Chapter 13 Return, Risk, and the Security Market Line
The risk of owning an asset comes from:
- unanticipated events - surprises
Which of the following are examples of systematic risk?
Future rates of inflation Regulatory changes in tax rates
The cost ___ of is the minimum required return on a new investment.
capital
market risk premium
the slope of the SML - the difference between the expected return on a market portfolio and the risk-free rate
The ___ is the squared standard deviation.
variation
What are the two components of the market risk premium?
the risk-free rate The expected return on the market
security market line (SML)
a positively sloped straight line displaying the relationship between expected return and beta
cost of capital
the minimum required return on a new investment
As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?
It is likely to decrease. It may eventually be almost totally eliminated.
What is an uncertain or risky return?
It is the portion of return that depends on information that is currently unknown.
Which of the following are examples of unsystematic risk?
Labor strikes Changes in management
Which type of risk is unaffected by adding securities to a portfolio?
Systematic risk
The ___ is the excess return an asset earns based on the level of risk taken.
alpha
What is the term for the excess return an asset earns based on the level of risk taken?
alpha
The ___ coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset.
beta
When we ___ an announcement or a news item, we say that it has less of an impact on price because the market already factored it in.
discounts
What two factors determine a stock's total return?
expected return and unexpected return
The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.
increases; increases
The variance of a portfolio ___ generally a simple combination of the variances of the assets in the portfolio.
isn't
There is ______ correlation between the unsystematic risk of two companies from different industries.
no
Systematic risk will ____ when securities are added to a portfolio.
not change
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be _____.
positive
The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.
positive
The SML is very important because it tells us the "going rate" for bearing ___ in the economy.
risk
capital asset pricing model (CAPM)
the equation of the SML showing the relationship between expected return and beta
The standard deviation is ___.
the square root of the variance
The true risk of any investment is the _____ portion.
unanticipated
The risk that affects a single asset or a small group of assets is ______ risk.
unsystematic
The percentage of a portfolio's total value that is invested in a particular asset is the portfolio ___.
weight
The risk-free asset has a beta of _____.
0
By definition, what is the beta of the average asset equal to?
1
If a security's expected return is equal to the expected return on the market, its beta must be ____.
1
The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. Which of the following are possible values for the standard deviation of the portfolio?
12.9% 10.9%
According to the CAPM, which of the following events would affect the return on a risky asset?
A change in the yield on T-bills A strengthening of the country's currency Federal reserve actions that affect the economy
portfolio
A group of assets such as stocks and bonds held by an investor.
systematic risk
A risk that influences a large number of assets. Also, market risk.
A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?
An increase in the corporate tax rate An increase in the Federal funds rate
Asset A has an expected return of 17 percent and standard deviation of 5 percent. Asset B has an expected return of 15 percent and standard deviation of 5 percent. Which asset would a rational investor choose?
Asset A
Assets A and B each have an expected return of 10 percent. Asset A has a standard deviation of 12 percent while Asset B has a standard deviation of 13 percent. Which asset would a rational investor choose?
Asset A
Consider the following two assets: Asset Expected Return Beta X 5.8% 0.8 Y 14.2% 1.8 If the risk free rate is 1%, what will happen to the prices of assets X and Y in an efficient market?
Asset Y's price will rise and Asset X's price will fall
How can a positive relationship between the expected return on a security and its beta be justified?
Because the difference between the return on the market and the risk-free rate is likely to be positive
What is the equation for the capital asset pricing model?
Expected return on security = Risk-free rate + Beta × (Return on market - Risk-free rate)
A well-diversified portfolio will eliminate all risks.
False
Systematic risk will impact all securities in every portfolio equally.
False
The process to calculate a portfolio's beta is opposite of the process to calculate a portfolio's expected return.
False
Which of the following are examples of a portfolio?
Investing $100,000 in a combination of U.S. and Asian stocks Holding $100,000 investment in a combination of stocks and bonds Investing $100,000 in the stocks of 50 publicly traded corporations
What does the security market line depict?
It is a graphical depiction of the capital asset pricing model. It shows the relationship between expected return and beta.
What is unsystematic risk?
It is a risk that affects a single asset or a small group of assets
What is systematic risk?
It is a risk that pertains to a large number of assets.
What is a risk premium?
It is additional compensation for taking risk, over and above the risk-free rate.
If a security's expected return is equal to the risk-free rate of return, and the market-risk premium is greater than zero, what can you conclude about the value of the security's beta based on CAPM?
It is equal to 0.
What is the definition of expected return?
It is the return that an investor expects to earn on a risky asset in the future.
Which one of the following types of risk is not reduced by diversification?
Systematic, or market risk
Which type of risk does not change as we add more securities to a portfolio?
Systematic, or market, risk
A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?
The death of the CEO A hostile takeover attempt by a competitor
alpha
The excess return an asset earns based on the level of risk taken
What is the expected return on a security with beta of 1?
The expected return on the market.
What is the slope of the security market line (SML)?
The market-risk premium
Which of the following are examples of information that may impact the risky return of a stock?
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
portfolio weight
The percentage of a portfolio's total value that is invested in a particular asset.
What is the intercept of the security market line (SML)?
The risk-free rate
According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?
The risk-free rate of return
What are the two components of unexpected return (U) in the total return equation?
The systematic portion The unsystematic portion
How are the unsystematic risks of two different companies in two different industries related?
There is no relationship.
What is the equation for total return as a function of expected and unexpected returns?
Total return = Expected return + Unexpected return
If you wish to create a portfolio of stocks, what is the required minimum number of stocks?
You must invest in stocks of more than one corporation.
The calculation of a portfolio beta is similar to the calculation of _____.
a portfolio's expected return
Based on the capital asset pricing model (CAPM) there is generally ___ relationship between beta and the expected return on a security.
a positive
unsystematic risk
a risk that affects at most a small number of assets. Also, unique or asset-specific risk
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
Place the steps in the computation of variance in the correct order from the first step to the last step.
calculate the expected return determine the squared deviation from the expected return multiply each squared deviation by its probability the result is the variance
The minimum required return on a new project when its risk is similar to that of projects the firm currently owns is known as the _____.
cost of capital
The increase in the number of stocks in a portfolio results in a(n) ___ in the average standard deviation of annual portfolio returns.
decline
Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio _____.
declines
The ___ return is the return that an investor will probably earn on a risky asset in the future.
expected
The principle of diversification tells us that spreading an investment across a number of assets will eliminate ___ of the risk.
some
principle of diversification
spreading an investment across a number of assets will eliminate some, but not all, of the risk
The first step to calculate the variances of the returns on two stocks is to determine the ___ deviations from the expected return.
squared
The ___ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.
systematic
The principle of diversification tells us that, to a diversified investor, the only type of risk that matters is ___ risk.
systematic
When an investor is diversified only ________ risk matters.
systematic
The systematic risk principle argues that the market does not reward risks _____.
that are borne unnecessarily
beta coefficient
the amount of systematic risk present in a particular risky asset relative to that in an average risky asset
systematic risk principle
the expected return on a risky asset depends only on that asset's systematic risk
The portfolio weight is _____.
the percentage of the total value that is invested in an asset
expected return
the return on a risky asset expected in the future
To determine whether an investment has a positive NPV, you can compare the expected return on that new investment to what the financial market offers on an investment with _____.
the same beta
