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Chapter 3
The Theory of Portfolio Allocation
 Multiple Choice Questions
1.
A portfolio is a
(a) brokerage house specializing in the trading of common stock.
(b) brokerage house specializing in the trading of corporate bonds.
(c) measure of the risk involved with a holding a particular asset.
(d) collection of assets.
2.
The theory of portfolio allocation describes
(a) why savers behave as they do when selecting one asset rather than another.
(b) the relationship among interest rates on bonds of different maturities.
(c) why firms sometimes raise funds by issuing equities and sometimes by issuing debt.
(d) the reasons why assets differ in their degree of liquidity.
3.
An asset in a portfolio always represents
(a) a medium of exchange.
(b) a unit of account.
(c) a store of value.
(d) the same thing as a liability.
4.
Which of the following assets made up the largest fraction of the portfolios of U.S. households in
2003?
(a) Pension reserves
(b) Equities
(c) Mortgages
(d) U.S. government securities
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The Theory of Portfolio Allocation
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5.
Which of the following assets made up the largest fraction of the portfolios of U.S. households in
1950?
(a) Pension reserves
(b) Equities
(c) Mortgages
(d) U.S. government securities
6.
Which of the following was NOT a major store of U.S. household wealth in 1950?
(a) Mutual funds
(b) Equities
(c) Bank accounts
(d) U.S. government securities
7.
Comparing U.S. household portfolios in 2003 with U.S. household portfolios in 1950, which of the
following statements is true?
(a) Pension reserves were a larger fraction of U.S. household portfolios in 2000, but U.S.
government securities were a smaller fraction.
(b) Life insurance reserves were a larger fraction of U.S. household portfolios, but pension reserves
were a smaller fraction.
(c) Money market mutual funds were a smaller fraction of U.S. household portfolios, but U.S.
government securities were a larger fraction.
(d) U.S. government securities were a smaller fraction of U.S. household portfolios, but life
insurance reserves were a larger fraction.
8.
The theory of portfolio allocation
(a) predicts how savers allocate their assets.
(b) explains the relative liquidity of different assets.
(c) explains the relative riskiness of different assets.
(d) predicts the inflation rate.
9.
Which of the following is NOT a determinant of asset demand?
(a) The saver’s wealth
(b) The saver’s income
(c) Expectations of the return on the asset
(d) The liquidity of the asset
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
10.
Economists believe that as a saver’s wealth increases the saver will generally
(a) increase his or her holdings of all assets proportionately.
(b) increase the fraction of wealth held as cash.
(c) increase the fraction of wealth held as common stock.
(d) decrease the fraction held as corporate bonds.
11.
As wealth increases, which of the following is likely to account for a smaller fraction of a saver’s
portfolio?
(a) Corporate stock
(b) Corporate bonds
(c) Cash
(d) U.S. government securities
12.
As wealth decreases, which of the following is likely to account for a larger fraction of a saver’s
portfolio?
(a) Corporate stock
(b) Corporate bonds
(c) U.S. government securities
(d) Checking account balance
13.
The wealth elasticity of demand describes the percentage change in
(a) the quantity demanded of an asset for a given percentage change in the price of the asset.
(b) the amount of wealth possessed for a given percentage change in the age of the saver.
(c) the quantity of an asset demanded for a given percentage change in wealth.
(d) wealth for a given percentage change in the amount of any one asset added to the saver’s
portfolio.
14.
Suppose that when your wealth increases from $1 million to $2 million, your holdings of U.S.
savings bonds increases from $100,000 to $175,000. Your wealth elasticity of demand for savings
bonds then is
(a) less than 1 and savings bonds are a necessity asset.
(b) greater than 1 and savings bonds are a necessity asset.
(c) less than 1 and savings bonds are a luxury asset.
(d) greater than 1 and savings bonds are a luxury asset.
Chapter 3
The Theory of Portfolio Allocation
15.
Suppose that when your wealth increases from $1 million to $2 million, your holdings of stock
mutual funds increases from $100,000 to $300,000. Your wealth elasticity of demand for stock
mutual funds then is
(a) less than 1 and stock mutual funds are a necessity asset.
(b) greater than 1 and stock mutual funds are a necessity asset.
(c) less than 1 and stock mutual funds are a luxury asset.
(d) greater than 1 and stock mutual funds are a luxury asset.
16.
Suppose that when your wealth increases from $1 million to $2 million, your holdings of U.S.
government securities increases from $50,000 to $125,000. Your wealth elasticity of demand for
U.S. government securities then is
(a) less than 1 and U.S. government securities are a luxury asset.
(b) greater than 1 and U.S. government securities are a luxury asset.
(c) less than 1 and U.S. government securities are a necessity asset.
(d) greater than 1 and U.S. government securities are a necessity asset.
17.
Necessity assets are assets
(a) with wealth elasticities of less than 1.
(b) with wealth elasticities of greater than 1.
(c) held by savers for investment.
(d) not subject to federal income tax.
18.
Necessity assets are assets
(a) used by savers to conduct regular transactions.
(b) with wealth elasticities of greater than 1.
(c) held by savers for investment.
(d) not subject to federal income tax.
19.
Luxury assets are assets
(a) with wealth elasticities of less than 1.
(b) held by savers for investment.
(c) used by savers to conduct regular transactions.
(d) not subject to federal income tax.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
20.
Luxury assets
(a) have wealth elasticities of less than 1.
(b) generally have low fixed costs of ownership.
(c) generally have high transactions costs of acquisition.
(d) have returns that are taxed at a higher rate than the returns on necessity assets.
21.
As wealth increases, savers choose
(a) more necessity assets and fewer luxury assets.
(b) more luxury assets and fewer necessity assets.
(c) more of both luxury assets and necessity assets.
(d) fewer of both luxury assets and necessity assets.
22.
The main reason that savers must assess the impact of inflation on returns is
(a) an increase in inflation will lower the nominal return on an asset.
(b) changes in the value of money will affect the real value of returns.
(c) inflation has a larger impact on the returns on luxury assets than on the returns on necessity
assets.
(d) real after-tax returns generally rise during periods of inflation.
23.
The expected real return to savers equals
(a) expected inflation less the nominal return.
(b) expected inflation plus the nominal return.
(c) the nominal return minus expected inflation.
(d) the nominal return divided by expected inflation.
24.
Savers generally compare
(a) the nominal rates of return on assets.
(b) the real rates of return on assets.
(c) the real after-tax rates of return on assets.
(d) the nominal after-tax rates of return on assets.
25.
Interest from U.S. Treasury securities is
(a) not subject to taxation.
(b) taxed at the federal level but not at the state and local levels.
(c) taxed at the state and local levels but not at the federal level.
(d) taxed at the local, state, and federal levels.
26.
The obligations of state and local governments
(a) are taxed at the federal level, but not at the state and local levels.
(b) are taxed at the state and local levels, but not at the federal level.
(c) are taxed at the state, local, and federal levels.
(d) are called municipal bonds.
27.
Securities issued by state and local governments generally are
(a) not subject to taxation.
(b) taxed at the federal level, but not at the state and local levels.
(c) taxed at the state and local levels, but not at the federal level.
Chapter 3
The Theory of Portfolio Allocation
(d) taxed at the local, state, and federal levels.
28.
Which of the following is an example of a tax-exempt bond?
(a) A bond issued by Acme Widget
(b) A bond issued by the U.S. Treasury
(c) A bond issued by the state of Pennsylvania
(d) No bonds issued in the United States are exempt from taxation.
29.
In making investment decisions, savers evaluate
(a) the variability of the expected return as well as the size of the return.
(b) the size of the expected return, but not the variability of the return.
(c) the variability of the expected return, but not the size of the return.
(d) neither the size nor the variability of the expected return.
30.
Suppose that Acme Widget has a return of 10% one-quarter of the time and a return of 0% threequarters of the time. Your expected return from investing in Acme Widget would be
(a) 2.5%.
(b) 5.0%.
(c) 7.5%.
(d) 10.0%.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
31.
How would a risk-averse saver rank the following three investment opportunities?
A
Return Prob.
$100
0.50
$400
0.50
B
Return Prob.
$250
1.00
C
Return Prob.
$100
0.55
$400
0.45
(Let A > B > C stand for “Choice A is preferred to Choice B is preferred to Choice C”; that is, the
investor likes A the most and C the least.)
(a) A > B > C
(b) B > C > A
(c) B > A > C
(d) C > B > A
Questions 32 through 34 refer to a saver presented with the following choices.
Choice 1
Return
Probability
$15,000
1.00
Choice 2
Return
Probability
$10,000
0.50
$22,000
0.50
32.
A risk-neutral saver will
(a) prefer Choice 1 to Choice 2.
(b) prefer Choice 2 to Choice 1.
(c) be indifferent between Choice 1 and Choice 2.
(d) Not enough information has been provided to be certain of the saver’s decision.
33.
A risk-averse saver will
(a) prefer Choice 1 to Choice 2.
(b) prefer Choice 2 to Choice 1.
(c) be indifferent between Choice 1 and Choice 2.
(d) Not enough information has been provided to be certain of the saver’s decision.
34.
A risk-loving saver will
(a) prefer Choice 1 to Choice 2.
(b) prefer Choice 2 to Choice 1.
(c) be indifferent between Choice 1 and Choice 2.
(d) Not enough information has been provided to be certain of the saver’s decision.
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The Theory of Portfolio Allocation
67
35.
A risk-averse saver will
(a) always accept a lower expected return in exchange for less risk.
(b) sometimes accept a lower expected return in exchange for less risk.
(c) never accept a lower expected return in exchange for less risk.
(d) will only choose investments with zero risk.
36.
Comparing average annual real rates of return on long-term government bonds and on common
stocks for the period from 1926 to 1999 reveals that
(a) the rates of return have been about the same.
(b) the rates of return on common stocks have been higher.
(c) the rates of return on long-term government bonds have been higher.
(d) there has been no consistent relationship between the rates of return on these securities.
37.
The existence of a substantial gap in the long run between rates of return on common stock and rates
of return on long-term government bonds indicates that investors
(a) are risk averse and require higher returns on stock investments to compensate them for the
greater risk.
(b) are risk averse and require higher returns on long-term government bonds to compensate them
for the greater risk.
(c) are risk loving and invest in common stock because of its greater riskiness.
(d) are risk loving and invest in long-term government bonds because of their greater riskiness.
38.
The “equity premium” refers to
(a) the exemption of stock dividends from federal income tax.
(b) the gap between the return on stocks and the return on bonds.
(c) the premium investors are willing to pay for Internet stocks.
(d) the low mortgage rates available to borrowers who make large down payments when purchasing
a home.
39.
According to many economists, the equity premium
(a) is mainly attributable to tax considerations.
(b) reflects investors’ fears of future inflation.
(c) is probably zero.
(d) is too large to be explained by risk considerations alone.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
40.
Suppose that information is made public that Mammoth Computer is having severe financial
difficulties. The effect will be to
(a) increase the yield on Mammoth’s long-term bonds.
(b) increase the yield on rival Orange Computer’s long-term bonds.
(c) lower the yield on Mammoth’s long-term bonds.
(d) increase the yield on both Mammoth’s long-term bonds and rival Orange Computer’s long-term
bonds.
41.
Comparing the range of the one-year returns on stocks to the range of the 20-year returns over the
period from 1926 to 1999 reveals that
(a) the range has been about the same.
(b) the range has been narrower for one-year returns.
(c) the range has been narrower for twenty-year returns.
(d) there has been no consistent relationship between the ranges for one-year returns and 20-year
returns.
42.
In general, a young saver should choose a financial portfolio based on
(a) maximizing expected return with only limited concern for variability.
(b) minimizing variability with only limited concern for expected return.
(c) equal concern for expected return and variability.
(d) maximizing the number of tax-free securities included.
43.
In general, an older saver should choose a financial portfolio based on
(a) selecting safe assets to earn an expected real return of about zero.
(b) maximizing expected return with only limited concern for variability
(c) equal concern for expected return and variability.
(d) avoiding tax-free securities.
44.
Assets with greater liquidity
(a) also typically have greater returns.
(b) are generally tax-free.
(c) help savers smooth spending over time.
(d) are generally available only through brokers.
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The Theory of Portfolio Allocation
69
45.
Liquidity is
(a) the ease with which an asset can be converted into cash.
(b) desirable but reduces the value of assets held to smooth spending.
(c) desirable but reduces the value of assets held for precautionary purposes.
(d) greater for common stock than for checkable deposits in commercial banks.
46.
Rank the following assets from least liquid to most liquid: U.S. Treasury bonds; Municipal bonds
issued by Tinytown, Montana; General Motors corporate bonds.
(a) General Motors, Tinytown, U.S. Treasury
(b) Tinytown, General Motors, U.S. Treasury
(c) Tinytown, U.S. Treasury, General Motors
(d) General Motors, U.S. Treasury, Tinytown
47.
Suppose that the number of buyers and sellers of municipal bonds increases substantially. The result
should be a (an)
(a) decline in municipal bond yields.
(b) increase in municipal bond yields.
(c) decline in U.S. Treasury bond yields.
(d) increase in the tax rate on municipal bond yields.
48.
Suppose that the number of buyers and sellers of municipal bonds decreases substantially. The result
should be a (an)
(a) increase in the prices of municipal bonds.
(b) decrease in the prices of municipal bonds.
(c) increase in U.S. Treasury bond yields.
(d) decrease in the tax rate on municipal bond yields.
49.
A small company that issues bonds for the first time may have to offer them at a high yield because
the bonds will
(a) not be as liquid as many other corporate bonds.
(b) be less risky than many other corporate bonds.
(c) be less costly to gather information on than other corporate bonds.
(d) be subject to a lower tax rate than other corporate bonds.
The average investor must weigh the benefits of liquidity against
(a) the high taxes generally levied on liquid assets.
(b) the lower returns on liquid assets.
(c) the high transactions costs involved in disposing of liquid assets.
(d) the greater variability in the nominal returns on liquid assets.
50.
51.
Why do CDs have higher interest rates than savings accounts?
(a) CDs are much riskier investments than savings accounts.
(b) Interest on CDs is taxable while interest on savings accounts is not.
(c) CDs provide better hedges against inflation than do savings accounts.
(d) CDs are not as liquid as savings accounts.
52.
Which of the following assets has the lowest information costs?
(a) A U.S. Treasury bond
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
(b) A bond issued by the city of Smallplace, South Dakota
(c) A bond issued by General Motors
(d) A share of stock issued by General Motors
53.
Which of the following assets has the highest information costs?
(a) A U.S. Treasury bond
(b) A bond issued by the city of Smallplace, South Dakota
(c) A bond issued by General Motors
(d) A share of stock issued by General Motors
54.
One of the important hindrances to savers placing their funds in foreign financial assets is
(a) the costliness of gathering information about foreign financial assets.
(b) the higher tax rates levied by the U.S. government on earnings from such assets.
(c) the reluctance of many European countries to allow foreign investment in their financial assets.
(d) the difficulty in reading company reports written in a foreign language.
55.
The theory of portfolio selection leads to the conclusion that
(a) there is one best asset for each investor.
(b) there is one best asset for all investors.
(c) savers should allocate their savings among many different assets.
(d) savers should concentrate their savings in as few assets as possible.
56.
Diversification refers to
(a) choosing assets so as to maximize expected return.
(b) choosing assets so as to minimize tax liability.
(c) choosing assets so as to maximize liquidity.
(d) allocating savings among different assets.
57.
The main reason for diversifying a portfolio is
(a) to take advantage of the fact that returns on assets are imperfectly correlated.
(b) to take advantage of the favorable tax treatments diversified portfolios receive from the federal
government.
(c) that diversified portfolios have greater liquidity than undiversified portfolios.
(d) that diversified portfolios have lower information costs than undiversified portfolios.
58.
Which of the following economists has NOT won a Noble Prize in economics for research on the
benefits of diversification?
(a) James Tobin
(b) Harry Markowitz
(c) Milton Friedman
(d) William Sharpe
59.
Suppose that you own $10,000 worth of stock in Mammoth Computer Company. Adding stock in
which of the following companies would be least likely to reduce the risk in your portfolio?
(a) Giant Automobile Company
(b) Midget Furniture Company
(c) Orange Computer Company
(d) Stupendous Electric Company
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The Theory of Portfolio Allocation
71
If the returns on two assets are perfectly positively correlated, adding the second asset to your
portfolio when you already own the first
(a) reduces the risk in the portfolio.
(b) increases the risk in the portfolio.
(c) has no effect on the risk in the portfolio.
(d) reduces the risk in the portfolio only if you are risk averse.
Diversification can eliminate
(a) all risk in a portfolio.
(b) the idiosyncratic risk in a portfolio.
(c) the market risk in a portfolio.
(d) risk only if the saver is risk neutral.
62.
Market risk
(a) can be eliminated through diversification.
(b) represents the risk generated through chance events affecting a single company.
(c) cannot be eliminated through diversification.
(d) is another name for idiosyncratic risk.
63.
Acme Gold Mining, Inc. discovers a huge vein of gold in the mountains of Iowa. This is an example of
(a) the high returns that can be expected from investing in companies that mine minerals.
(b) idiosyncratic risk.
(c) market risk.
(d) systematic risk.
64.
Unsystematic risk is another name for
(a) liquidity.
(b) market risk.
(c) idiosyncratic risk.
(d) diversification.
65.
If the returns to Mammoth Computer and Stupendous Chemicals are independent (have zero
correlation), adding Stupendous Chemicals to a portfolio already containing Mammoth Computer
(a) reduces the overall portfolio risk.
(b) does not affect the overall portfolio risk.
(c) increases the overall portfolio risk.
(d) affects the overall portfolio risk only if the saver is risk averse.
If General Auto and Crystal Auto have returns that are perfectly positively correlated, then adding
Crystal Auto to a portfolio that already contains General Auto will
(a) reduce the risk in the portfolio.
(b) increase the risk in the portfolio.
(c) neither increase nor decrease the risk in the portfolio.
(d) reduce the risk in the portfolio only for risk-averse savers.
66.
67.
A risk-neutral saver
(a) can eliminate the market risk in his or her portfolio through diversification.
(b) gains nothing from diversification.
(c) benefits from diversification more than does the risk-averse saver.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
(d) actually increases the risk in his or her portfolio by diversification.
68.
A portfolio consisting of every stock traded on the New York Stock Exchange would have
(a) diversified away all risk.
(b) diversified away idiosyncratic risk.
(c) diversified away market risk.
(d) much more risk than a portfolio containing only a few stocks.
69.
Suppose you hold a portfolio consisting of a single stock. About how many more stocks would you
need to add to your portfolio in order to reduce its average annual variability to about the level of
average annual variability you would experience if you held a portfolio consisting of every stock
listed on the New York Stock Exchange?
(a) 1
(b) 20
(c) 1000
(d) 10,000
70.
The variable beta
(a) measures the degree of liquidity in a portfolio.
(b) is the responsiveness of a stock’s expected return to changes in the value of the complete market
portfolio.
(c) measures the degree of idosyncratic risk in the complete market portfolio.
(d) is always less for an individual portfolio than for the complete market portfolio.
If a 1% increase in the market portfolio leads to an increase of 3% in the value of an asset, then the
asset’s beta equals
(a) 0.333
(b) 1
(c) 3
(d) Not enough information has been given to determine the asset’s beta.
71.
72.
A portfolio made of all the stocks listed on the New York Stock Exchange would
(a) have a higher expected return than the expected return on any individual stock.
(b) face no idiosyncratic risk, only systematic risk.
(c) face no systematic risk, only idiosyncratic risk.
(d) face neither systematic nor idiosyncratic risk.
73.
Investors are less willing to hold an asset with a high beta because
(a) such assets tend to be illiquid.
(b) systematic risk cannot be diversified away.
(c) idiosyncratic risk cannot be diversified away.
(d) such assets tend to have lower expected returns.
74.
According to the capital asset pricing model, the expected return on asset j, Rje equals
(a) Rf – j  ( Rme – Rf).
(b) Rf – j  ( Rme – Rf).
(c) Rf  j – ( Rme – Rf).
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(d) Rf  j 2  ( Rme – Rf).
75.
Households save through life insurance reserves, at least in part, because
(a) life insurance reserves are very liquid.
(b) the transactions costs of saving in this way are very low.
(c) life insurance reserves receive favorable tax treatment.
(d) life expectancy in the United States has been declining.
76.
About what fraction of the financial assets of U.S. households are in mutual funds?
(a) 1%
(b) 2%
(c) 11%
(d) 50%
77.
Mutual funds arose to
(a) reduce the transactions costs small savers incur when diversifying.
(b) take advantage of the tax breaks the federal government grants for diversified portfolios.
(c) provide home buyers with an inexpensive source of mortgage funds.
(d) provide personal financial advice to small savers.

Essay Questions
1.
As a saver’s wealth increases, explain whether each of the following is likely to become a smaller or
a larger fraction of her portfolio.
(a) Corporate bonds
(b) Corporate stock
(c) Cash
(d) Checking account balance
2.
An investor makes the following remark: “I don’t understand the junk bond market. Junk bonds
have become more liquid. This should have made them more desirable and increased the demand for
them. The increased demand should have driven their yields up, but in fact their yields have gone
down. I guess investors just don’t value liquidity.” Do you agree with the investor’s reasoning?
TIAA-CREF is the pension plan for college professors. Professors can direct their contributions
entirely to the TIAA part of the plan which offers a guaranteed, but generally relatively low, return
or entirely to the CREF part of the plan, which invests in the stock market, or they can divide their
contributions between the two parts of the plan. Funds invested in the CREF part of the plan will on
average earn a higher rate of return than funds invested in the TIAA part of the plan, but the return is
not guaranteed and in some years the value of funds invested in the CREF part of the plan will
decline. How would you expect each of the following professors to divide his or her contributions
between the TIAA and CREF parts of the plan: (a) a 28-year professor just beginning her career; (b)
a 58-year old professor who is about 10 years from retirement; and (c) a 68-year old professor on the
verge of retirement?
3.
4.
Suppose the expected return on the market portfolio is 10%, the risk-free rate is 2%, and the beta for
an asset is 2. According to CAPM what is the expected return on the asset?