Chapter 8 - Risk and Rate of Return

standard deviation

-Rational, risk-averse investors are concerned with ____________, which is based upon market risk.

0.85

Investment X has a 25% chance of producing a 20% return, a 50% chance of producing a 15% return, and a 25% chance of producing a return of -5%. What's Investment X's coefficient of variation?

d

Investment X has a 25% chance of producing a 20% return, a 50% chance of producing a 15% return, and a 25% chance of producing a return of -5%. What's Investment X's standard deviation? a. 8.8% b. 11.4% c. 10.7% d. 9.6% e. 9.3%

true

Is the following statement true or false? There is a fundamental trade-off between risk and return: to entice investors to take on more risk, you have to provide them with higher expected returns.

capital asset pricing model

Model linking risk and required returns. suggests that there is a Security Market Line (SML) that states that a stock's required return equals the risk-free return plus a risk premium that reflects the stock's risk after diversification

0.5 to 1.5

Most stocks have betas in the range of

compensate

No investment should be undertaken unless the expected rate of return is high enough to DO WHAT for the perceived risk.

true

People differ with regard to their willingness to bear risks. However, if two stocks have the same expected rate of return, then most individuals would prefer the less risky to the more risky stock. This is called risk aversion. True or false?

coefficient of variation

Standard deviation divided by the mean (expected return)

c

Suppose a stock has a beta of 1.3, the risk-free rate is 6.0%, and the market risk premium is 4.5%. If the stock's beta falls to 1.0 but the other two variables remain unchanged, by how much would the stock's required rate of return decline? a. 0.62% b. 0.88% c. 1.35% d. 2.28% e. 1.71%

true

Suppose the standard deviation of expected returns for a given corporate project is quite high, and the project's returns are also highly correlated with returns on the firm's other assets. This suggests that the project is quite risky. However, if the project is not perfectly positively correlated with returns on other stocks in the market, then the project's true risk to stockholders might not be very large. True or false?

false; When calculating the portfolio's risk, you have to consider the effect of the relationship between the security holdings in the portfolio. Thus, it cannot be calculated simply by taking the weighted average of the individual stocks' standard deviations. The portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk.

T or F : Because of the effects of diversification, the portfolio's risk is likely to be more than the average of all stocks' standard deviations.

true

T or F: A portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk.

true

T or F: But because we can't look into the future, we often use historical data and assume that the stock's historical beta will give us a reasonable estimate of how the stock will move relative to the market in the future.

true

T or F: If a choice has to be made between two investments that have the same expected returns but different standard deviations, most people would choose the one with the lower standard deviation and therefore the lower risk.

false

T or F: Portfolio risk will increase if more stocks that are negatively correlated with other stocks are added to the portfolio.

false ; When calculating the portfolio's risk, you have to consider the effect of the relationship between the security holdings in the portfolio. Thus, it cannot be calculated simply by taking the weighted average of the individual stocks' standard deviations. The portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk.

T or F: The portfolio's risk is the weighted average of the individual stocks' standard deviations.

true

T or F: The unsystematic risk component of the total portfolio risk can be reduced by adding negatively correlated stocks to the portfolio.

false; only one

T or F: There can be many prices (the market return) for a given security

c

The Beta of a stock measures: a. How many times the stock has split. b. How much dividends the corporation has paid in the past. c. How the stock price moves relative to the rest of the market. d. How the stock price moves relative to interest rate movements.

true

The Security Market Line (SML) shows the relationship between stocks' required rates of return (measured on the vertical axis) and their betas (measured on the horizontal axis). The vertical axis intercept is the required rate of return on a riskless asset, and the required rate of return associated with b = 1.0 is the required rate of return on "the market." The difference between the required rate of return on the market and that on the riskless asset (rM - rRF) is defined as the "market risk premium." The steeper the SML, the larger the market risk premium, and the greater the average investor's aversion to risk. True or false?

realized rate of return

The actual interest rate earned on an investment in a financial security.

true

The coefficient of variation is a better measure of risk than the standard deviation if one is comparing assets that have substantially different expected returns, because it shows the amount of risk per unit of expected return. True or false?

false

The higher the positive correlation between two assets' returns, the greater is the risk reduction from holding them in a portfolio. True or false?

diversified and market risk

The portfolio's total risk can be divided into two parts, what are they

true

The probability distribution for a stock would list the stock's set of possible returns and the probability of each return. We could use this data to find both the stock's expected rate of return and the standard deviation of that return, which is one measure of risk. True or false?

relevant risk

The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. It is measured by the extent to which the stock moves up or down with the market.

risk aversion

The tendency to prefer a sure gain of a moderate amount over a riskier outcome, even if the riskier outcome might have a higher expected payoff.

d

The weights in the expected rate of return calculation must sum to equal: a. One hundred. b. The current real market interest rate. c. The expected rate of return. d. One.

false

True or False: If a company's beta doubles, its required return doubles.

c

Which of the following statements is CORRECT? a. The realized rate of return is denoted simply as a lower-case r. It represents a statistical calculation of what will happen with the stock's future return. b. The required rate of return is denoted simply as a lower-case r with a straight line on top. This rate of return doesn't represent speculation about a stock's future return but represents the actual return you receive from the stock. c. The required return represents the return an investor requires to invest in the stock; the expected return is based on a statistical calculation of what will happen with the future value of the stock; and the realized rate of return is the actual, historic return earned on the stock. d. The actual values of the expected rate of return, the required rate of return, and the realized rate of return must be identical for financial markets to operate. e. None of the statements above are correct.

portfolio risk

You invest $100,000 in 40 stocks, 20 bonds, and a certificate of deposit (CD). To which kind of risk will you primarily be exposed? Stand-alone risk Portfolio risk

standard deviation

a measure of how far the actual return is likely to deviate from the expected return.

diversifiable risk

a risk that affects only individuals or small groups and not the entire economy

Diversification

company growth through starting up or acquiring businesses outside the company's current products and markets Spreading out investments to reduce risk

b

enerally, investors would prefer to invest in assets that have: A lower-than-average expected rate of return given the perceived risk. A higher-than-average expected rate of return given the perceived risk.

stand-alone risk

market risk + diversifiable risk = what?

sharpe ratio

measures excess return per unit of risk -the larger the better Reward-to-volatility ratio; ratio of portfolio excess return to standard deviation.

market risk

risk that affects all companies in the stock market - •Measured by beta.

market risk

risk that remains even if the portfolio holds every stock in the market.

false

t or F: The market risk component of the total portfolio risk can be reduced by randomly adding stocks to the portfolio.

beta coefficient

the amount of systematic risk present in a particular risky asset relative to that in an average risky asset

risk premium

the excess return required from an investment in a risky asset over that required from a risk-free investment

required return

the expected return of an investment that is necessary to compensate for the risk of undertaking the investment

higher

the higher a security's risk, the _____________ its required return, and if this situation does not hold, prices will change to bring about the required condition.

expected return

the return on a risky asset expected in the future

stand-alone risk

the risk an investor would face if he or she held only this one asset. Most financial assets, and stocks in particular, are held in portfolios, but it is necessary to understand stand-alone risk to understand risk in a portfolio context.

diversified risk

the risk that is eliminated by adding stocks

expected return on a portfolio

the weighted average of the expected returns of the individual assets in the portfolio, with the weights being the percentage of the total portfolio invested in each asset:

market risk premium

•Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. •Its size depends on the perceived risk of the stock market and investors' degree of risk aversion. •Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year.

No ; -Stand-alone risk is not important to a well-diversified investor.

•If an investor chooses to hold a one-stock portfolio (doesn't diversify), would the investor be compensated for the extra risk they bear?

beta

•Measures a stock's market risk, and shows a stock's volatility relative to the market. •Indicates how risky a stock is if the stock is held in a well-diversified portfolio.

beta coefficient

•The slope of the regression line is defined as the WHAT for the security.

move relative to the market in the future.

•Well-diversified investors are primarily concerned with how a stock is expected to

b

A stock with a Beta of more than one: a. Has paid more dividends than the average stock in the market. b. Has experienced price changes that are more volatile than the over market. c. Has paid out more than the rate of inflation. d. Will reduce the overall volatility of a stock portfolio

b

A stock with a Beta of more than one: a. Has paid more dividends than the average stock in the market. b. Has experienced price changes that are more volatile than the over market. c. Has paid out more than the rate of inflation. d. Will reduce the overall volatility of a stock portfolio.

a

Based on your understanding of P/E ratios, in which of the following situations would the average trailing P/E ratio (current price divided by earnings per share over the previous 12 months) of the S&P 500 Index be higher? Forecast earnings for S&P 500 companies are expected to rise in the future. Forecast earnings for S&P 500 companies are expected to fall in the future.

true

Betas can be found by plotting stocks' returns on the vertical axis and the returns on an index like the S&P 500 on the horizontal axis, and then calculating the slope of the resulting regression line. This slope is the stock's beta coefficient. The steeper the slope, the larger the beta and the riskier the stock. True or false?

1.12

A 2-stock portfolio that contains $40,000 of GE stock with a beta of 1.25 and $60,000 of Duke Energy stock with a beta of 0.60 would have a beta of 0.86. What would be the portfolio's beta, if the owner rebalanced the portfolio so that it contained $80,000 of GE and $20,000 of Duke Energy stock?

beta

A metric that shows the extent to which a given stock's returns move up and down with the stock market. measures market risk.

e

Diversification is a fundamental investment tool. Which of the following is a key to diversification? a. Variety—Invest in a wide range of financial products. b. Correlation—Look at investments that are not closely correlated, meaning that their values don't tend to move in the same direction at the same time. c. Quantity—There's no such thing as a diminishing return to diversification, so you should invest in the maximum number of investments as possible. If you can invest in thousands of different investments within your portfolio, you should. d. Statements a, b, and c are all correct. e. Statements a and b are correct.

asset's return - risk free rate / standard deviation

How do you calculate the Sharpe ratio

true

If all investors were completely indifferent to risk, i.e., if they had no aversion to risk at all, then the SML would plot as a horizontal line. True or false?

true

If two assets are held in a portfolio, the assets will generally be less risky than if they were held in isolation. True or false?

true

If two assets are perfectly positively correlated, then their returns will move up and down exactly in sync with one another. True or false?

c

In calculating the expected rate of return, the expected returns in each state are weighted by: a. The time it takes to earn that return. b. The rate of return expected. c. The probability of that state occurring. d. The after tax rate of return earned

true

In response to concerns about the CAPM's validity, some researchers have developed models that include more explanatory variables than just beta. While these models are promising, the basic CAPM is still the most widely used method for estimating required rates of returns on stocks. True or false?

e

Investment X has a 25% chance of producing a 20% return, a 50% chance of producing a 15% return, and a 25% chance of producing a return of -5%. What is X's expected return? a. 10.15% b. 9.33% c. 10.69% d. 9.65% e. 11.25%