FIN 4504 | FIN4504 Exam 3: Investments Updated
and Latest Questions and Correct Answers with
Rationale - Florida State University
1. Which of the following defines the ‘Efficient Frontier’ in Modern Portfolio Theory?
A. The set of portfolios that maximize return for a given level of risk.
B. The combination of all risky assets in the market weighted by value.
C. The line representing the risk-return trade-off of a single stock.
D. A portfolio containing only risk-free government securities.
Correct Answer: A
Explanation: The efficient frontier represents the optimal portfolios that offer the highest
expected return for a specific level of risk. Any portfolio located below this frontier is
considered inefficient because it provides less return for the same risk. Investors use this
concept to identify the best possible diversification benefits available in the market.
Markowitz’s theory assumes that rational investors will always seek to be on this
boundary. This boundary is curved because of the imperfect correlations between different
asset classes.
2. In the context of the Capital Asset Pricing Model (CAPM), what does a Beta of 1.5 imply for
a stock?
A. The stock’s price is expected to move 1.5 times the market’s movement.
B. The stock has 50% less systematic risk than the market average.
C. The stock has zero unsystematic risk and high total risk.
D. The stock is guaranteed to return 15% more than the risk-free rate.
Correct Answer: A
Explanation: Beta measures the sensitivity of an individual security’s returns to the
movements of the overall market. A beta of 1.5 indicates that the stock is 50% more volatile
than the market index. If the market rises by 10%, this stock is theoretically expected to
rise by 15% based on its systematic risk. Conversely, if the market falls, this stock is
expected to fall more significantly than the average. This metric is a core component of
calculating the required rate of return in CAPM.
3. According to the Security Market Line (SML), what should happen to a stock with a positive
Jensen’s Alpha?
A. The risk-free rate will increase to offset the excess return.
B. The stock is overvalued and investors should sell it immediately.
,C. The stock’s beta will automatically decrease to compensate for the return.
D. The stock is undervalued and its price should rise to reach equilibrium.
Correct Answer: D
Explanation: Jensen’s Alpha measures the difference between a portfolio’s actual return
and its expected return as predicted by CAPM. A positive alpha indicates that the security
has performed better than its risk level would suggest. In an efficient market, this suggests
the stock is currently undervalued by the market participants. As more investors realize
this mispricing and buy the stock, the price will increase until the alpha disappears.
Therefore, a positive alpha is a signal of superior risk-adjusted performance that attracts
demand.
4. What type of risk is effectively eliminated through a well-diversified portfolio of 30 or more
stocks?
A. Market risk
B. Unsystematic risk
C. Systematic risk
D. Inflation risk
Correct Answer: B
Explanation: Unsystematic risk refers to the hazards specific to a single company or
industry, such as a strike or a product recall. Because these events are random and unique,
they can be cancelled out by holding a variety of different assets. Studies show that holding
approximately 30 different stocks across sectors removes most of this diversifiable risk.
Systematic risk, however, remains because it affects the entire economy simultaneously.
Consequently, the market only rewards investors for bearing systematic risk that cannot be
diversified away.
5. An investor’s optimal portfolio is found at the tangency point between which two lines?
A. The Security Market Line and the horizontal axis.
B. The characteristic line and the market proxy line.
C. The Capital Allocation Line and the Efficient Frontier.
D. The yield curve and the indifference curve.
Correct Answer: C
Explanation: The optimal risky portfolio is located where the Capital Allocation Line (CAL)
is tangent to the efficient frontier. This specific point represents the portfolio with the
highest possible Sharpe ratio available to the investor. At this tangency point, the investor
achieves the maximum excess return per unit of total risk. The CAL essentially introduces
, the possibility of lending or borrowing at the risk-free rate. All rational investors should
hold this tangency portfolio in combination with the risk-free asset.
6. If the risk-free rate is 3%, the market return is 10%, and a stock’s beta is 1.2, what is the
required return according to CAPM?
A. 12.0%
B. 11.4%
C. 8.4%
D. 15.0%
Correct Answer: B
Explanation: To find the required return, use the CAPM formula: Expected Return = Risk-
Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the numbers gives: 3% +
1.2 * (10% - 3%), which simplifies to 3% + 1.2 * 7%. This results in 3% + 8.4%, equaling a
total required return of 11.4%. This calculation shows how investors are compensated for
both the time value of money and the systematic risk taken. The difference between market
return and risk-free rate is known as the market risk premium.
7. Which performance measure is most appropriate for evaluating a non-diversified portfolio
where total risk is the primary concern?
A. Treynor Ratio
B. Jensen’s Alpha
C. Information Ratio
D. Sharpe Ratio
Correct Answer: D
Explanation: The Sharpe ratio uses standard deviation as the denominator, which
accounts for both systematic and unsystematic risk. Because a non-diversified portfolio still
contains unsystematic risk, standard deviation is the correct measure of its total risk. The
Treynor ratio and Jensen’s Alpha only account for systematic risk (beta), which would be
misleading here. Using the Sharpe ratio allows an investor to see the reward relative to the
total volatility they are experiencing. This makes it the superior choice for assessing the
efficiency of individual, concentrated asset holdings.
8. What does the slope of the Capital Market Line (CML) represent?
A. The beta of the market portfolio.
B. The correlation coefficient between assets.
C. The unsystematic risk of the average security.
D. The risk premium of the market portfolio per unit of total risk.
and Latest Questions and Correct Answers with
Rationale - Florida State University
1. Which of the following defines the ‘Efficient Frontier’ in Modern Portfolio Theory?
A. The set of portfolios that maximize return for a given level of risk.
B. The combination of all risky assets in the market weighted by value.
C. The line representing the risk-return trade-off of a single stock.
D. A portfolio containing only risk-free government securities.
Correct Answer: A
Explanation: The efficient frontier represents the optimal portfolios that offer the highest
expected return for a specific level of risk. Any portfolio located below this frontier is
considered inefficient because it provides less return for the same risk. Investors use this
concept to identify the best possible diversification benefits available in the market.
Markowitz’s theory assumes that rational investors will always seek to be on this
boundary. This boundary is curved because of the imperfect correlations between different
asset classes.
2. In the context of the Capital Asset Pricing Model (CAPM), what does a Beta of 1.5 imply for
a stock?
A. The stock’s price is expected to move 1.5 times the market’s movement.
B. The stock has 50% less systematic risk than the market average.
C. The stock has zero unsystematic risk and high total risk.
D. The stock is guaranteed to return 15% more than the risk-free rate.
Correct Answer: A
Explanation: Beta measures the sensitivity of an individual security’s returns to the
movements of the overall market. A beta of 1.5 indicates that the stock is 50% more volatile
than the market index. If the market rises by 10%, this stock is theoretically expected to
rise by 15% based on its systematic risk. Conversely, if the market falls, this stock is
expected to fall more significantly than the average. This metric is a core component of
calculating the required rate of return in CAPM.
3. According to the Security Market Line (SML), what should happen to a stock with a positive
Jensen’s Alpha?
A. The risk-free rate will increase to offset the excess return.
B. The stock is overvalued and investors should sell it immediately.
,C. The stock’s beta will automatically decrease to compensate for the return.
D. The stock is undervalued and its price should rise to reach equilibrium.
Correct Answer: D
Explanation: Jensen’s Alpha measures the difference between a portfolio’s actual return
and its expected return as predicted by CAPM. A positive alpha indicates that the security
has performed better than its risk level would suggest. In an efficient market, this suggests
the stock is currently undervalued by the market participants. As more investors realize
this mispricing and buy the stock, the price will increase until the alpha disappears.
Therefore, a positive alpha is a signal of superior risk-adjusted performance that attracts
demand.
4. What type of risk is effectively eliminated through a well-diversified portfolio of 30 or more
stocks?
A. Market risk
B. Unsystematic risk
C. Systematic risk
D. Inflation risk
Correct Answer: B
Explanation: Unsystematic risk refers to the hazards specific to a single company or
industry, such as a strike or a product recall. Because these events are random and unique,
they can be cancelled out by holding a variety of different assets. Studies show that holding
approximately 30 different stocks across sectors removes most of this diversifiable risk.
Systematic risk, however, remains because it affects the entire economy simultaneously.
Consequently, the market only rewards investors for bearing systematic risk that cannot be
diversified away.
5. An investor’s optimal portfolio is found at the tangency point between which two lines?
A. The Security Market Line and the horizontal axis.
B. The characteristic line and the market proxy line.
C. The Capital Allocation Line and the Efficient Frontier.
D. The yield curve and the indifference curve.
Correct Answer: C
Explanation: The optimal risky portfolio is located where the Capital Allocation Line (CAL)
is tangent to the efficient frontier. This specific point represents the portfolio with the
highest possible Sharpe ratio available to the investor. At this tangency point, the investor
achieves the maximum excess return per unit of total risk. The CAL essentially introduces
, the possibility of lending or borrowing at the risk-free rate. All rational investors should
hold this tangency portfolio in combination with the risk-free asset.
6. If the risk-free rate is 3%, the market return is 10%, and a stock’s beta is 1.2, what is the
required return according to CAPM?
A. 12.0%
B. 11.4%
C. 8.4%
D. 15.0%
Correct Answer: B
Explanation: To find the required return, use the CAPM formula: Expected Return = Risk-
Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the numbers gives: 3% +
1.2 * (10% - 3%), which simplifies to 3% + 1.2 * 7%. This results in 3% + 8.4%, equaling a
total required return of 11.4%. This calculation shows how investors are compensated for
both the time value of money and the systematic risk taken. The difference between market
return and risk-free rate is known as the market risk premium.
7. Which performance measure is most appropriate for evaluating a non-diversified portfolio
where total risk is the primary concern?
A. Treynor Ratio
B. Jensen’s Alpha
C. Information Ratio
D. Sharpe Ratio
Correct Answer: D
Explanation: The Sharpe ratio uses standard deviation as the denominator, which
accounts for both systematic and unsystematic risk. Because a non-diversified portfolio still
contains unsystematic risk, standard deviation is the correct measure of its total risk. The
Treynor ratio and Jensen’s Alpha only account for systematic risk (beta), which would be
misleading here. Using the Sharpe ratio allows an investor to see the reward relative to the
total volatility they are experiencing. This makes it the superior choice for assessing the
efficiency of individual, concentrated asset holdings.
8. What does the slope of the Capital Market Line (CML) represent?
A. The beta of the market portfolio.
B. The correlation coefficient between assets.
C. The unsystematic risk of the average security.
D. The risk premium of the market portfolio per unit of total risk.
