Financial Analysis for Decision Making Chapter 11 (Ross)
optimistic; pessimistic
A bull market is characterized by ______ sentiment, while a bear market is characterized by ______ sentiment of investors in the stock market.
-an increase in the Federal funds rate -an increase in the corporate tax rate
A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?
7%
A reasonable estimate for the US equity risk premium is
Systemic
Beta measures the risk of a security.
1
By definition, the market's beta is ______.
beta
For a diversified investor, what is the best way to measure the systematic risk of an individual security?
3%
For every 3% movement in the market, the market must move by:
maximize expected return and minimize risk
From an investor's perspective, an optimal portfolio will
all possess the same estimates regarding expected returns, variances, and covariances
If investors have homogeneous expectations, they ___.
Portfolio beta = 0.5 × 1.5 + 0.5 × 1 = 1.25.
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?
-.05/(.45 × .30) = -.37
If the covariance between stocks C and D is -.05, what is the correlation between these stocks? Assume the standard deviation of returns is .45 for Stock C and .30 for Stock D.
False
Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios.
total; systematic
Standard deviation measures ______ risk, while beta measures ______ risk.
market
The ____________ portfolio is the market value weighted portfolio of all existing securities.
Positive
The historical market risk premium for equities has been ______.
no
There is _____ correlation between the unsystematic risk of two companies from different industries.
Market risk Unsystematic risk
What are the two components of risky return (U) in the total return equation?
-the risk-free rate (RF) -the risk premium
What are the two components of the expected return on the market (RMRM)?
They both measure how two random variables are related
What do covariance and correlation measure?
All relevant information available to shareholders
What does a normal return depend upon?
It measures the risk of security in relation to the overall market.
What does beta measure?
It means that, on average, if the returns of stock A are positive, the returns of stock B will be negative.
What does it mean if the returns of two stocks, A and B, are negatively correlated?
1.5/2.5 = 0.6.
What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5?
045/(.3 × .2) = .75
What is the correlation of returns between stocks A and B based on the following information? The standard deviation of returns is .30 for A and .20 for B and the covariance between A and B's returns is .045.
4% + 1.2(12% − 4%) = 13.6%.
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?
The variance will decrease
What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is negative?
The risk-free rate
What is the intercept of the security market line (SML)?
A measure of the squared deviations of a security's return from its expected return
What is variance?
Systematic, or market risk
Which type of risk does not change as we add more securities to a portfolio?
Systematic Risk
Which type of risk is unaffected by adding securities to a portfolio?
This ensures that that the sum of the deviations is a positive number.
Why are the deviations of returns squared when computing variance?
Because unsystematic risk should be eliminated through diversification
Why can an investor holding a well-diversified portfolio of securities ignore the unsystematic risk of individual securities?
because unsystematic risk should be eliminated through diversification
Why can an investor holding a well-diversified portfolio of securities ignore the unsystematic risk of individual securities?
unsystematic diversifiable
Another name for idiosyncratic risk is ______ risk.
a positive
Based on the capital asset pricing model (CAPM) there is generally ___ relationship between beta and the expected return on a security.
epsilon
In the return equation, the unsystematic risk is denoted by:
unsystematic risk part of risky return
In the return equation, which of the following does epsilon (ε) refer to?
the square root of the variance
The standard deviation is ___.
It measures the spread of the sample of returns. It measures the riskiness of a security's returns.
What does variance measure?
0.05 + 1.5(0.09 − 0.05) = 11%.
What is the expected return for a security if the risk-free rate is 5 percent, the expected return on the market is 9 percent, and the security's beta is 1.5?
Regulatory changes in tax rates Future rates of inflation
Which of the following are examples of systematic risk?
The returns will be positively correlated over time. The returns will move in the same direction (i.e. positive) but not by the same magnitude.
Which of the following are likely to be true if we observe the returns of two stocks in the same industry, such as Pfizer and Merck?
-the covariance between stocks A and B -the market value, in dollars, of the investments in stocks A and B -the variances of stocks A and B
Which of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B?
The actual return can be higher or lower than the expected return. The expected return can be calculated as the average of the returns in previous periods. The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes.
Which of the following statements are true about expected return?
1. Standard deviation is the square root of variance. 2. Variance is a measure of the squared deviations of a security's return from its expected return.
Which of the following statements are true about variance?
All investors will hold the market portfolio.
Which of the following will be true in a world with homogeneous expectations?
Systematic, or market risk
Which one of the following types of risk is not reduced by diversification?
the death of the CEO a hostile takeover attempt by a competitor
A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?
The expected return will increase to 19% from 11%.
A security has a beta of 1, the market risk premium is 8 percent, and the risk-free rate is 3 percent. What will happen to the expected return if the beta doubles?
False
A well-diversified portfolio will eliminate all risks.
βP = (2.5 + 1.5)/2 = 2. Expected return = 4% +2(9%) = 22%.
ABC has a beta of 2.5 and XYZ has a beta of 1.5. The risk-free rate is 4 percent and the market risk premium is 9 percent. What is the expected return on a portfolio that is equally invested in ABC and XYZ?
true
According to CAPM, if the historical market risk premium is negative, we cannot justify a positive relationship between a security's expected return and its beta.
above
According to the CAPM, a security is considered underpriced when its expected return plots ___ the SML.
When its expected return plots below the SML
According to the CAPM, when is a security considered overpriced?
the expected return on the market
According to the capital asset pricing model, what is the expected return on a security with beta of 1?
-diversifiable -unsystematic
Another name for idiosyncratic risk is _________ risk.
The historical market risk premium for equities has been positive. The historical market return for equities has been significantly higher (more than 5%) than the risk-free rate.
Based on historical data, which of the following are true about the market risk premium?
systematic
Beta measures ______ risk.
maximize expected return and minimize risk
From an investor's perspective, an optimal portfolio will ___.
-The risk aversion of investors will change in the future. -Future risk is different from historical risk.
Future equity risk premiums may not be equal to past equity risk premiums due to which of the following factors?
There is no relationship.
How are the unsystematic risks of two different companies in two different industries related?
Because the difference between the return on the market and the risk-free rate is likely to be positive.
How can a positive relationship between expected return on a security and its beta be justified?
It is equal to 0.
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?
increases; may change decreases; may change
If future risk ______, the future equity risk premium ______.
positive
If investors are risk-averse, it is reasonable to assume that the risk premium for the stock market will be ______.
10% ± 12% = −2% to 22%.
If the expected return is 10 percent and the standard deviation is 12 percent, what is the range of returns that will occur about 68 percent of the time?
+5 to 25
If the expected return of a portfolio is 15 percent and the standard deviation of the portfolio is 10 percent, then the 68 percent probability range is ____ percent.
increase ex: If the variance of a portfolio increases, then the portfolio standard deviation will also increase because the standard deviation is the square root of the variance.
If the variance of a portfolio increases, then the portfolio standard deviation will
σp= .0025.5= .05, or 5%
If the variance of a portfolio is .0025, what is the standard deviation?
0.1243
If the variance of a security is 0.01545, what is the standard deviation?
negative
In a two-asset portfolio, a ________ covariance of returns between the two securities will lead to a reduction in the variance of the portfolio.
True
In practice, economists use proxies for the market portfolio instead of the actual market portfolio.
True
It is possible for the unsystematic risk of a portfolio to be reduced to practically zero.
A is better as it offers the same return at a lower level of risk.
Portfolios A and B have an expected return of 10 percent. Portfolio A has a standard deviation of 6 percent, while Portfolio B has a standard deviation of 13 percent. Which portfolio would a rational investor choose?
market risk
Systematic risk is sometimes referred to as
not change
Systematic risk will ____ when securities are added to a portfolio.
False
Systematic risk will impact all securities in every portfolio equally.
-individual securities portfolios
The CAPM can be used for which of the following?
upward sloping
The SML will be ______ if the expected return on the market is higher than the risk-free rate.
diversification
The ______ effect applies as long as there is less than perfect correlation.
actual; expected; unexpected
The ______ return is equal to the ______ return and a(n) ______ part of the return.
False
The diversification effect applies as long as there is a perfect correlation.
increases; increases
The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.
remain unchanged
The expected returns of the existing securities in your portfolio ______ when new securities are added to the portfolio
σA × σB
The formula for computing the correlation of the returns on Stocks A and B is equal to the Cov(RA,RB) divided by _____.
to maximize the expected return and minimize the standard deviation.
The goal of a rational, wealth-maximizing investor in developing a portfolio is to maximize the Blank______ and minimize the Blank______.
characteristic
The line shows a security's return in relation to the market's return.
premium
The return on market minus the risk-free rate is the market risk
decrease
The risk of a large, diversified portfolio will ______ if a security with a negative beta is added to the portfolio.
.is less than one
The standard deviation of a portfolio of two securities will be less than the weighted average of the standard deviation of the two securities when the correlation between the two securities
less than +1.
The standard deviation of the S&P 500 index is likely less than the weighted average of the individual securities in the index because the correlations between pairs of the securities are likely ____.
covariance correlation
Two ways to measure the relationship between the returns of two securities are ______ and ______.
True
Unsystematic risk is eliminated in a well-diversified portfolio of securities.
It shows a security's return in relation to the market's return.
What does the characteristic line for a security show?
It is a graphical depiction of the capital asset pricing model.
What does the security market line depict?
3.75/2.5 = 1.5.
What is Stock B's beta if the covariance between stock B and the market is 3.75, and variance of the market is 2.5?
It is the return that shareholders predict or expect.
What is a normal return?
It is additional compensation for taking risk, over and above the risk-free rate.
What is a risk premium?
It is the portion of return that depends on information that is currently unknown.
What is an uncertain or risky return?
The return that an individual expects to earn over the next period.
What is expected return?
It is a risk that pertains to a large number of assets.
What is systematic risk?
beta
What is the appropriate measure of risk for individual security if an investor holds a diversified portfolio?
Zero
What is the covariance for two securities with returns that are unrelated to each other?
A bull market is characterized by rising prices, while a bear market is characterized by falling prices.
What is the difference between a bull market and a bear market?
Expected return on a security = Risk-free rate + beta x expected risk premium on market
What is the equation for the capital asset pricing model?
Actual Return = Normal return + Risky return
What is the equation for the return on a company's stock?
0.5 × 10% + 0.5 × 15% = 12.5%.
What is the expected return of 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.
It is the market value weighted portfolio of all existing securities.
What is the market portfolio?
.5 × 7% + .3 × -3% + .2 × 18% = 6.2%
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.
The market-risk premium
What is the slope of the security market line (SML)?
It is a risk that affects a single asset or a small group of assets.
What is unsystematic risk?
It can increase or decrease.
What will happen to the risk of a portfolio composed of two securities as more dollars are invested in the riskier asset?
does not matter
When expressing covariance between two securities, the ordering of variables
does not matter
When expressing covariance between two securities, the ordering of variables:
decrease
When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to ______.
The death of the CEO of a publicly traded corporation Management fraud leading to significant losses
Which of the following are examples of idiosyncratic risk?
-The Fed's decision on interest rates at their meeting next week -The outcome of an application currently pending with the Food and Drug Administration.
Which of the following are examples of information that may impact the risky return of a stock?
The variances of stocks A and B The covariance between stocks A and B The market value, in dollars, of the investments in stocks A and B
Which of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B?
-If the market declines 1 percent, AIG should rise by about 4.53 percent. -If the market rises 1 percent, AIG should decline by about 4.53 percent.
Which of the following are true if AIG's beta is −4.53?
Correlation is related to covariance. Correlation measures the interrelationship between the returns of two securities.
Which of the following statements are true about correlation?
Unsystematic Idiosyncratic Unique
____ risk is reduced as more securities are added to the portfolio