Ch. 8- EXAM 3

Which of the following risks cannot be diversified away? A. risk of a local natural disaster affecting company production B. risk created by world political happenings C. risk of losing a major contract D. risk of a CEO being caught in a scandal E. risk of a failed marketing campaign

B. risk created by world political happenings

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.) A. When held in isolation, Stock A has more risk than Stock B. B. Stock B would be a more desirable addition to a portfolio than Stock A. C. Stock A would be a more desirable addition to a portfolio than Stock B. D. The required return on Stock A will be greater than that on Stock B. E. The required return on Stock B will be greater than that on Stock A.

D. The required return on Stock A will be greater than that on Stock B.

A well-diversified investor will require to earn higher return on stocks with higher standard deviation.

False: For a well-diversified investor, only MARKET risk matters.

T or F (cards 14-38) Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.

False: It is not just about the possibilities of unfavorable events.

According to CAPM, the required return for stock A and stock B are 10% and 12% respectively. Stock A might have a higher market risk premium or a higher beta.

False: Market risk premium is the same for all stocks so A can only have a higher beta

A stock with a beta of 2 is less risky than an average stock on the market.

False: More risky

According to CAPM, the required return for stock A and stock B are 10% and 12% respectively. Stock A much have a higher beta.

False: Stock B should have a higher beta because it has a higher required return

Since virtually all stocks are positively correlated, but not perfectly so in real life, we can not reduce risk by combining stocks into portfolios.

False: We CAN reduce risk as long as the stocks are NOT perfectly positively correlated

T or F: Since virtually all stocks are positively correlated, but not perfectly so in real life, we cannot reduce risk by combining stocks into portfolios.

False: We can reduce risk by combining stocks into portfolios

According to CAPM, the required rate of return for a stock with beta=1 equals the risk-free rate.

False: equals the MARKET rate

A stock with a beta of 1 is more risky than an average stock on the market.

False: just as risky as the average

A stock with a higher standard deviation must also have a higher beta

False: not necessarily

The smaller σi is, the less likely that actual returns will be closer to expected returns, the lower the investment risk.

False: the MORE likely

Assume that rRF = 6%, and an average share of stock has a required rate of return of rM = 10%. Use CAPM: 1. What is the market risk premium? 2. Stock B's beta is 2, what is stock B's required rate of return? 3. Stock C's beta is 0.5, what is stock C's required rate of return? 4. Stock A's beta is 1, what is stock A's required rate of return?

1. RPm= rM-rRF= 10-6= 4% 2. ri = rRF + (rM - rRF) bi = 6%+(10%-6%)*2 = 14% 3. ri = rRF + (rM - rRF) bi = 6%+(10%-6%)*0.5 = 8% 4. ri = rRF + (rM - rRF) bi = 6%+(10%-6%)*1 = 10%

If $1,000 was invested one year ago, and $1,200 is received from that investment, what is the rate of return?

20% Ret= 1200-1000 / 1000= 20%

Suppose you have $1000. You invest $400 in stock A (return=12%), and the rest in stock B (return=5%). What is your portfolio return?

7.8% Weight of A: 400/1000=== 40% Weight of B: 600/1000=== 60% Portf. Ret= WA x Return A + WB x Return B 40% x 12% + 60% x 5%==== 7.8%

Over the past 75 years, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of their annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following lists correctly ranks investments from highest to lowest returns and risk (thus, the highest risk security should be shown first, the lowest risk securities shown last)? A. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. B. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills. C. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds. D. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks. E. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.

A. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.

Inflation, recession, and high interest rates are economic events that are best characterized as being...

A. factors associated with market risk.; *they affect all companies in the market

Which of the following statements is CORRECT? A. According to CAPM, the required rate of return for a stock with beta=1 equals the risk-free rate. B. According to CAPM, the required rate of return for a stock with beta=1 equals the market return. C. An investor can eliminate virtually all market risk if he or she holds a very large, well diversified portfolio of stocks. D. As the number of assets in a portfolio increases, the risk of the portfolio increases. E. A stock with a beta of 0.9 is more risky than an average stock in the market.

B. According to CAPM, the required rate of return for a stock with beta=1 equals the market return.

Which of the following statements is CORRECT? A. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events. B. Portfolio diversification reduces the variability of returns on an individual stock. C. The smaller standard deviation is, the less likely that actual returns will be closer to expected returns, the lower the investment risk. D. A stock with a beta of 1 is more risky than an average stock on the market. E. A well-diversified investor will require to earn higher return on stocks with higher beta.

E. A well-diversified investor will require to earn higher return on stocks with higher beta.

Historically, bonds earn higher returns than stocks.

False- stocks earn higher returns than bonds

As the number of assets in a portfolio increases, the risk of the portfolio increases.

False-risk decreases; notes-Slide 16

An investor can eliminate virtually all market risk if he or she holds a very large, well diversified portfolio of stocks.

False-we cannot reduce market risk; however we can eliminate diversifiable risk

T or F: Stock A has a standard deviation of .30 and Stock B has a standard deviation of .80. Stock B is expected to earn a higher return.

False: Standard deviation measures total risk that includes both diversifiable and market risk. Only market risk matters in the risk-return tradeoff, but we don't know which stock has higher market risk. So we don't know which stock is expected to earn higher return!

Portfolio diversification reduces the variability of returns on an individual stock.

False: Combining stocks into portfolios reduces risk by taking advantage of the CORRELATION of stocks. It will not reduce the risk or variability of individual stocks

Diversifiable risk is caused by such random events as lawsuits, strikes, successful or unsuccessful market programs, and winning or losing a major contract. Since all these events are unique to a particular firm, diversifiable risk can be diversified away in a portfolio.

True

Investment risk refers to the uncertainty associated with the return on an investment

True

Market risk stems from factors that systematically affect most firms, such as war, inflation, and recession, and therefore it cannot be eliminated by diversification.

True

Most investors are risk averse, and therefore require higher rates of return to encourage them to hold riskier securities.

True

The CAPM relates a firm's required return to its market risk.

True

When company-specific risk has been diversified away, the inherent risk that remains is market risk.

True

If we have a portfolio of two perfectly positively correlated stocks, there is no reduction in portfolio risk.

True -look in notes: Slide 14

Since virtually all stocks are positively correlated, but not perfectly so in real life, we can not completely eliminate risk by combining stocks into portfolios

True- Notes: Slide 15

If we have a portfolio of two perfectly negatively correlated stocks, portfolio risk can be reduced to zero.

True- look in notes: Slide 13

A well-diversified investor will require to earn higher return on stocks with higher beta.

True: only market risk matters; beta measures market risk: higher beta=higher market risk

By how much portfolio risk is reduced depends on correlation of stocks in the portfolio.

True: we have the most risk reduction when the stocks are perfectly negatively related and no risk reduction when they are perfectly positively correlated

The smaller σi is, The ________ likely that actual returns will be closer to expected returns. The ________ the investment risk

more lower

Magee Company's stock has a beta of 1.20, the risk-free rate is 4.50%, and the market risk premium is 5.00%. What is Magee's required return?

ri= 10.5% CAPM: Req. ret.= riskfree return+ market risk premium x beta 4.5 + (5 x 1.20)==== 10.5