved. Since the risk-free asset has no volatility, its Sharpe ratio is infinite. As a result, regardless of the investors' risk aversion coefficients, the optimal complete portfolios will have the same Sharpe ratio as the risk-free asset. However, the expected returns and volatilities of the portfolios will differ based on the investors' risk preferences.

Macaulay's duration is a measure of the weighted average time it takes to receive the cash flows from a bond, including both coupon payments and the return of principal at maturity. For a zero-coupon bond, there are no coupon payments, so the entire cash flow is received at maturity. Therefore, the Macaulay's duration of a zero-coupon bond is equal to its maturity.

If markets are semi-strong form efficient, it means that all publicly available information is already reflected in the stock prices. Therefore, it would not be worth paying a management fee to a fund that claims to implement "technical trading" strategies, as these strategies rely on analyzing historical price patterns and trends to make investment decisions. Since all relevant information is already incorporated into the stock prices, technical analysis would not provide any additional advantage in terms of generating higher returns.

If markets are weak-form efficient, it means that all publicly available information is already reflected in the stock prices. In such a scenario, it is unlikely for a fund manager to consistently outperform the market by using technical trading strategies. Therefore, it would not be worth paying a management fee to a fund manager who claims to "beat the market" in this situation.

If markets are strong-form efficient, all information, including both public and private information, is already reflected in the current stock prices. Therefore, it would be impossible for any investor, even those using actively managed investment strategies, to consistently outperform the market and earn positive returns in the long run. Consequently, the long-run average return on any investment strategy would not be zero but rather negative, as transaction costs and fees would eat into any potential gains. Hence, the statement is false.

If two portfolios have the same beta but different average returns, it means that they have the same sensitivity to market movements but generate different overall returns. Alpha measures the excess return of a portfolio compared to its expected return based on its beta. Therefore, if the portfolios have different average returns, it implies that at least one of them has a non-zero alpha, indicating that it is outperforming or underperforming the market. Hence, the statement is true.

If markets are strong-form efficient, it means that all information, including both public and private, is already reflected in the prices of financial assets. In such a scenario, it would be extremely difficult for any investor or fund manager to consistently outperform the market and generate above-average returns. However, it does not necessarily mean that the long-run average return on any actively managed investment strategy will be zero. There may still be periods where active managers can outperform or underperform the market, resulting in positive or negative average returns over the long run. Therefore, the statement is false.

The statement is true because the volatility of an investor's optimal portfolio is directly related to the investor's coefficient of risk aversion. A risk-averse investor is more likely to have a less volatile portfolio, as they are more concerned about minimizing risk. Therefore, if no risk-free asset is traded, the volatility of the portfolio will be inversely related to the investor's coefficient of risk aversion.

Diversification is a risk management strategy that involves investing in a variety of assets to reduce the impact of any single investment's performance on the overall portfolio. When assets are perfectly positively correlated, it means that their returns move in perfect synchronization, so if one asset performs poorly, all others will as well. In this scenario, diversification would not provide any benefit because all assets would be affected equally. However, in any other case where assets have even a slight degree of correlation, diversification can still provide some level of benefit by spreading risk and potentially reducing losses. Therefore, the statement that diversification will always provide some benefit unless returns are perfectly positively correlated is true.

Diversification can work even if all the stocks in a portfolio have identical high volatilities. Diversification is the strategy of spreading investments across different assets to reduce risk. By including stocks with high volatilities, the portfolio may experience greater fluctuations in value, but if these stocks are not perfectly correlated, diversification can still provide benefits. The goal is to have a mix of assets that react differently to market conditions, so that if one stock performs poorly, others may perform well, thereby reducing overall risk. Therefore, the statement is false.

If two assets are perfectly negatively correlated, it means that when the value of one asset increases, the value of the other asset decreases by the same amount. This correlation helps to offset the risks associated with each asset. By combining these assets in a portfolio, the fluctuations in their values cancel each other out, resulting in zero total risk. Therefore, the statement is true.

The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk. Individual assets, on the other hand, have their own risk-return characteristics. Since the efficient frontier represents the optimal portfolios, it follows that individual assets will always plot on or inside the efficient frontier. This is because any portfolio that includes an individual asset will have a risk-return profile that is equal to or worse than the efficient frontier. Therefore, the statement is true.

A well-diversified portfolio with a beta of zero means that it is not sensitive to market movements. This implies that its returns are not influenced by changes in the overall market, making it similar to a risk-free asset. Since the risk-free asset has a constant return and volatility, a well-diversified portfolio with a beta of zero will also exhibit the same behavior. Therefore, the statement is true.

A bond's duration measures its sensitivity to changes in interest rates. A higher coupon rate implies higher periodic interest payments, which can offset the bond's price volatility caused by interest rate fluctuations. Therefore, a bond with a higher coupon rate will have a lower duration because its cash flows are received sooner, reducing the bond's sensitivity to interest rate changes. Thus, the statement that a bond with a higher coupon rate will have a higher duration is false.

Adding a zero-beta asset to a portfolio containing stocks with positive betas will reduce the portfolio's risk because the zero-beta asset is not correlated with the market and will provide diversification benefits. However, it will also affect the portfolio's expected return. The expected return of the portfolio will decrease because the zero-beta asset typically has a lower expected return compared to the stocks with positive betas. Therefore, the statement is false.

The Random Walk Model suggests that past events can still have an impact on current asset prices. This means that even if an event occurred a long time ago, its effects can still be observed in today's prices. If the event had not occurred, the prices would be different. Therefore, the statement "True" is a correct explanation of the Random Walk Model.

A portfolio of stocks with identical betas and identical volatilities will have the same expected return as, but lower volatility than its constituent stocks. This is because when stocks are combined in a portfolio, their individual volatilities tend to offset each other, resulting in a lower overall volatility for the portfolio. However, the expected return remains the same as the weighted average of the expected returns of the individual stocks.

The statement is true because when there is a risk-free asset available, investors can earn a risk-free return by investing in it. As a result, the expected return of the optimal risky portfolio, which consists of risky assets, will also increase in order to compensate for the additional risk taken. Similarly, the volatility of the optimal risky portfolio will also increase as investors demand a higher return for taking on more risk. Therefore, both the expected return and the volatility of the optimal risky portfolio are positively related to the risk-free interest rate.

The statement is true because without a risk-free asset, the optimal portfolio for an investor will be closer to the Global Minimum Variance (GMV) on the frontier. This is because the GMV represents the portfolio with the lowest level of risk for a given level of expected return. As the investor's risk aversion increases, they will be more inclined to choose a portfolio with lower risk, hence moving closer to the GMV on the frontier.

A bond with a higher coupon rate will actually have a shorter duration than an otherwise identical bond with lower coupons. Duration is a measure of a bond's sensitivity to changes in interest rates. Higher coupon payments provide more cash flow to the bondholder, which reduces the bond's price volatility and therefore its duration. On the other hand, lower coupon payments make the bond more sensitive to interest rate changes, resulting in a longer duration.

This statement is true because when a portfolio does not involve borrowing or short-selling, it means that the investor can only invest in the assets that are already available in the market. In such a scenario, the expected return of the portfolio is determined by the weighted average of the expected returns of its constituent assets. Since the portfolio cannot generate returns higher than the assets it holds, the expected return of the portfolio cannot exceed that of its constituent assets.

A portfolio of stocks with identical returns and volatilities will have the same expected return as the constituent stocks because the expected return of a portfolio is the weighted average of the expected returns of its constituent stocks. However, the portfolio will have lower volatility because the volatilities of the stocks tend to cancel each other out to some extent when combined in a portfolio. This is due to diversification, which reduces the overall risk of the portfolio. Therefore, the statement is true.

Adding an additional risky asset to an existing universe of risky assets does not necessarily restrict the movement of the Global Minimum Variance (GMV) portfolio to only the north-east direction. The GMV portfolio represents the portfolio with the lowest volatility or risk. When a new risky asset is added, the GMV portfolio can move in any direction depending on the risk and return characteristics of the new asset and the existing assets. Therefore, the statement is false.

The statement is false because the optimal complete portfolio for two investors with different risk aversion coefficients will have the same Sharpe ratio. The Sharpe ratio measures the excess return per unit of risk, and it is independent of an investor's risk aversion. Therefore, regardless of their risk aversion coefficients, both investors will aim to construct a portfolio that maximizes the Sharpe ratio, resulting in the same optimal complete portfolio.

This statement is false because the volatility of a portfolio can be lower than the minimum volatility of its constituent assets even if short-selling is not allowed. This can be achieved by diversifying the portfolio and selecting assets with low correlations to each other. Diversification helps to reduce the overall risk and volatility of the portfolio, even without short-selling. Therefore, the statement is not true.

A bond is valued at par when the coupon rate (the interest rate on the bond) is equal to the yield (the rate of return on the bond). This means that the bond is being sold at its face value, and the interest payments received by the bondholder are equal to the yield they are earning on the bond. If the coupon rate and yield are not equal, the bond will be valued either at a premium (if the coupon rate is higher than the yield) or at a discount (if the coupon rate is lower than the yield).

A bond's duration measures the sensitivity of its price to changes in interest rates. When interest rates rise, the price of a bond with a longer duration will decline more than the price of a bond with a shorter duration. This is because the longer duration bond has a longer time period over which it will be affected by the higher interest rates. On the other hand, when interest rates fall, the price of a bond with a longer duration will increase more than the price of a bond with a shorter duration. Therefore, since duration and yield-to-maturity move in opposite directions, it is true that a bond's duration is inversely related to its yield-to-maturity.

Adding a zero-beta asset to a portfolio containing stocks with positive betas will actually affect its expected return. This is because the zero-beta asset will have a different expected return compared to the stocks with positive betas. The expected return of a portfolio is a weighted average of the expected returns of its individual assets, and the addition of a zero-beta asset will change the weights and therefore the overall expected return of the portfolio.

The Random Walk Model states that the future price of an asset cannot be predicted based on its past price. This is because the model assumes that the price movements are random and unpredictable. Therefore, the best prediction of an asset's future price is not the long-run average of its past price, but rather it is considered to be unpredictable.

Diversification can produce benefits even if all the assets in the portfolio are not negatively correlated. While negative correlation can help reduce risk, diversification can still provide benefits by spreading investments across different asset classes or industries. This helps to reduce the impact of any single investment's performance on the overall portfolio. Positive correlation between assets can still provide some level of diversification, as long as the assets are not perfectly correlated. Therefore, the statement that at least some assets must be negatively correlated for diversification to produce any benefit is false.

Assets or portfolios with negative beta will not always plot below the security market line (SML). The SML represents the expected return of an asset or portfolio based on its beta, which measures its sensitivity to market movements. A negative beta indicates that the asset or portfolio moves in the opposite direction of the overall market. While assets with negative beta tend to be less risky during market downturns, they can still plot above or below the SML depending on their specific risk and return characteristics. Therefore, the statement is false.

The statement is false because the "Random Walk Model" suggests that the future returns on any asset are independent of past returns. In other words, the model assumes that future price movements are unpredictable and cannot be forecasted based on past returns. Therefore, the best forecast of the next period's return is not the return in the previous period.

The statement is false because the level of risk aversion of investors plays a crucial role in determining the optimal portfolios. Investors with different levels of risk aversion will have different preferences for risk and return trade-offs. Therefore, their optimal portfolios will have different volatilities, as they will choose different combinations of risky assets based on their risk aversion levels.

In the time-series formulation of the CAPM, "alpha" is not a measure of an asset's idiosyncratic risk. Instead, "alpha" represents the excess return of an asset above what would be expected based on its beta. It measures the asset's performance relative to the market. Therefore, the correct answer is False.

Diversification is a risk management strategy that involves spreading investments across different assets to reduce the impact of any single investment's performance on the overall portfolio. It is not necessary for the constituent stocks to have a negative correlation with each other for diversification to have an effect. In fact, diversification can still provide benefits even if the stocks have a positive correlation, as long as their returns are not perfectly correlated. By investing in different stocks with different risk and return characteristics, diversification can help to reduce the overall risk of the portfolio.

Diversification can reduce the volatility caused by a systematic risk factor regardless of its correlation with the business cycle. By investing in a variety of assets that are not perfectly correlated, the impact of any one factor on the overall portfolio is minimized. Therefore, diversification can help reduce volatility even if the risk factor is not negatively correlated with the business cycle.

If markets are strong-form efficient, it means that all information, both public and private, is already reflected in the prices of financial assets. In such a scenario, it would be impossible for any investor, including actively managed ones, to consistently outperform the market and earn positive returns in the long run. However, this does not imply that the average return on any investment would be zero. It simply means that while some investors may earn positive returns, others may earn negative returns, resulting in an average return that is not necessarily zero. Therefore, the statement is false.

The given statement is true. The efficient frontier represents a set of portfolios that offer the highest expected return for a given level of risk. The Global Minimum Variance (GMV) portfolio is the portfolio with the lowest level of risk on the efficient frontier. If there is no risk-free asset available, the distance between an investor's optimal portfolio and the GMV portfolio on the efficient frontier will be inversely related to the investor's coefficient of risk aversion. This means that as the investor becomes more risk-averse, the distance between the two portfolios will increase.