R02 Modern portfolio theory: free practice questions

1. Question 1 of 5

   What does modern portfolio theory assume about investors?

   Option A: They always prefer the investment with the highest returnOption B: Given equal returns, they'll choose the less risky investmentOption C: They ignore how investments move against each otherOption D: They choose investments on dividend yield alone

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   The answer is B: Given equal returns, they'll choose the less risky investment

   MPT assumes investors are risk averse: offered two investments with the same return, they'd choose the less risky one, and they'd take more risk only for a higher expected return.

   Why the other options are wrong

   A

   They'd only take more risk for a higher return.

   C

   How investments move relative to each other is central to MPT.

   D

   MPT is about risk and return across the portfolio.

2. Question 2 of 5

   An asset's returns are normally distributed, with a mean of 8% and a standard deviation of 5%. Within what range would you expect about 95% of its returns to fall?

   Option A: −2% to 18%Option B: 3% to 13%Option C: 0% to 16%Option D: −7% to 23%

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   The answer is A: −2% to 18%

   About 95% of returns fall within two standard deviations of the mean: 8% ± (2 × 5%) = −2% to 18%. About 68% fall within one standard deviation: 3% to 13%.

   Why the other options are wrong

   B

   That's one standard deviation either side, covering about 68% of returns.

   C

   That doesn't use the standard deviation correctly.

   D

   That's three standard deviations, not two.

3. Question 3 of 5

   How does hedging with a put option differ from hedging by selling a futures contract?

   Option A: Only options lock in a price at the outsetOption B: Only futures protect against a fall in the marketOption C: The option holder needn't sell; the futures seller mustOption D: The option holder must sell; the futures seller needn't

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   The answer is C: The option holder needn't sell; the futures seller must

   Both lock in a price if the market falls. A put option gives the right, not the obligation, to sell. Selling futures is an open-ended obligation to sell until expiry or closing out.

   Why the other options are wrong

   A

   Both lock in a price.

   B

   Both protect against a fall.

   D

   It's the other way round.

4. Question 4 of 5

   An investor holds equal stakes in an ice cream maker and an umbrella maker, whose profits depend only on the weather. Why does this reduce risk?

   Option A: Their returns are negatively correlatedOption B: Both have very low betasOption C: Their returns are perfectly positively correlatedOption D: Both pay high dividends every year

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   The answer is A: Their returns are negatively correlated

   Good weather helps one and hurts the other. Because their returns move in opposite directions, combining them reduces or removes the variability: the risk is diversified away.

   Why the other options are wrong

   B

   The point is how they move against each other.

   C

   Positively correlated holdings don't offset each other.

   D

   Dividends aren't the reason.

5. Question 5 of 5

   Which inputs does an efficient frontier model need?

   Option A: Each asset's return, its standard deviation and the correlationsOption B: Each asset's beta and the risk-free rate of return, and nothing elseOption C: Each asset's dividend yield and price/earnings ratioOption D: The investor's age and income

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   The answer is A: Each asset's return, its standard deviation and the correlations

   The model's inputs are the return of each asset, the standard deviation of each asset's returns and the correlation between each pair of assets' returns.

   Why the other options are wrong

   B

   Those are CAPM inputs.

   C

   These aren't the model's inputs.

   D

   These matter for advice, not the model.

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