Ch 8 Finance

Which of the following statements is correct?

A stock's beta can be calculated by comparing its returns to the market's returns over some time period because the beta coefficient measures a stock's volatility relative to market. Correct. A stock's beta can be calculated by comparing its returns to the market's returns over some time period because the beta coefficient measures a stock's volatility relative to market. See 8-3: Portfolio Risk—Holding Combinations of Investments

Which of the following measures captures the effects of both risk and return, which makes it a better measure than standard deviation for evaluating stand-alone risk in situations where investments differ with respect to both their amounts of total risk and their expected returns?

Coefficient of variation Answer Feedback: Correct. Coefficient of variation of the investment captures the effects of both risk and return for evaluating investments that differ with respect to both their amounts of total risk and their expected returns. See 8-2: Expected Rate of Return

The expected returns for Stocks A, B, C, D, and E are 7 percent, 10 percent, 12 percent, 25 percent, and 18 percent, respectively. The corresponding standard deviations for these stocks are 12 percent, 18 percent, 15 percent, 23 percent, and 15 percent, respectively. Which one of the securities should a risk-averse investor purchase if the investment will be held in isolation (by itself)?

E Correct. The coefficient of variation = Standard deviation / Expected return Stock E is the best investment because it has the lowest coefficient of variation; that is, Stock E has the best risk-return relationship. See 8-2: Expected Rate of Return

The Security Market Line (SML) relates the risks of individual securities to their required rate of return. If investors conclude that the inflation rate is going to increase, which of the following change would occur?

The required returns on all stocks will increase. Answer Feedback: Correct. If the inflation rate increases, the risk free rate also increases, but there is no change in the risk premium. The expected rate of return of all the securities increases as a result. See 8-4: The Relationship between Risk and Rates of Return: The CAPM

Which of the following portfolios would have no diversification benefits?

A portfolio consisting of two perfectly positively correlated stocks Correct. Returns on two perfectly positively correlated stocks exhibit the same relative movement in the same direction. A portfolio consisting of two such stocks would be exactly as risky as the individual stocks, because the stocks would seem like identical twins with respect to the variability of their returns. See 8-3: Portfolio Risk—Holding Combinations of Investments

Which of the following statements about the risk-return relationship observed in investing is correct?

An increase in the expected inflation rate would lead to an increase in the required return on all the risky assets by the same amount, assuming all other things were held constant. Answer Feedback: Correct. Because the inflation premium is built into the required rates of return of both riskless and risky assets, the increase in expected inflation would cause an equal increase in the rates of return on all risky assets. See 8-4: The Relationship between Risk and Rates of Return: The CAPM

Which of the following statements about beta is correct?

Firms with greater systematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are less than 1.0. Correct. Firms with greater systematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are less than 1.0. See 8-3: Portfolio Risk—Holding Combinations of Investments

Which of the following is the only risk that is relevant to a rational, diversified investor, because it cannot be eliminated or reduced through diversification?

Market risk

Which of the following pairs of terms are names for the same risk?

Market risk and relevant risk Answer Feedback: Correct. Market risk is a nondiversifiable risk, and the investors are rewarded only for this component of risk; thus, it is the relevant risk of an investment. See 8-6: Different Types of Risk

Which of the following statements about relevant risk and irrelevant risk is correct?

Relevant risk includes interest rate risk, but excludes a firm's default risk Correct. Interest rate risk is a relevant risk because it cannot be diversified, but a firm's default risk is an irrelevant risk because it can be diversified. See 8-6: Different Types of Risk

The standard deviation of the returns of Stock A is 45.9 percent, and the standard deviation of the returns of Stock B is 52.7 percent. Which of the following statements about the stocks is correct?

Stock A has a tighter probability distribution than Stock B, and hence lower total risk. Answer Feedback: Correct. The standard deviation of the returns on a stock is a measure of the tightness, or variability, of a set of outcomes. It measures the stand-alone or the total risk of a stock. The smaller the value of the standard deviation, the tighter the probability distribution, and the lower the total risk associated with the investment. See 8-2: Expected Rate of Return

Which of the following statements about correlation is correct?

The weaker the positive correlation two stocks exhibit, the more risk can be reduced when they are combined in a portfolio. Answer Feedback: Correct. The weaker (lower) the positive correlation or the stronger (higher) the negative correlation two stocks exhibit, the more risk can be reduced when they are combined in a portfolio—that is, the greater the diversification effect. See 8-3: Portfolio Risk—Holding Combinations of Investments

Which of the following statements about diversification is correct?

When two perfectly positively correlated stocks with the same risk are combined, the portfolio risk is equal to the risk associated with the individual stocks. Answer Feedback: Correct. When two perfectly positively correlated stocks with the same risk are combined, the portfolio risk is equal to the risk associated with the individual stocks. See 8-3: Portfolio Risk—Holding Combinations of Investments

Assume Danny is considering combining two investments to form a portfolio, and he is very concerned with the risk that will result from the combination. If he wants to attain the greatest effect from diversification, he would prefer that the assets _____.

are negatively related Answer Feedback: Correct. Maximum diversification benefits are achieved when the stocks are negatively correlated. In fact, perfectly negatively correlated stocks can result in a portfolio with no risk. See 8-3: Portfolio Risk—Holding Combinations of Investments

According to the capital asset pricing model (CAPM), _____.

investors should expect to be rewarded for only the systematic risk associated with an individual investment, which is measured by the beta coefficient Answer Feedback: Correct. According to the CAPM, investors should not be rewarded for all of the risk associated with an individual investment—that is, its total, or stand-alone, risk— because some risk can be eliminated through diversification. They should expect to be rewarded for only the systematic risk associated with an individual investment, which is measured by the beta coefficient. See 8-6: Different Types of Risk