RISK & RETURN

If markets are in equilibrium, which of the following conditions will exist? A. Each stock's expected return should equal its required return as seen by the marginal investor. B. All stocks should have the same expected return as seen by the marginal investor. C. The expected and required returns on stocks and bonds should be equal. D. All stocks should have the same realized return during the coming year. E. Each stock's expected return should equal its realized return as seen by the marginal investor.

A

The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic rIsk.

ANS: F

Your friend is considering adding one additional stock to a 3-stock portfolio, to form a p 4-stock portfolio. She is highly risk averse and has asked for your advice. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter? a. Stock A. b. Stock B. C. Neither A nor B, as neither has a return sufficient to compensate for risk. d. Add A. since its beta must be lower. e.Either A or B, i.e., the investor should be indifferent between the two.

B

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

F

A stock with a beta equal to - 1.0 has zero systematic (or market) risk.

F

A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

F

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other

F

An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

F

Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.

F

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk

F

If investors become less averse to risk, the slope of the Security Market Line (SML) will increase

F

If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.

F

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

F

Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will by definition be riskless.

F

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions.

F

The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

F

The slope of the SML is determined by the value of beta.

F

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

F

Two conditions are used to determine whether or not a stock is in equilibrium: (1)Does the stock's market price equal its intrinsic value as seen by the marginal investor, and ( 2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

F

We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

F

We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

F

Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?

Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta. b. The beta of an "average stock," or "the market," can change over time, sometimes drastical-ly. C. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. d. e. All of the statements above are true. The fact that a security or project may not have a past history that can be used as the basis for calculating bet B

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

T

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

T

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

T

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

T

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

T

Diversification will normally reduce the riskiness of a portfolio of stocks.

T

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

T

If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

T

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

T

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation.

T

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

T

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data.

T

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

T

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

T

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM.

T

Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky.

T

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

T

Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.

T

The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML.

T

Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation.

T

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

T