Chapter 17

3. What would be the portfolio standard deviation if the investment in problem 2 is combined with another stock with an expected return of 13% and standard deviation of 2.3%. 40% of your total investment goes to first stock and remaining to the second stock. Two stock returns have a correlation coefficient (rij) of +0.40?

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1. The Infidelity Mutual Fund projects three possible outcomes for next year: weak performance (-5 percent), good performance (10 percent), and outstanding performance (30 percent). The good performance has a 50 percent chance of happening and is twice as likely as the other two outcomes. What is the expected value?

11.25%

8. Using the formula for the capital market line, if the risk-free rate is 8 percent, the market rate of return is 12 percent, the market standard deviation is 10 percent, and the standard deviation of the portfolio is 12 percent, compute the anticipated return.

12.8%

10. Using the formula for the security market line, if the risk-free rate (RF) is 7 percent, the beta (bi) is 1.25, and the market rate of return (KM) is 11.8 percent, compute the anticipated rate of return (Ki).

13%

9. Recompute the answer to problem 8 based on a portfolio standard of 16 percent. In terms of capital market theory, explain why KP has increased.

14.4% Kp has increased because the portfolio is now riskier with a standard deviation of 16 percent versus 12 percent in the prior problem.

The beta coefficient is a measure of: A. the relationship between the return of an individual stock and the return on the market. B. the relationship between the return on a stock and the return on the portfolio. C. the relationship between the portfolio risk and the market risk. D. None of the above

A. the relationship between the return of an individual stock and the return on the market.

One way to express the trade-off between risk and return for an individual security is through: A. the security market line. B. the beta coefficient. C. the correlation coefficient. D. arbitrage pricing theory.

A. the security market line.

A good way to minimize risk and receive an optimum return on your portfolio is: A. through diversification. B. to buy only risk-free securities. C. through blue-chip stock purchases only. D. through junk-bonds.

A. through diversification.

The standard deviation of a risk-free asset is: A. 1. B. 0. C. -1. D. any number between -1 and 1.

B. 0.

If the _____ of any individual stock is known, an investor can use the _____ to determine the expected rate of return on that stock. A. Beta; capital market line B. Beta; security market line C. Standard deviation; capital market line D. None of the above

B. Beta; security market line

Because of portfolio effect, the most significant factor related to the risk of any investment is: A. its standard deviation, or degree of uncertainty. B. its effect on the risk of the portfolio. C. systematic risk associated with the investment. D. None of the above

B. its effect on the risk of the portfolio.

For two investments with a correlation coefficient (rij) less than +1, the portfolio standard deviation will be __________ the weighted average of the individual investments' standard deviation. A. more than B. less than C. equal to D. zero compared to

B. less than

The efficient frontier: A. represents all possible portfolios for a given level of risk. B. separates unattainable portfolios from less than optimal portfolios. C. is different for every investor. D. More than one of the above

B. separates unattainable portfolios from less than optimal portfolios.

The capital asset pricing model (CAPM) takes off where the _________ concluded. A. Security market line B. Capital market line C. Efficient frontier and Markowitz portfolio theory D. Arbitrage pricing theory

C. Efficient frontier and Markowitz portfolio theory

If you took all the possible investments that investors could acquire and determined the optimum basket of investments, you would come up with point _________ on the capital market line. A. RF B. K C. M D. Z

C. M

The capital market line (CML) as defined by the capital asset pricing model is characterized by all of the following except: A. a straight line tangent to the efficient frontier. B. a straight line which includes the rate of return on a risk-free asset. C. a point on the efficient frontier above which higher returns can be generated by borrowing funds without assuming more risk. D. All of the above are characteristics of the capital market line

C. a point on the efficient frontier above which higher returns can be generated by borrowing funds without assuming more risk.

Systematic risk is rewarded with a premium in the marketplace because: A. risk is particular to the stock or industry. B. it represents a random occurrence which could not have been foreseen. C. it is associated with market movements which cannot be eliminated through diversification. D. None of the above

C. it is associated with market movements which cannot be eliminated through diversification.

If the market rate of return is 10% and the beta on a particular stock is .78, the return on the stock will be: A. greater than 10%. B. greater or less than 10%, depending on the risk-free rate of return. C. less than 10%. D. dependent on some other factor.

C. less than 10%.

Assume a portfolio has the possibility of returning 7%, 8%, 10%, or 12%, with a likelihood of 20%, 30%, 25%, and 25%, respectively. Considering the portfolio's standard deviation and expected value, would you say that this portfolio is of: A. average yield, low-risk. B. lower-than-average yield, low-risk. C. average yield, average risk. D. Not enough information to tell

D. Not enough information to tell

The risk that is assumed to be rewarded for an individual stock under the capital asset pricing model is measured by the: A. portfolio standard deviation. B. portfolio beta. C. individual stock's standard deviation. D. individual stock's beta.

D. individual stock's beta.

2. An investment has the following range of outcomes and probabilities: Outcomes: 6%, 9%, 1% Probability of Outcomes: 0.2, 0.6, 0.12 Calculate the expected value and the standard deviation.

Expected Value: 9% Standard Deviation: 1.9%

According to the capital asset pricing model, it is possible to compose a portfolio with a return greater than any one on the efficient frontier, given equal risk, without borrowing funds for investment.

False

If a particular stock is less risky than the market, its beta coefficient will fall somewhere between -1 and 0.

False

In general, the greater the dispersion of outcomes, the lower the risk.

False

In using the capital market line, the higher the portfolio standard deviation, the lower the anticipated return (Kp).

False

The expected value is a commonly used measure of dispersion.

False

The standard deviation for a portfolio is a weighted average of the individual securities' standard deviations.

False

The steeper the slope on a risk-return indifference curve, the more anxious an investor is to take risks.

False

Unlike the capital market line, the security market line is unique for each investor.

False

Unsystematic risk earns a risk premium, because it cannot be offset through efficient portfolio management.

False

11. If another security had a lower beta than indicated in problem 10, would Ki be lower or higher? What is the logic behind your answer in terms of risk?

Ki would be lower. There is less market related risk for which the investor is assumed to be compensated.

Security Market line formula

Ki=Rf+Bi*(Km-Rf)

Capital Market line formula

Kp=Rf+[(Km-Rf)/Om)]*Op

Portfolio Standard Deviation formula

Square root of (Xi^2)*(Oi^2)+(Xj^2)*(Oj^2)+2*Xi*Xj*Rij*Oi*Oj

Standard Deviation formula

Square root of the summation of (Ki minus average Ki)^2 * Pi

Expected Value formula

Summation of Ki*Pi

Points above the efficient frontier have superior risk-return characteristics to those along the efficient frontier, but are not part of the feasible set.

True

Points along the capital market line represent a combination of a risk-free asset and M (the market portfolio) with the possibility of borrowing beyond point M.

True

Points below the efficient frontier have less desirable risk-return characteristics than those along the efficient frontier.

True

Systematic risk measures risk that is related to the market.

True

The beta coefficient indicates how volatile a stock is, relative to the market.

True

The capital asset pricing model (CAPM) takes off where the efficient frontier concludes, with the introduction of a new investment outlet, the risk-free asset (RF).

True

The capital market line enables investors to achieve a higher level of utility than they could on the efficient frontier.

True

The essence of the capital market line is that the only way to earn greater returns is to take increasingly greater risks.

True

The expected value for a portfolio is a weighted average of the individual securities' expected values.

True

The greater the negative correlation between two (or more) securities, the lower the portfolio standard deviation (all else being equal).

True

The idea behind the portfolio effect is that risk can be reduced by combining securities, but there will be a corresponding reduction in return.

True

The security market line shows the risk-return trade-off for an individual security.

True