Question

1. Under which of the following circumstances is it most likely that the nominal return of an investment will be less than its real return?

1. During periods of deflation.
2. During periods of low inflation
3. During periods of high inflation.
4. Under no circumstances is it possible for the nominal return to be less than its real return.

Please use the following information for Questions #2 & #3.

You have been provided this information about four securities.  You are considering adding one or more to a portfolio that has an expected return of 11% and a variance of 85.

                                                Return                        Variance        Correlation

            Security One               8%                                81                  –.25

            Security Two             10%                              110                  +.75

            Security Three          12%                              150                  –.70

Security Four            14%                              220                  +.55

2. Which of the following security or securities is or are most likely to increase the portfolio’s expected return while providing diversification benefits?  

1. Security One only
2. Security Three only
3. Security One and Security Three only
4. Security Three and Security Four only

3. If the portfolio manager’s only mandate were to maximize the expected return of the portfolio, which of the following security or securities would you recommend that she add to the portfolio?

1. Security Three only
2. Security Four only
3. Security One and Security Three
4. Security Three and Security Four

Answer 1

1).

a. During periods of deflation

The real rate of return adjusts the nominal rate of return for the effects of inflation. During the periods of inflation, Real rate is less by taking into account the inflation. During deflation, nominal rate will be less.

2).

b. Security Three only

To increase the portfolio return, the new asset to be added should have expected return greater than the portfolio return of 11%. To Provide diversification benefits, the correlation should be negative. Among the given securities, Only security three has return greater than 11% (12%) and negative correlation (-0.70)

3).

d. Security Three and Security Four

As the only mandate is to maximise the expected return, we need to select the securities which have return greater than the portfolio return of 11%. Securities 3 and 4 have returns greater than 11% (12% and 14%).