CH. 13, FRL 301

Assets Risk Premium in the CAPM

E(Ra)- Rf or Ba( E(Rm) - Rf)

The ____ of a security divided by the beta of that security is equal to the slope of the security market line if the security is priced fairly.

Risk premium

Total Risk

Total risk = Systematic + unsystematic risk measured by standard deviation Systematic measured by beta.

Which one of the following measures the amount of systematic Risk present in a particular risky asset relative to the systematic Risk present in an average risky asset?

Beta

The Capital Asset Pricing Model CAPM

E(Ra) = Rf + Ba (E(Rm) -Rf

According to CAPM, the amount of reward an investor receives fro bearing the risk of an individual security depends upon the:

Market risk premium and the amount of systematic risk inherent in the security.

If a stock portfolio is well diversifiable, then the portfolio variance:

May be less than the variance of the least risky stock in the portfolio

The Principle of Diversification

Spreading an investment across assets and thereby forming a portfolio is diversification. this reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another.

The total risk is measured by______ and systematic risk is measured by_____.

Standard deviation, beta

Which one of the following is a risk that applies to most securities?

Systematic Risk

The intercept point of the security market line is the rate of return which corresponds to:

The risk free rate

Which one of the following statements related to unexpected returns is correct?

Unexpected returns can be either positive or negative in the short term but tend to be zero over the long term.

Sytematic risk is measured by

beta

Reward to risk ratio for the market index

E(Rm)- Rf, Bm= 1.0

The reward to risk ratio fro stock A is less then the reward to risk ratio of stock B. Stock A has a beta of .82 and the stock B has a beta of 1.29. This information implies that:

Either stock A is overpriced or stock B is under-priced or both.

At a minimum, which of the following would you need to know to estimate the amount of additional reward you will receive for purchasing a risky asset instead of a risk-free asset? I. asset's standard deviation II. asset's beta III. risk-free rate of return IV. market risk premium

II and IV

The excess return earned by an asset that has a beta of 1.34 over that earned by a risk free asset is referred to as the:

Risk premium

The ____ tells us that the expected return on a risky asset depends only on that assets nodiversifiable risk.

Systematic Risk Principle

Can we reduce variability without reducing equivalent amount of returns? Is there a limit that how much risk we can diversify away?

Yes

Unsystematic Risk

can be effectively eliminated by portfolio diversification

The standard deviation of a portfolio

can be less than the standard deviation of the least risky security in the portfolio can be less than the weighted average of the standard deviations of all the individual securities held in that portfolio

Which one of the following is the formula that explains the relationship between the expected return on a security and the level of that security's systematic risk?

capital asset pricing model

Reward to risk ratio:

(E(Ra- Rf)/ Ba = E(Rm- Rf)/Bm

How many diverse securities are required to eliminate the majority of the diversifiable risk from a portfolio?

25

Which one of the following statements is correct concerning a portfolio of 20 securities with multiple states of the economy when both the securities and the economic states have unequal weights?

Given both the unequal weights of the securities and the economic states, an investor might be able to create a portfolio that has an expected standard deviation of zero.

Which of the following are examples of diversifiable risk? I. earthquake damages an entire town II. federal government imposes a $100 fee on all business entities III. employment taxes increase nationally IV. toymakers are required to improve their safety standards

I AND IV

Which of the following statements are correct concerning diversifiable risks? I. Diversifiable risks can be essentially eliminated by investing in thirty unrelated securities. II. There is no reward for accepting diversifiable risks. III. Diversifiable risks are generally associated with an individual firm or industry. IV. Beta measures diversifiable risk.

I,II,and III

Systematic Risk

Influence: affect a large number of assets Also called: non-diversifiable risk or market risk Examples: changes in GDP, inflation, interest rates

Which one of the following is an example of systematic risk?

Investors panic causing security prices around the globe to fall precipitously

Which of the following statements concerning risk are correct?

Nondiversifiable risk is measured by beta. Systematic Risk is another name for nondiversifiable risk.

Which one of the statements is correct?

Over time, the average unexpected return will be zero.

Suzie owns five different bonds valued at $36,000 and twelve different stocks valued at 482,500 total. Which one of the following terms most applies to Suzies investment?

Portfolio

Which one of the following will be constant for all securities if the market is efficient and securities are priced fairly?

Reward to risk ratio

Which one of the following is positively sloped linear function that is created when expected returns are graphed against security betas?

Security Market line

The Security Market Line

The security market line (SML) shows the relation between the expected return and systematic risk (Beta) The slope od SML is he reward to risk ratio is the riak premium/ beta: (E(Rm) -Rf)/ Bm= E(Rm)- Rf

Which one of the following events would be in the expected return on Sussex stock?

This morning, Sussex confirmed that its CEO is retiring at the end OF THE YEAR AS WAS ANTICIPATED.

Standard deviation measures which type of risk?

Total

new flash just appeared that caused about a dozen stocks to suddenly drop in value by about 20%. What type of risk does this news flash represent?

Unsystematic

Which one of the following is most directly affected by the level of systematic risk in a security?

expected rate of return

The expected rate of return on a stock portfolio is a weighted average where the weights are based on the:

market value of the investment in each stock

Can we diversify systematic risk? Will diversifiable risk be rewarded? Does risky assets always lead to risky portfolio?

no

Steve Invested in twelve different stocks that have a combined value today of $121,300. 15% of that total is invested in Wise Man Foods. the 15% is a measure of which one of the following?

portfolio weight

Which one of the following is least apt to educe the unsystematic risk of a portfolio?

reducing the number of stocks held in the portfolio

Which one of the following should earn the most risk premium based on CAPM?

stock with beta of 1.38

The market risk premium is computed by:

subtracting the risk free rate of return from the market rate of return

Overpriced and Underpriced Assets within the SML context

-The SML shows the relation between expected return and systematic risk( beta) - If an asset lies above the SML line, it is under priced, and has a higher reward to risk ratio then that is implied by the CAPM. If an asset lies below the SML line, it is overpriced, and has a lower reward to risk ratio then that is implied by the CAPM.

Which one of the following statements is correct concerning a portfolio beta?

A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio

Which one of the following is represented by the slope of the security market line?

Market Risk Premium

Treynor Industries is investing in a new project. The minimum rate of return the firm requires on this project is referred to as the:

Cost of capital

The primary purpose of portfolio diversification is to:

Eliminate asset-specific risk

Which one of the following statements is correct concerning unsystematic risk?

Eliminating unsystematic risk is the responsibility of the individual investor.

You own a stock that you think will produce a return of 11 percent in a good economy and 3 percent in a poor economy. Given the probabilities of each state of the economy occurring, you anticipate that your stock will earn 6.5 percent next year. Which one of the following terms applies to this 6.5 percent?

Expected return

The capital asset pricing model (CAPM) assumes which of the following? I. a risk-free asset has no systematic risk. II. beta is a reliable estimate of total risk. III. the reward-to-risk ratio is constant. IV. the market rate of return can be approximated.

I, III, and IV only

The expected return on a portfolio: I. can never exceed the expected return of the best performing security in the portfolio. II. must be equal to or greater than the expected return of the worst performing security in the portfolio. III. is independent of the unsystematic risks of the individual securities held in the portfolio. IV. is independent of the allocation of the portfolio amongst individual securities.

I,II,AND III

The expected return on a portfolio considers which of the following factors? I. percentage of the portfolio invested in each individual security II. projected states of the economy III. the performance of each security given various economic states IV. probability of occurrence for each state of the economy

I,II,III, AND IV

Unsystematic Risk

Influence: Affect a limited number of assets Also Called: unique risk and assets specific risk, firm specific risk Examples: labor strikes, part shortages, etc.

The expected risk premium on a stock is equal to the expected return on the stock minus the

Risk free rate

Beat and the Risk Premium

Risk premium= Expected Return- Risk free rate The higher the beta, the greater the risk premium should be

The principle of diversification tells us that:

Spreading an investment across many diverse assets will eliminate some of the total risk

Which one of the following statements related to risk is correct?

The systematic risk of a portfolio can be effectively lowered by adding T-bills to the portfolio.

Which one of the following risks is irrelevant to well-diversified investor?

Unsystematic risk

The expected return on a stock given various states of the economy is equal to the :

Weighted average of the returns for each economic state

The systematic risk of the market is measured by:

a beta of 1.0

Which one of the following indicates a portfolio is being effectively diversified?

a decrease in the portfolio standard deviation

Which one of the following is the best example of a diversifiable risk?

a firms sales decrease

A stock with an actual return that lies above the security market line has:

a higher return than expected for the level of risk assumed.

The expected return on a stock computed using economic probabilities is:

a mathematical expectation based on a weighted average and not an actual anticipated outcome.

The market rate of return is 11 percent and the risk-free rate of return is 3 percent. Lexant stock has 3 percent less systematic risk than the market and has an actual return of 12 percent. This stock:

is underpriced

Systematic risk

o A beta of 1 implies the asset has the same systematic risk as the overall market o A beta < 1 implies the asset has less systematic risk than the overall market o A beta > 1 implies the asset has more systematic risk than the overall market o Beta=0 implies risk-free asset