Investments

Midterm
This is an open-book midterm exam. I’ve provided a hint after each question—please use it to
read the corresponding chapter and page(s) and answer accordingly. Preparing these questions
took a lot of effort, so do not use AI tools. By working through them yourself, you will learn the
course material more effectively.

1) Which statement best distinguishes real assets from financial assets?

A. Real assets are liquid claims; financial assets produce goods and services

B. Real assets generate net output; financial assets allocate ownership of income

C. Both create net wealth for the economy in the same way

D. Financial assets are tangible; real assets are intangible

Hint: Ch.1, p.3 — Real Assets versus Financial Assets

2) In competitive markets, the risk–return trade-off implies that, holding other factors constant,
investors who accept higher risk should expect:

A. The same expected return as risk-free assets

B. Lower expected return due to diversification

C. Higher expected return as compensation for bearing risk

D. Guaranteed higher realized return every period

Hint: Ch.1, p.11 — Markets are Competitive: The Risk–Return Trade-off

3) During the 2008–2009 financial crisis, which mechanism most directly amplified systemic risk
through mortgage-related securitization?

A. Treasury bill auctions

B. Credit default swaps written on mortgage pools

C. Share repurchases by nonfinancial firms

D. Statutory reserve requirements on demand deposits

Hint: Ch.1, pp.20–22 — Mortgage Derivatives; Credit Default Swaps; Systemic Risk
4) A Treasury bill quoted on a bank-discount basis will generally have which property relative to
its bond-equivalent yield (BEY)?

A. It is greater because it annualizes with compounding

B. It is less because it uses price instead of face value

C. It is less because it uses a 360-day year and discounts from face

D. It is equal for any maturity under 6 months

Hint: Ch.2, pp.29–30 — T-bills: bank-discount vs. BEY

5) An investor in the 32% tax bracket is comparing a 3.0% municipal bond to a taxable bond. The
equivalent taxable yield on the muni is closest to:

A. 2.04%

B. 3.00%

C. 4.41%

D. 5.00%

Hint: Ch.2, p.37 — Equivalent Taxable Yield

6) The Dow Jones Industrial Average differs from the S&P 500 primarily because it is:

A. Value-weighted and includes 30 stocks

B. Price-weighted and includes 30 stocks

C. Equally-weighted and includes 500 stocks

D. Value-weighted and free-float adjusted

Hint: Ch.2, pp.43–46 — DJIA vs. S&P 500

7) A futures contract obligates the buyer to:

A. Buy or sell an asset at today's spot price

B. Buy or sell an asset at a pre-specified price on a future date

C. Pay an option premium to secure a right without obligation

D. Receive a dividend stream during the life of the contract

Hint: Ch.2, pp.48–49 — Futures Contracts

Chapter 3

8) In a firm commitment underwriting, who bears the price risk of distributing new shares?

A. Issuing firm

B. Lead underwriter/underwriting syndicate

C. SEC

D. Individual investors participating in IPO allocations

Hint: Ch.3, p.57 — Publicly Traded Companies; Underwriting

9) A limit buy order instructs a broker to:

A. Buy immediately at the best available price

B. Buy only if the price falls to or below a specified level

C. Buy only if the price rises above a trigger price

D. Buy on margin with the minimum maintenance requirement

Hint: Ch.3, p.60 — Types of Orders

10) Buying on margin primarily increases:

A. Expected return and magnifies volatility of returns

B. Expected return and reduces volatility of returns

C. Dividends without affecting risk

D. Voting rights per share

Hint: Ch.3, pp.71–73 — Buying on Margin

11) In a short sale, the short seller must pay the lender of the stock:

A. Any dividends declared during the short position

B. The bid–ask spread at closing

C. A fixed borrow fee equal to LIBOR

D. Accrued interest at the Treasury bill rate

Hint: Ch.3, p.74 — Short Sales

12) Investment companies create value for small investors primarily through:

A. Lower expected returns with higher risk

B. Record-keeping, diversification, professional management, and lower trading costs

C. Guaranteed positive alpha

D. Exemptions from federal taxation

Hint: Ch.4, pp.87–90 — Functions of Investment Companies

13) The net asset value (NAV) of an open-end mutual fund is best defined as:

A. Market price per share in secondary trading

B. Total market value of assets minus liabilities, per share

C. Historical cost per share adjusted for distributions

D. Offer price before sales load

Hint: Ch.4, pp.90–97 — NAV and pricing

14) Compared with open-end funds, ETFs typically offer:

A. Intraday trading and potential tax efficiency via in-kind creations/redemptions

B. Daily pricing only at market close

C. Higher mandatory 12b-1 fees

D. No exposure to market risk

Hint: Ch.4, pp.98–100 — Exchange-Traded Funds

15) Empirical evidence on mutual fund performance persistence suggests that:

A. Past winners reliably remain winners net of fees and risk

B. Persistence is weak, especially after adjusting for costs and risk

C. Losers become winners due to mean reversion with certainty

D. Star ratings perfectly predict alpha

Hint: Ch.4, pp.100–103 — Mutual Fund Performance

16) The geometric average return over multiple periods is:

A. Always greater than the arithmetic average

B. Equal to the arithmetic average if returns vary

C. Less than or equal to the arithmetic average when returns vary

D. Unrelated to compounding

Hint: Ch.5, pp.113–115 — Measuring Returns over Multiple Periods

17) The real interest rate can be approximated by:

A. Nominal rate minus inflation rate

B. Nominal rate plus inflation rate

C. Inflation rate minus nominal rate

D. Nominal rate times inflation rate

Hint: Ch.5, pp.116–117 — Inflation and the Real Rate

18) A risk premium is best described as:

A. The difference between market return and risk-free return

B. The Sharpe ratio times volatility

C. The covariance of returns with the market

D. The idiosyncratic variance of an asset

Hint: Ch.5, pp.118–125 — Risk and Risk Premiums

19) The Capital Allocation Line (CAL) depicts combinations of:

A. Two risky portfolios with different correlations

B. A risky portfolio and the risk-free asset

C. Two risk-free assets with different maturities

D. A bond index and an equity index only

Hint: Ch.5, pp.133–137 — Risk-free Asset and CAL

20) Evidence on the Capital Market Line (CML) and passive strategies suggests:

A. Passive indexing can be a competitive benchmark after costs

 B. Active managers always dominate in efficient markets

C. The CML slope is unaffected by the market risk premium

D. Passive strategies require frequent security selection

Hint: Ch.5, pp.137–139 — Passive Strategies and the CML

21) The primary source of risk reduction from diversification across risky assets is:

A. Lower standard deviation of each asset individually

B. Lower covariance/correlation among asset returns

C. Higher average return of the assets

D. Equal weighting of all assets

Hint: Ch.6, pp.148–156 — Diversification; Covariance and Correlation

22) For two risky assets, the minimum-variance portfolio weight depends on:

A. Only the expected returns

B. Only the volatilities

C. Expected returns, volatilities, and covariance

D. The risk-free rate only

Hint: Ch.6, pp.154–156 — Two-Asset Portfolio Rules

23) With a risk-free asset available, the optimal risky portfolio is chosen to:

A. Maximize expected return regardless of risk

B. Minimize standard deviation

C. Maximize the Sharpe ratio

D. Equalize marginal utilities across investors

Hint: Ch.6, p.159 — Optimal Risky Portfolio with a Risk-Free Asset

24) The efficient frontier with no short sales is typically:

A. Identical to the unconstrained frontier

B. Superior at both ends of expected return

C. Inferior at the extremes (very low and very high expected returns)
 D. A straight line

Hint: Ch.6, pp.163–166 — No-Short-Sale Constraints

25) In the single-index (market) model, a stock’s total variance decomposes into:

A. Market beta and expected return

B. Systematic variance and firm-specific (idiosyncratic) variance

C. Book and market components

D. Price and volume components

Hint: Ch.6, pp.168–173 — Single-Index Model

26) A central implication of the CAPM is that all mean–variance efficient investors hold:

A. Different tangency portfolios according to risk aversion

B. The market portfolio combined with the risk-free asset

C. Only risk-free assets at equilibrium

D. Only the minimum-variance portfolio

Hint: Ch.7, pp.195–197 — Why All Investors Hold the Market Portfolio

27) The expected excess return on an asset in CAPM is proportional to:

A. Its variance

B. Its beta with the market portfolio

C. Its idiosyncratic volatility

D. Its dividend yield

Hint: Ch.7, pp.198–201 — Expected Returns and the SML

28) The Security Market Line (SML) plots:

A. Expected return vs. total variance

B. Expected return vs. beta (systematic risk)

C. Expected return vs. firm-specific risk

D. Realized return vs. idiosyncratic variance

Hint: Ch.7, p.200 — The Security Market Line

29) Relative to CAPM, the Fama–French Three-Factor model adds:

A. Momentum and liquidity

B. Size (SMB) and value (HML) factors

C. Term structure and default spread

D. Inflation and consumption growth

Hint: Ch.7, p.206 — Fama–French Three-Factor Model

30) Arbitrage Pricing Theory (APT) asserts that in well-diversified portfolios, expected returns
are:

A. Determined only by the market factor

B. Linear in multiple systematic factor betas

C. Independent of factor loadings

D. Unrelated to risk premiums

Hint: Ch.7, pp.208–213 — Arbitrage Pricing Theory

Calculation Question:
A financial analyst provides the following forecast of returns in three economic scenarios:

Scenario Probability Market Return Stock A Stock B

Recession 0.20 -6% -8% -2%
Normal 0.50 10% 12% 8%
Boom 0.30 18% 24% 12%

Answer the following:

a) Compute the betas of Stock A and Stock B with respect to the market.
b) Calculate the expected return of each stock.
c) If the risk-free rate is 4 %, write the equation of the Security Market Line (SML).
d) According to CAPM, what is the required rate of return for each stock? What are the alphas of
each stock?
e) If a new project has the same systematic risk as Stock B, what hurdle rate should the firm use?

Show your work (expected values, covariance/variance, beta, and CAPM steps).