CFA Level 1 - Portfolio Management Session 12 - Reading 52 Portfolio Risk and Return: Part I-LOS c

CFA Level 1 – Portfolio Management, Session 12 – Reading 52

Portfolio Risk and Return: Part I-LOS c

(Notes, Practice Questions, Sample Questions)
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1. A bond analyst is looking at historical returns for two bonds, Bond 1 and Bond 2. Bond 2’s returns are much more volatile than Bond 1. The variance of returns for Bond 1 is 0.012 and the variance of returns of Bond 2 is 0.308. The correlation between the returns of the two bonds is 0.79, and the covariance is 0.048. If the variance of Bond 1 increases to 0.026 while the variance of Bond B decreases to 0.

188 and the covariance remains the same, the correlation between the two bonds will:

A) remain the same.

B) increase.

C) decrease. [Explanation: P1,2 = 0.048/(0.0260.5 × 0.1880.5) = 0.69 which is lower than the original 0.79]

2. Stock A has a standard deviation of 10%. Stock B has a standard deviation of 15%. The covariance between A and B is 0.0105. The correlation between A and B is:

A) 0.55.

B) 0.70. [Explanation: CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x.

Then, (rA,B) = CovA,B / (SDA × SDB) = 0.0105 / (0.10 × 0.15) = 0.700]

C) 0.25.

3. The standard deviation of the rates of return is 0.25 for Stock J and 0.30 for Stock K. The covariance between the returns of J and K is 0.025. The correlation of the rates of return between J and K is:

A) 0.33. [Explanation: CovJ,K = (rJ,K)(SDJ)(SDK), where r = correlation coefficient and SDx = standard deviation of stock x.

Then, (rJ,K) = CovJ,K / (SDJ × SDK) = 0.025 / (0.25 × 0.30) = 0.333]

B) 0.10.

C) 0.20.

4. If the standard deviation of stock A is 10.6%, the standard deviation of stock B is 14.

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6%, and the covariance between the two is 0.015476, what is the correlation coefficient?

A) 0.0002.

B) 0.

C) +1. [Explanation: The formula is: (Covariance of A and B) / [(Standard deviation of A)(Standard Deviation of B)] = (Correlation Coefficient of A and B) = (0.015476) / [(0.106)(0.146)] = 1]

5. If the standard deviation of returns for stock A is 0.40 and for stock B is 0.30 and the covariance between the returns of the two stocks is 0.007 what is the correlation between stocks A and B?

A) 17.14300.

B) 0.05830. [Explanation: CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x.

Then, (rA,B) = CovA,B / (SDA × SDB) = 0.007 / (0.400 × 0.300) = 0.0583]

C) 0.00084.

6. If the standard deviation of asset A is 12.2%, the standard deviation of asset B is 8.9%, and the correlation coefficient is 0.20, what is the covariance between A and B?

A) 0.0022. [Explanation: The formula is: (correlation)(standard deviation of A)(standard deviation of B) = (0.20)(0.122)(0.089) = 0.0022]

B) 0.0001.

C) 0.0031.

7. Stock A has a standard deviation of 10.00. Stock B also has a standard deviation of 10.00. If the correlation coefficient between these stocks is – 1.00, what is the covariance between these two stocks?

A) -100.00.; [Explanation: Covariance = correlation coefficient × standard deviationStock 1 × standard deviationStock 2 = (- 1.00)(10.00)(10.00) = – 100.00]

B) 1.00.

C) 0.00.

8. The correlation coefficient between stocks A and B is 0.75. The standard deviation of stock A’s returns is 16% and the standard deviation of stock B’s returns is 22%. What is the covariance between stock A and B?

A) 0.0264.; [Explanation: cov1,2 = 0.75 × 0.16 × 0.22 = 0.0264 = covariance between A and B]

B) 0.3750.

C) 0.0352.

9. If two stocks have positive covariance, which of the following statements is CORRECT?

A) The two stocks must be in the same industry.

B) If one stock doubles in price, the other will also double in price.

C) The rates of return tend to move in the same direction relative to their individual means.; [Explanation: This is a correct description of positive covariance. If one stock doubles in price, the other will also double in price is true if the correlation coefficient = 1. The two stocks need not be in the same industry]

10. A measure of how well the returns of two risky assets move together is the:

A) covariance.; [Explanation: This is a correct description of covariance. A positive covariance means the returns of the two securities move in the same direction. A negative covariance means that the returns of two securities move in opposite directions. A zero covariance means there is no relationship between the behaviors of two stocks. The magnitude of the covariance depends on the magnitude of the individual stock’s standard deviations and the relationship between their co-movements. The covariance is an absolute measure of movement and is measured in return units squared]

B) standard deviation.

C) range.

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