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1. Which of the following statements regarding risk-averse investors is true?

Risk-averse investors only accept risky investments that offer risk premiums over the risk-free rate.

7
1. The standard deviation of a two-asset portfolio is a linear function of the assets' weights when the assets
have a correlation coefficient equal to one.
2. Typically, as more securities are added to a portfolio, total risk would be expected to decrease at a decreasing
rate.
3. An investor who wishes to form a portfolio that lies to the right of the optimal risky portfolio on the capital
allocation line must borrow some money at the risk-free rate and invest in the optimal risky portfolio. This
also implies that the investors must invest only in risky securities.
4. A statistic that measures how the returns of two risky assets move together is correlation or covariance.
5. Portfolio theory as described by Markowitz is most concerned with the effect of diversification on portfolio
risk.

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Which statement is not true regarding the market portfolio?
It must be the tangency point between the capital market line and the indifference curve.

11
Studies of positive earnings surprises have shown that there is a positive abnormal return on
the day positive earnings surprises are announced and a positive drift in the stock price on the days
following the earnings surprise announcement.

12
Some economists believe that the anomalies literature is consistent with investors inability to always
process information correctly and therefore they infer incorrect probability distributions about future
rates of return and given a probability distribution of returns, they often make inconsistent or
suboptimal decisions.

If a person gives too much weight to recent information compared to prior beliefs, they would make
forecasting errors.

Statman argues that mental accounting is consistent with some investors' irrational preference
for stocks with high cash dividends and with a tendency to hold losing positions too long.

Arbitrageurs may be unable to exploit behavioral biases due to fundamental risk, model risk and
implementation costs.

The Dow theory posits that the three forces that simultaneously affect stock prices are the primary
trend, intermediate trend, and minor trend.

The put/call ratio is computed as the number of outstanding put options divided by outstanding call
options and higher values are considered bullish or bearish signals.
14

The current yield on a bond is equal to annual interest payment divided by the current market price.
A coupon bond is a bond that pays interest on a regular basis (typically every six months).

Consider two bonds, X and Y. Both bonds presently are selling at their par value of $1,000. Each
pays interest of $150 annually. Bond X will mature in 6 years while bond Y will mature in 7 years.
If the yields to maturity on the two bonds decrease from 15% to 12%

If the yields to maturity on the two bonds decrease from 15% to 12% both bonds will increase in value, but
bond Y will increase more than bond X. It is a general property that, ceteris paribus, the prices of bonds with
longer maturities change more as required yields change.

Consider a 5-year bond with a 10% coupon that has a present yield to maturity of 8%. If interest
rates remain constant, one year from now the price of this bond will be

If interest rates remain constant, one year from now the price of this bond will be lower. The bonds is currently
selling at a premium to par. To prevent arbitrage, the bond must sell at par when it matures. Thus, each
year, the premium decreases (price declines toward par).

The more volatile the underlying stock, the greater the value of the conversion feature. This is because the
probability of profitable conversion increases.

When a bond indenture includes a sinking fund provision, bondholders may lose because their bonds can be
repurchased by the corporation at below-market prices.

Bond analysts might be more interested in a bond's yield to call if interest rates are expected to fall. If rates fall,
firms may desire to call higher coupon bonds.

One year ago, you purchased a newly issued TIPS bond that has a 6% coupon rate, five years to maturity,
and a par value of $1,000. The average inflation rate over the year was 4.2%. What is the amount of the
coupon payment you will receive and what is the current face value of the bond?

The bond price, which is indexed to the inflation rate, becomes $1,000 × 1.042 = $1,042. The interest payment is
based on the coupon rate and the new face value. The interest amount equals $1,042 × .06 = $62.52.

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Fiscal policy is difficult to implement quickly because it requires political negotiations and much of government
spending is non-discretionary and cannot be changed.

If the economy is growing, firms with low operating leverage will experience smaller increases in profits than firms
with high operating leverage.

According to Michael Porter, there are five determinants of competition. An example of pressure from substitute
products is when the availability of substitutes limits the prices that can be charged to customers.
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You wish to earn a return of 10% on each of two stocks, C and D. Each of the stocks is expected
to pay a dividend of $2 in the upcoming year. The expected growth rate of dividends is 9% for
stock C and 10% for stock D. The intrinsic value of stock C will be less than the intrinsic value
of stock D.
Given that dividends are equal, the stock with the higher growth rate will have the
higher value.

Historically, P/E ratios have tended to be lower when inflation has been high.

If a firm has a required rate of return equal to the ROE the amount of earnings
retained by the firm does not affect market price or the P/E.

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The straightforward generalization of the simple CAPM to international stocks is problematic because
taxes, transaction costs, and capital barriers across countries make it difficult for investors to hold a
world index portfolio. Also, investors in different countries view exchange rate risk from the
perspective of different domestic currencies and inflation risk perceptions by different investors in
different countries will differ as consumption baskets differ.