Chapter 11

o Historical return data includes that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio: Fluctuates randomly Does not change Declines Increases

• Declines

o Which one of these is the best example of systematic risk? Discovery of a major gas field Decrease in textile imports Increase in agricultural exports Decrease in gross domestic product Decrease in management bonuses for banking executives

• Decrease in gross domestic product

o Which one of the following statements is correct? The risk premium on a risk-free security is generally considered to be one percent. The expected rate of return on any security, given multiple states of the economy, must be positive. There is an inverse relationship between the level of risk and the risk premium given a risky security. If a risky security is correctly priced, its expected risk premium will be positive. If a risky security is priced correctly, it will have an expected return equal to the risk-free rate.

• If a risky security is correctly priced, its expected risk premium will be positive.

o Which one of these represents systematic risk? Major layoff by a regional manufacturer of power boats Increase in consumption created by a reduction in personal tax rates Surprise firing of a firm's chief financial officer Closure of a major retail chain of stores Product recall by one manufacturer

• Increase in consumption created by a reduction in personal tax rates

o What is the definition of expected return? It is the variation in return during the last period It is the return that was earned in the past on a risky asset It is the return that an investor expects to earn on a risky asset in the future It is the expected variation in return on a risky asset

• It is the return that an investor expects to earn on a risky asset in the future

o An investment will have a negative NPV when its expected return is _________ _________ what the financial marketers offer for the same risk. Greater than Equal to Less than

• Less than

o What are two components of risky return (U) in the total return equation?(2) Expected risk Market risk Unsystematic risk Expected return

• Market risk • Unsystematic risk

o Systematic risk will ______ when securities are added to a portfolio Decrease Increase Not change Be eliminated

• Not change

o If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be: Negative Zero Unimaginably large Positive

• Positive

o Which of the following statements is (are) true about variance?(2) Variance measures a security's expected return over many periods Standard deviation is the square root of variance Computation of variance requires the use of a computer Variance is a measure of the squared deviations of a security's return from its expected return

• Standard deviation is the square root of variance • Variance is a measure of the squared deviations of a security's return from its expected return

o When an investor is diversified only _______ risk matters Systematic Unnatural Diversifiable Unsystematic

• Systematic

o The systematic risk principle argues that the market does not reward risks: (2) In any circumstances That are borne unnecessarily That are systematic That are diversifiable

• That are borne unnecessarily • That are diversifiable

o A security has a beta of 1, a market risk premium of 8%, and a risk-free rate of 3%. What will happen to the expected return if the beta doubles? The expected return will decrease by 8% The expected return will double The expected return will increase by 1% The expected return will increase to 19% from 11%

• The expected return will increase to 19% from 11%

o If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities? .5 1.25 2.5 1.5

• 1.25

o True or False: Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios

False

o True or false: A well-diversified portfolio will eliminate all risks

False

o True or false: The surprise is information that market uses to form the expectations of the return on the stock.

False

o What is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5? 13.5% 6.5% 4% 11%

• 11%

o If the variance of a portfolio is .0025, what is the standard deviation? 12.5% 25% 5% 6.25%

• 5%

o Unsystematic risk will affect (2) All manufacturing firms Firms in a single industry A specific firm The market as a whole

• Firms in a single industry • A specific firm

o Which of the following are examples of systematic risk?(2) Labor strikes An increase in competition in the industry Future rates of inflation Regulatory changes in tax rates

• Future rates of inflation • Regulatory changes in tax rates

o Systematic risk is also called ____________ risk Industry-specific Diversifiable Market World-wide

• Market

o How are the unsystematic risks of two different companies in two different industries related? There is no relationship The relationship can be either positive or negative There is a negative relationship There is a positive relationship

• There is no relationship

o The true risk of any investment comes from: (2) Expectations Unanticipated events Surprises Forecasts

• Unanticipated events • Surprises

o As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?(2) It will not change It is likely to decrease It is likely to increase It may eventually be almost totally eliminated

• It is likely to decrease • It may eventually be totally eliminated

o If an asset has a reward-to-risk ratio of 6%, that means it has a ________ of 6% per unit of ___________ Return; systematic risk Risk premium; systematic risk Systematic risk; risk premium Return; risk

• Risk premium; systematic risk

o What is the intercept of the security market line (SML)? The market rate of return The risk-free rate Beta The market-risk premium

• The risk-free rate

o Fiddler's Music Stores' stock has a risk premium of 8.3 percent while the inflation rate is 3.1 percent and the risk-free rate is 3.8 percent. What is the expected return on this stock? 9.0 percent 6.9 percent 12.1 percent 13.7 percent 15.2 percent

• 12.1 Percent

o What is the expected return on a portfolio consisting of stocks A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both the stocks. 10% 12.5% 15% 25%

• 12.5%

o What is the expected return of a security with a beta of 1.2 if the risk-free rate is 4 percent and the expected return on the market is 12 percent? 18.4% 12% 13.6% 14.8%

• 13.6%

o PL Lumber stock is expected to return 22 percent in a booming economy, 15 percent in a normal economy, and lose 2 percent in a recession. The probabilities of an economic boom, normal state, or recession are 5 percent, 92 percent, and 3 percent, respectively. What is the expected rate of return on this stock? 14.84 percent 14.23 percent 14.51 percent 15.47 percent 15.26 percent

• 14.84 Percent

o What is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund and $20,000 in a foreign stock fund? The expected returns are 7 percent, -3 percent, and 18 percent respectively. 22% 6.2% .06% 7.26%

• 6.2%

o The calculation of a portfolio's beta is similar to the calculation of: A portfolio's variance A portfolio's expected return The value of a put option A portfolio's standard deviation

• A portfolio's expected return

o Which one of the following is the best example of unsystematic risk? Inflation exceeding market expectations A warehouse fire Decrease in corporate tax rates Decrease in the value of the dollar Increase in consumer spending

• A warehouse fire

o When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market: Already knew about most of the news item Reversed its position based on the news Doesn't pay attention to news items

• Already knew about most of the news items

o ________ is reduced as more securities are added to the portfolio(3) Company-specific Diversifiable Marketwide Unsystematic

• Company-specific • Diversifiable • Unsystematic

o Which of the following are examples of unsystematic risk?(2) Changes in the federal tax code The expected rate of inflation next year Labor strikes Changes in management

• Labor strikes • Changes in management

o The appropriate discount rate to use to evaluate a new project is the ________. Average market return Cost of capital Risk free rate

• Cost of capital

o To determine the appropriate required return for an investment, we can use _______________ The lowest going rate The risk free rate The average return on the market The Security Market Line

• The Security Market Line

o John's portfolio consists of $1,200 worth of Chi Corporation common stock and $400 worth of Lambda Corporation common stock. Lambda's portfolio weight is 25%, and Chi's portfolio weight is: 75% 33.33% 25% 300%

• 75%

o The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last Calculate the average squared deviation Calculate the deviation of each return from the expected return Calculate the expected return Square each deviation

• Calculate the expected return • Calculate the deviation of each return from the expected return • Square each deviation • Calculate the average squared deviation

o The minimum require return on a new project is known as the: Payback period Internal rate of return Capital of cost Cost of capital

• Cost of capital

o Which of the following are examples of information that may impact the risky return of a stock? (2) Last year's net income as a percentage of sales and gross fixed assets The outcome of an application currently pending with the Food and Drug Administration The Fed's decision on interest rates at their meeting next week The trend in sales growth over the last 10 years

• The outcome of an application currently pending with the Food and Drug Administration • The Fed's decision on interest rates at their meeting next week

o What is the beta of a risk free asset? Zero .5 1 Unknown

• Zero

o Which statement is true? The expected rate of return on any portfolio must be positive. The arithmetic average of the betas for each security held in a portfolio must equal 1.0. The beta of any portfolio must be 1.0. The weights of the securities held in any portfolio must equal 1.0. The standard deviation of any portfolio must equal 1.0.

• The weights of the securities held in any portfolio must equal 1.0.

o Standard deviation measures _____ risk while beta measures _____ risk. systematic; unsystematic unsystematic; systematic total; unsystematic total; systematic asset-specific; market

• total; systematic

o Which one of the following is the minimum required rate of return on a new investment that makes that investment attractive? Risk-free rate Market risk premium Expected return minus the risk-free rate Market rate of return Cost of capital

• Cost of Capital

o Mary owns a risky stock and anticipates earning 16.5 percent on her investment in that stock. Which one of the following best describes the 16.5 percent rate? Expected return Real return Market rate Systematic return Risk premium

• Expected Return

o What two factors determine a stock's total return?(2) Bond rates Expected return Abnormal return Unexpected return

• Expected return • Unexpected return

o Which of the following are examples of a portfolio?(3) Investing $100,000 in a combination of US and Asian stocks Investing $100,000 in a combination of stocks and bonds Investing $100,000 in the stocks of 50 publicly traded corporations Investing $100,000 to buy 100 shares of the best performing stock on the NYSE

• Investing $100,000 in a combination of US and Asian stocks • Investing $100,000 in a combination of stocks and bonds • Investing $100,000 in the stocks of 50 publicly traded corporations

o What is an uncertain or risky return? It is the portion of return that depends on information that is currently known It is the portion of return that is unaffected by present or future information It is the return that is classified as risky by bond rating agencies It is the portion of return that depends on information that is currently unknown

• It is the portion of return that depends on information that is currently unknown

o Which of the following types of risk is not reduced by the diversification? Asset-specific risk Systematic, or market risk Unsystematic risk Unique risk

• Systematic, or market risk

o What is the slope of the security market line (SML)? The expected return on market The market-risk premium The expected return on the market plus the risk-free rate of return The risk-free rate of return

• The market-risk premium