FRL 3000: Smartbook: CH 13 - Return, Risk & the Security Market Line

The risk-free asset has a beta of _____.

0.00 Reason: The risk-free asset has a beta of zero, because it does not change with changes in the market portfolio.

If a security's expected return is equal to the expected return on the market, its beta must be ____.

1 Reason: If a security's expected return is equal to the expected return on the market, its beta must be 1, because the beta of the market is 1.

By definition, what is the beta of the average asset equal to?

1 Reason: By definition, the beta of the average asset is one, because it is the yardstick by which all the other assets are measured.

Select all that apply 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? 10.9% 12.9% 14.9%

10.9% 12.9% Reason: The standard deviation of a portfolio is less than or equal to the weighted average of the standard deviations of the assets in the portfolio.

Select all that apply A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm? A hostile takeover attempt by a competitor An increase in the dividend tax rate A change in the Federal Reserve's monetary policy The death of the CEO

A hostile takeover attempt by a competitor The death of the CEO Reason: An increase in the dividend tax rate would affect all firms; it is systematic risk. Reason: A change in the Fed's monetary policy would affect all firms; it is systematic risk.

Select all that apply A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks? Management turnover An increase in the Federal funds rate A fire in a manufacturing plant An increase in the corporate tax rate

An increase in the Federal funds rate An increase in the corporate tax rate

Select all that apply A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks? An increase in the Federal funds rate Management turnover An increase in the corporate tax rate A fire in a manufacturing plant

An increase in the Federal funds rate An increase in the corporate tax rate Reason: Management turnover would affect only that company; it is unsystematic risk. A fire in a manufacturing plant would not affect the entire economy - only that company and perhaps its customers and suppliers; it is unsystematic risk.

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 Reason: A is better as it offers the same return at a lower level of risk.

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 Reason: Asset A offers a higher expected return for the same level of risk.

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 Reason: Asset X's price will fall, leading to an increase in its expected return. Asset Y's price will rise, leading to a decrease in its expected return. This process will continue until the reward-to-risk ratio is the same for both assets.

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

The __________ is the excess return an asset earns based on the level of risk taken.

Blank 1: alpha

The ____________ is the excess return an asset earns based on the level of risk taken.

Blank 1: alpha

The __________ coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset.

Blank 1: beta

The cost of __________ is the minimum required return on a new investment.

Blank 1: capital

The increase in the number of stocks in a portfolio results in a(n) _________ in the average standard deviation of annual portfolio returns.

Blank 1: decline, fall, decrease, reduction, or drop

The increase in the number of stocks in a portfolio results in a(n) ___________ in the average standard deviation of annual portfolio returns.

Blank 1: decline, fall, decrease, reduction, or drop

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.

Blank 1: discount, discounts, or discounted

The ______________ return is the return that an investor will probably earn on a risky asset in the future.

Blank 1: expected

The variance of a portfolio ________ (is/isn't) generally a simple combination of the variances of the assets in the portfolio.

Blank 1: isn't, is not, not, or isnt

The variance of a portfolio _________(is/isn't) generally a simple combination of the variances of the assets in the portfolio.

Blank 1: isn't, is not, not, or isnt

The SML is very important because it tells us the "going rate" for bearing _________ in the economy.

Blank 1: risk

The SML is very important because it tells us the "going rate" for bearing ___________ in the economy.

Blank 1: risk

The _____________ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.

Blank 1: systematic

The principle of diversification tells us that, to a diversified investor, the only type of risk that matters is ________________ (systematic/unsystematic) risk.

Blank 1: systematic

The __________- is the squared standard deviation.

Blank 1: variance or variation

The percentage of a portfolio's total value that is invested in a particular asset is the portfolio __________.

Blank 1: weight or weights

Select all that apply Which of the following are examples of unsystematic risk? Changes in the federal tax code The expected rate of inflation next year Changes in management Labor strikes

Changes in management Labor strikes Reason: Changes in the federal tax code are systematic risks that affect a large number of companies. Reason: Unsystematic risk affects a single or small group of assets. Inflation is a systematic risk that affects a large number of companies.

What is the equation for the capital asset pricing model?

Expected return on security = Risk-free rate + Beta × (Return on market - Risk-free rate)

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

False Reason: Even if the portfolio is well diversified, the investor is still exposed to systematic, or nondiversifiable risk.

True or false: Systematic risk can be eliminated by diversification

False Reason: Unsystematic risk is essentially eliminated by diversification

True or false: The process to calculate a portfolio's beta is opposite of the process to calculate a portfolio's expected return.

False Reason: The processes are similar.

True or false: Systematic risk will impact all securities in every portfolio equally.

False Reason: While it is possible, it is highly unlikely that systematic risk (such as changes in interest rates) will affect all firms equally.

Select all that apply Which of the following are examples of a portfolio? Investing $100,000 in a combination of U.S. and Asian stocks Holding $100,000 in cash to buy after five years 100 shares of the best performing stock on the NYSE Holding $100,000 investment in a combination of stocks and bonds Investing $100,000 in the stocks of 50 publicly traded corporations

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

Select all that apply Which of the following are examples of a portfolio? Holding $100,000 in cash to buy after five years 100 shares of the best performing stock on the NYSE Investing $100,000 in the stocks of 50 publicly traded corporations Holding $100,000 investment in a combination of stocks and bonds Investing $100,000 in a combination of U.S. and Asian stocks

Investing $100,000 in the stocks of 50 publicly traded corporations Holding $100,000 investment in a combination of stocks and bonds Investing $100,000 in a combination of U.S. and Asian stocks Reason: Since by definition a portfolio is a group of assets held by an investor, holding a single asset would generally not be considered to be a portfolio.

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 an uncertain or risky return?

It is the portion of return that depends on information that is currently unknown. Reason: The risky return is the portion that depends on unknown information. The normal return depends on information that is currently known.

What is the definition of expected return?

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

Select all that apply As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk? It is likely to increase. It may eventually be almost totally eliminated. It will not change. It is likely to decrease.

It may eventually be almost totally eliminated. It is likely to decrease. Reason: Since financial securities tend to be less than perfectly positively correlated, the addition of more securities to a portfolio will likely decrease unsystematic risk.

Select all that apply Which of the following are examples of systematic risk? Regulatory changes in tax rates An increase in competition in the industry Future rates of inflation Labour strikes

Regulatory changes in tax rates Future rates of inflation Reason: Competition within an industry is an example of unsystematic risk. Labour strikes are an example of unsystematic risk.

Which type of risk is unaffected by adding securities to a portfolio?

Systematic risk Reason: Systematic risk cannot be diversified away. Unsystematic risk is reduced by adding securities to the portfolio.

Which one of the following types of risk is not reduced by diversification?

Systematic, or market risk Reason: Systematic risk cannot be diversified away.

Which type of risk does not change as we add more securities to a portfolio?

Systematic, or market, risk

What is the expected return on a security with beta of 1?

The expected return on the market. Reason: The expected return on a security with a beta of 1 must equal the expected return on the market, because the beta of the market is 1. E(r)=Risk-free rate+(1*Market risk premium) = Expected return on the market

What is the slope of the security market line (SML)?

The market-risk premium Reason: The slope of the SML is the market-risk premium (expected return on the market minus the risk-free rate of return).

Select all that apply 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 The trend in sales growth over the last 10 years. 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 Reason: Risky return is affected by information that will be revealed in the near future, not historical information.

What is the intercept of the security market line (SML)?

The risk-free rate

Select all that apply What are the two components of the market risk premium? The risk-free rate Beta The default spread The expected return on the market

The risk-free rate The expected return on the market

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 Reason: Risk-free rate + 0 × Market risk premium = Risk-free rate

How are the unsystematic risks of two different companies in two different industries related?

There is no relationship. Reason: Unsystematic risk is specific only to a single company or industry. Thus, one company's unsystematic risk will generally be unrelated to another company's systematic risk.

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. incorrect Reason: By definition, a portfolio is a group of assets held by an investor. Thus, to have a portfolio, one needs to have at least two assets.

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 Reason: The market risk premium is the slope of the CAPM. As long as the market risk premium is positive, the relationship between beta and the expected return on a security will be positive.

What is the term for the excess return an asset earns based on the level of risk taken?

alpha

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

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

Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio _____.

declines

When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.

decrease Reason: Total unsystematic risk decreases as more securities are added to a portfolio.

The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.

increases; increases

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 Reason: Adding securities will reduce unsystematic risk only. Systematic risk is unaffected by diversification.

The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.

positive Reason: According the the CAPM, the relationship is positive - the higher the beta, the higher the expected return.

The principle of diversification tells us that spreading an investment across a number of assets will eliminate Blank______ of the risk.

some

When an investor is diversified only ________ risk matters.

systematic Reason: If risk can be diversified away, it shouldn't matter when the risk premium is determined.

The systematic risk principle argues that the market does not reward risks _____.

that are borne unnecessarily Reason: The market only rewards systematic risk.

The portfolio weight is _____.

the percentage of the total value that is invested in an asset

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

The standard deviation is ___.

the square root of the variance

The true risk of any investment is the _____ portion.

unanticipated

Select all that apply The risk of owning an asset comes from: forecasts expectations unanticipated events surprises

unanticipated events surprises

Select all that apply The risk of owning an asset comes from: unanticipated events forecasts expectations surprises

unanticipated events surprises

Select all that apply For a well-diversified portfolio, the Blank______ risk is negligible. systematic unique unsystematic diversifiable market

unique unsystematic diversifiable

The risk that affects a single asset or a small group of assets is ______ risk.

unsystematic