Chapter 13 - Return, Risk and the Security Market Line
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%
Consider the betas for CBS at 1.71. If the risk-free rate is 3.15% and the market risk premium is 7.5%, what is its expected return?
15.97% 7.5 * 1.71 =.12825 .12825 + .0315 = .1597
Which of the following are examples of systematic risk?
Future rates of inflation Regulatory changes in tax rates
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.
Which type of risk does not change as we add more securities to a portfolio?
Systematic, or market, risk
What two factors determine a stock's total return?
Unexpected return Expected return
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 _____coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset.
beta
The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.
increases; increases Reason: The expected return on the market will increase if the risk-free rate increases or if the market risk premium increases. It is an increasing function of both.
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
he risk of owning an asset comes from:
surprises unanticipated events
The portfolio weight is _____.
the percentage of the total value that is invested in an asset
The _______ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.
unsystematic
The _____ is the squared standard deviation.
variance
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. Reason: E(Ri) = Rf +βi(RM - Rf) = Rf → βi= 0
A portfolio is invested 45 percent in Stock G, 40 percent in Stock J, and 15 percent in Stock K. The expected returns on these stocks are 11 percent, 9 percent, and 15 percent, respectively. What is the portfolio's expected return? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
10.80%
Consider the following information: State of Economy Probability of State of Economy Portfolio Return if State Recession .20 −.13 Boom .80 .19 Calculate the expected return. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
12.60
The risk free rate is 4%, and the required return on the market is 12%. What is the required return on an asset with a beta of 1.5?
16% .12 - .04 = .08 .08 * 1.5 = .12 .12 + .04 = .16 = 16%
True or false: A well-diversified portfolio will eliminate all risks.
False
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
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
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: The process to calculate a portfolio's beta is opposite of the process to calculate a portfolio's expected return.
False
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
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 systematic risk principle argues that the market does not reward risks _____.
that are borne unnecessarily
Consider the following two assets: Asset : X Expected Return: 5.8% Beta: 0.8 Asset: Y Expected return: 14.2% Beta: 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
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.
True or false: Systematic risk can be eliminated by diversification
False
True or false: Systematic risk will impact all securities in every portfolio equally.
False
What is the intercept of the security market line (SML)?
The risk-free rate
What is the equation for total return as a function of expected and unexpected returns?
Total return = Expected return + Unexpected return
The ______ return is the return that an investor will probably earn on a risky asset in the future.
expected
The standard deviation is ___.
the square root of the variance
By definition, what is the beta of the average asset equal to?
1
You own a portfolio that has $4,450 invested in Stock A and $9,680 invested in Stock B. If the expected returns on these stocks are 8 percent and 11 percent, respectively, what is the expected return on the portfolio? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
10.06%
The increase in the number of stocks in a portfolio results in a(n) ________ in the average standard deviation of annual portfolio returns.
decrease
When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.
decrease
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 ________ is the excess return an asset earns based on the level of risk taken.
Alpha
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 An increase in the corporate tax rate
Which type of risk is unaffected by adding securities to a portfolio?
Systematic risk
What are the two components of the market risk premium?
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
The calculation of a portfolio beta is similar to the calculation of _____.
a portfolio's expected return
What is the term for the excess return an asset earns based on the level of risk taken?
alpha
The variance of a portfolio _______ (is/isn't) generally a simple combination of the variances of the assets in the portfolio.
isn't (is not)
The risk-free asset has a beta of _____.
0
If a security's expected return is equal to the expected return on the market, its beta must be ____.
1
Place the steps in the computation of variance in the correct order from the first step to the last step.
1. Calculate the expected return 2. Determine the squared deviation from the expected return 3. Multiply each squared deviation by its probability 4. The result is the variance
Consider the following information: State of Economy Probability of State of Economy Portfolio Return if State Recession .10 −.17 Normal .60 .08 Boom .30 .27
11.20%
The risk free rate is 4%, and the required return on the market is 12%. What is the required return on a portfolio consisting of 40% of an asset with a beta of 1.5, and the rest invested in an asset with an average amount of systematic risk?
13.6% How did we get it? There's 2 assets, an asset of 40%, and an asset of 60% with an average amount of systematic risk. (100 - 40 = 60) Your equation will be divided into two, where 60% asset will have a beta of 1 (average systematic risk), and a return on market of 12%, because an average systematic risk will be equal to the return on market. The 40% will have to be found with risk premium and risk free rate. 60% Asset: .60*.12= .072 = 7.2% 40% Asset: Find risk premium by subtracting risk free rate from return on market, .12-.04 = .08 Multiply 8% risk premium by 1.5 beta .08 * 1.5 = .12 Add the risk free rate back .12 + .04 = .16 Multiply by 40% to find the return of the 40% asset .064 = 6.4% Add both asset returns to get compounded return .072 +.064 = .136 = 13.6%
Consider an asset with a beta of 1.2, a risk-free rate of 5%, and a market return of 13%. What is the expected return on the asset?
14.6% You have to deduct the risk-free rate of 5% from the market return of 13% to get the market risk premium before doing the equation 13-5 = 8% 1.2 * 8% = .09600 Add back risk free rate .09600 + .05 = .146 =14.6%
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 The death of the CEO
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.
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
According to the CAPM, which of the following events would affect the return on a risky asset?
Federal reserve actions that affect the economy A change in the yield on T-bills A strengthening of the country's currency Reason: According to the CAPM, a security's return is a function of the pure time value of money (risk-free rate), the reward for bearing systematic risk (risk premium on the market), and the amount of systematic risk present in the security (measured by beta). A fire in the company's plant is not likely to change any of these things.
Which of the following are examples of a portfolio?
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
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.
What is an uncertain or risky return?
It is the portion of return that depends on information that is currently unknown.
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 of the following are examples of unsystematic risk?
Labor strikes Changes in management
Which one of the following types of risk is not reduced by diversification?
Systematic, or market risk
Which of the following are examples of information that may impact the risky return of a stock?
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.
What is the slope of the security market line (SML)?
The market-risk premium
What are the two components of unexpected return (U) in the total return equation?
The unsystematic portion The systematic portion
How are the unsystematic risks of two different companies in two different industries related?
There is no relationship.
Based on the capital asset pricing model (CAPM) there is generally ___ relationship between beta and the expected return on a security.
a positive
The cost of _____ is the minimum required return on a new investment.
capital
Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio _____.
declines
The increase in the number of stocks in a portfolio results in a(n) ______ in the average standard deviation of annual portfolio
decrease
When we _____ an announcement or a news item, we say that it has less of an impact on price because the market already facto
discount
For a well-diversified portfolio, the
diversifiable unsystematic unique
The SML is very important because it tells us the "going rate" for bearing _____ in the economy.
risk
The principle of diversification tells us that spreading an investment across a number of assets will eliminate ______ of the risk.
some
The first step to calculate the variances of the returns on two stocks is to determine the ______ deviations from the expected return.
square
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
he percentage of a portfolio's total value that is invested in a particular asset is the portfolio ____
weight