Finance Chapter 11

The addition of a risky security to a fully diversified portfolio:

may or may not affect the portfolio beta.

Which one of the following statements related to the security market line is correct?

A security with a beta of 1.54 will plot on the security market line if it is correctly priced.

Which one of the following is the minimum required rate of return on a new investment that makes that investment attractive?

Cost of capital, not risk free rate!!!

The beta of a risky portfolio cannot be less than _____ nor greater than ____.

the lowest individual beta in the portfolio; the highest individual beta in the portfolio

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

Beta coefficient

Sugar and Spice stock is expected to produce the following returns given the various states of the economy. What is the expected return on this stock?

Expected return = (0.05 × 0.05) + (0.70 × 0.09) + (0.25 × 0.14) = 10.05 percent

Which one of the following describes systemic risk?

Risk that affects a large number of assets

systematic risk

all about the market, cannot control. measured by beta.

A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. Which one of the following will lower the overall expected rate of return on this stock?

A decrease in the PROBABILITY of an economic boom

Which one of the following portfolios will have a beta of zero?

A portfolio comprised solely of U. S. Treasury bills you will ALWAYS get your money

Ben & Terry's has an expected return of 12.9 percent and a beta of 1.25. The expected return on the market is 11.7 percent. What is the risk-free rate?

E(R) = 0.129 = Rf + 1.25(0.117 - Rf) Rf = 6.92 percent

The risk-free rate is 4.2 percent and the expected return on the market is 12.3 percent. Stock A has a beta of 1.2 and an expected return of 13.1 percent. Stock B has a beta of 0.75 and an expected return of 11.4 percent. Are these stocks correctly priced? Why or why not?

E(RA) = 0.042 + 1.2(0.123 - 0.042) = 13.92 percent E(RB) = 0.042 + 0.75(0.123 - 0.042) = 10.28 percent Stock A is overpriced because its expected return lies below the security market line

Noah's Landing stock is expected to produce the following returns given the various states of the economy. What is the expected return on this stock?

Expected return = (0.3 × -0.27) + (0.65 × 0.16) + (0.05 × 0.35) = 4.05 percent

Which one of the following best describes a portfolio?

Group of assets held by an investor

The expected return on a security depends on which of the following? I. Risk-free rate of return II. Amount of the security's unique risk III Market rate of return IV. Standard deviation of returns

I and III only

Julie wants to create a $5,000 portfolio. She also wants to invest as much as possible in a high risk stock with the hope of earning a high rate of return. However, she wants her portfolio to have no more risk than the overall market. Which one of the following portfolios is most apt to meet all of her objectives?

Invest $2,500 in a risk-free asset and $2,500 in a stock with a beta of 2.0

Diversifying a portfolio across various sectors and industries might do more than one of the following. However, this diversification must do which one of the following?

Reduce the portfolio's unique risks

Which one of the following is the vertical intercept of the security market line?

Risk-free rate

A stock has an expected return of 17.2 percent and a beta of 1.65. The risk-free rate is 5.1 percent. What is the slope of the security market line?

Slope = (0.172 - 0.051)/1.65 = 7.33 percent

The expected rate of return on Delaware Shores, Inc. stock is based on three possible states of the economy. These states are boom, normal, and recession which have probabilities of occurrence of 20 percent, 75 percent, and 5 percent, respectively. Which one of the following statements is correct concerning the variance of the returns on this stock?

The variance must be positive provided that each state of the economy produces a different expected rate of return.

unsystematic risk

can be reduced by diversifying, comes along with the market you invest in

A portfolio has an expected return of 12.3 percent. This portfolio contains two stocks and one risk-free security. The expected return on Stock X is 9.7 percent and on Stock Y it is 17.7 percent. The risk-free rate is 3.8 percent. The portfolio value is $78,000 of which $18,000 is the risk-free security. How much is invested in Stock X?

.

You would like to create a portfolio that is equally invested in a risk-free asset and two stocks. One stock has a beta of 1.15. What does the beta of the second stock have to be if you want the portfolio to be equally as risky as the overall market?

1/3(0) + 1/3(1.15) + 1/3(x) = 1.0 x = 1.85 higher beta=higher risk

Based on the capital asset pricing model, which one of the following must increase the expected return on an individual security, all else constant?

A decrease in the risk-free rate given a security beta of 1.06

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

Decrease in gross domestic product

Which one of the following terms best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?

Diversification

A stock has a beta of 1.24, an expected return of 13.68 percent, and lies on the security market line. A risk-free asset is yielding 2.8 percent. You want to create a $6,000 portfolio consisting of Stock A and the risk-free security such that the portfolio beta is 0.65. What rate of return should you expect to earn on your portfolio?

E(R) = 0.1368 = 0.028 + 1.24(MRP) MRP = 0.087742 E(RP) = 0.028 + 0.65(0.087742) = 8.50 percent must calculate the middle part of CAP ass then use portfolio beta

Given the following information, what is the expected return on a portfolio that is invested 30 percent in both Stocks A and C, and 40 percent in Stock B?

E(RBoom) = (0.30 × 0.078) + (0.40 × 0.236) + (0.30 × 0.184) = 0.1730 E(RNormal) = (0.30 × 0.091) + (0.40 × 0.154) + (0.30 × 0.137) = 0.1300 E(RRecession) = (0.30 × 0.118) + (0.40 × -0.123) + (0.30 × 0.064) = 0.0054 E(RPortfolio) = (0.05 × 0.1730) + (0.85 × 0.1300) + (0.10 × 0.0054) = 11.97 percent If given multiple economies it it the same process, find the weights and then multiply by the probability

You would like to invest $19,000 and have a portfolio expected return of 12.3 percent. You are considering two securities, A and B. Stock A has an expected return of 15.6 percent and B has an expected return of 10.3 percent. How much should you invest in Stock A if you invest the balance in Stock B?

E(RP) = 0.123 = 0.156x + 0.103(1 - x) x = 0.377358 InvestmentA = 0.377358 × $19,000 = $7,170

Mary owns a risky stock and anticipates earning 16.5 percent on her investment in that stock. Which one of the following best describes the 16.5 percent rate?

Expected return

Given the following information, what is the variance of the returns on this stock? boom, probability=.18, ROR= .29 normal prob=.77, ROR=.14 Recession prob=.05, ROR=-.45

Expected return = (0.18 × 0.29) + (0.77 × 0.14) + (0.05 × -0.45) = 0.1375 Variance = 0.18(0.29 - 0.1375)2 + 0.77(0.14 - 0.1375)2 + 0.05(-0.45 - 0.1375)2 = 0.021449 calculate expected return subtract expected return from each ROR, square it, and then multiply by probability Sum= variance

Fiddler's Music Stores' stock has a risk premium of 9.6 percent while the inflation rate is 4.1 percent and the risk-free rate is 3.9 percent. What is the expected return on this stock?

Expected return = 0.039 + 0.096 = 13.5 percent risk free rate + premium, no inflation involved

You own a portfolio that is invested 38 percent in Stock A, 43 percent in Stock B, and the remainder in Stock C. The expected returns on these stocks are 10.9 percent, 15.4 percent, and 9.1 percent, respectively. What is the expected return on the portfolio?

Expected return = [0.38 × 0.109] + [0.43 × 0.154] + [(1 - 0.38 - 0.43) × 0.091] = 12.49 percent

The security market line is a linear function that is graphed by plotting data points based on the relationship between which two of the following variables?

Expected return and beta

The security market line is defined as a positively sloped straight line that displays the relationship between which two of the following variables?

Expected return and beta If a security is underpriced it will plot ABOVE the line If a security is overpriced it will plot BELOW the line Backwards

Based on the capital asset pricing model, investors are compensated based on which of the following? I. Market risk premium II. Portfolio standard deviation III. Portfolio beta IV. Risk-free rate

I, III, IV only

Which of the following terms can be used to describe unsystematic risk?

I. Asset-specific risk II. Diversifiable risk III. Market risk IV. Unique risk I, II, IV Market risk is always systematic

The systematic risk principle states that the expected return on a risky asset depends only on which one of the following?

Market risk always systematic

What is the beta of the following portfolio

Portfolio value = $21,600 + $13,000 + $46,000 + $19,800 = $100,400 βP = ($21,600/$100,400)(1.48) + ($13,000/$100,400)(1.13) + ($46,000/$100,400)(0.99) + ($19,800/$100,400)(1.08) = 1.13 weight times beta

You are assigned the task of computing the expected return on a portfolio containing several individual stocks. Which one of the following statements is correct concerning this task?

The summation of the return deviation from the portfolio expected return for each economic state must equal zero.

Which one of the following best exemplifies unsystematic risk?

Unexpected increase in the variable costs for a firm

You want to create a $48,000 portfolio that consists of three stocks and has an expected return of 14.5 percent. Currently, you own $16,700 of Stock A and $24,200 of Stock B. The expected return for Stock A is 18.7 percent, and for Stock B it is 11.2 percent. What is the expected rate of return for Stock C?

Value Stock C = $48,000 - $16,700 - $24,200 = $7,100 E(RP) = 0.145 = [($16,700/$48,000) × 0.187] + [($24,200/$48,000) × 0.112] + [($7,100/$48,000) × E(RC)]; E(RC) = 15.87 percent

You have compiled the following information on your investments. What rate of return should you expect to earn on this portfolio?

ValueA = 150 × $23 = $3,450 ValueB = 400 × $37 = $14,800 ValueC = 200 × $42 = $8,400 ValueD = 350 × $16 = $5,600 ValuePort = $3,450 + $14,800 + $8,400 + $5,600 = $32,250 Expected return = [($3,450/$32,250) × 0.128] + [($14,800/$32,250) × 0.036] + [($8,400/$32,250) × 0.098] + [($5,600/$32,250) × 0.245] = 9.83 percent

You own a $46,000 portfolio comprised of four stocks. The values of Stocks A, B, and C are $5,600, $16,700, and $11,400, respectively. What is the portfolio weight of Stock D?

ValueD = $46,000 - $6,600 - $16,700 - $11,400 = $11,300 WeightD = $11,300/$46,000 = 24.57 percent

You own a portfolio consisting of the securities listed below. The expected return for each security is as shown. What is the expected return on the portfolio?

ValueW = 300 × $11 = $3,300 ValueX = 450 × $19 = $8,550 ValueY = 100 × $48 = $4,800 ValueZ = 575 × $33 = $18,975 ValuePort = $3,300 + $8,550 + $4,800 + $18,975 = $35,625 Expected return = [($3,300/$35,625) × 0.089] + [($8,550/$35,625) × 0.116] + [($4,800/$35,625) × 0.284] + [($18,975/$35,625) × 0.127] = 14.20 percent

You own a portfolio that is invested as follows: $11,400 of Stock A, $8,800 of Stock B, $14,900 of Stock C, and $3,200 of Stock D. What is the portfolio weight of Stock C?

WeightC = $14,900/($11,400 + $8,800 + $14,900 + $3,200) = 38.90 percent

The capital asset pricing model:

considers the time value of money

If a security plots to the right and below the security market line, then the security has ____ systematic risk than the market and is ____.

more; overpriced

Assume you own a portfolio of diverse securities which are each correctly priced. Given this, the reward-to-risk ratio:

of each security must equal the slope of the security market line.

to get variance from these problems

subtract the expected return of the portfolio from the expected return of the economy multiply by the probability again and square

Standard deviation measures _____ risk while beta measures _____ risk.

total; systematic

A portfolio is comprised of 35 securities with varying betas. The lowest beta for an individual security is 0.74 and the highest of the security betas of 1.51. Given this information, you know that the portfolio beta:

will be greater than or equal to 0.74 but less than or equal to 1.51.

A $36,000 portfolio is invested in a risk-free security and two stocks. The beta of Stock A is 1.29 while the beta of Stock B is 0.90. One-half of the portfolio is invested in the risk-free security. How much is invested in Stock A if the beta of the portfolio is 0.58?

βP = 0.58 = [A/$36,000][1.29] + [($18000-A)/$36,000)] [0.90] + [0][0.50] A = $12,000

You own a $222,000,000 portfolio that is invested in Stocks A and B. The portfolio beta is equal to the market beta. Stock A has an expected return of 18.7 percent and has a beta of 1.42. Stock B has a beta of 0.88. What is the value of your investment in Stock A?

βP = 1.0 = 1.42A + [0.88 × (1 - A)]; A = 0.222222 Investment in Stock A = $222,000 × 0.222222 = $49,333

Stock J has a beta of 1.17 and an expected return of 14.4 percent, while Stock K has a beta of 0.68 and an expected return of 7.6 percent. You want a portfolio with the same risk as the market. What is the expected return of your portfolio?

βP = 1.0 = 1.17x + 0.68(1 - x) x = 0.653061 E(RP) = 0.653061(0.144) + (1 - 0.653061)(0.076) = 12.04 percent

Stock J has a beta of 1.17 and an expected return of 14.4 percent, while Stock K has a beta of 0.68 and an expected return of 7.6 percent. You want a portfolio with the same risk as the market. What is the expected return of your portfolio?

βP = 1.0 = 1.17x + 0.68(1 - x) x = 0.653061 E(RP) = 0.653061(0.144) + (1 - 0.653061)(0.076) = 12.04 percent calculate the beta of the portfolio first multiply the portfolio beta times the expected return

A stock has a beta of 1.56 and an expected return of 17.3 percent. A risk-free asset currently earns 5.1 percent. If a portfolio of the two assets has a beta of 1.06, what are the portfolio weights?

βP = 1.06 = x(1.56) + (1 - x)(0) x = 0.68 Stock weight is 0.68 and the risk-free weight is 0.32

Which one of the following is the computation of the risk premium for an individual security? E(R) is the expected return on the security, Rf is the risk-free rate, β is the security's beta, and E(RM) is the expected rate of return on the market.

β[E(RM) - Rf]

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

Market risk premium

Stock Y has a beta of 1.28 and an expected return of 13.7 percent. Stock Z has a beta of 1.02 and an expected return of 11.4 percent. What would the risk-free rate have to be for the two stocks to be correctly priced relative to each other?

(0.137 - Rf)/1.28 = (0.114 - Rf)/1.02 Rf = 2.38 percent

Stock J has a beta of 1.47 and an expected return of 15.8 percent. Stock K has a beta of 1.05 and an expected return of 11.9 percent. What is the risk-free rate if these securities both plot on the security market line?

(0.158 - Rf)/1.47 = (0.119 - Rf)/1.05 Rf = 2.15 percent

A risky security has less risk than the overall market. What must the beta of this security be?

> 0 but < 1

Which one of the following is the best example of unsystematic risk?

A warehouse fire

The expected return on a security is currently based on a 22 percent chance of a 15 percent return given an economic boom and a 78 percent chance of a 12 percent return given a normal economy. Which of the following changes will DECREASE the expected return on this security?

II. A decrease in the rate of return given a normal economy III. An increase in the probability of a normal economy

Which one of the following statements is correct?

If a risky security is correctly priced, its expected risk premium will be positive.

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

Increase in consumption created by a reduction in personal tax rates

World United stock currently plots on the security market line and has a beta of 1.04. Which one of the following will increase that stock's rate of return without affecting the risk level of the stock, all else constant?

Increase in the market risk-to-reward ratio

Stock A comprises 28 percent of Susan's portfolio. Which one of the following terms applies to the 28 percent?

Portfolio weight

Which one of the following is the best example of an announcement that is most apt to result in an unexpected return?

Statement by a firm that it has just discovered a manufacturing defect and is recalling its product

The risk premium for an individual security is based on which one of the following types of risk?

Systematic

Consider a portfolio comprised of four risky securities. Assume the economy has three states with varying probabilities of occurrence. Which one of the following will guarantee that the portfolio variance will equal zero?

The portfolio expected rate of return must be the same for each economic state. If the expected rate of return is equal in all 3 states on a risky return, then the variance will equal 0.

You own a portfolio of two stocks, A and B. Stock A is valued at $6,500 and has an expected return of 11.2 percent. Stock B has an expected return of 8.1 percent. What is the expected return on the portfolio if the portfolio value is $9,500?

ValueB = $9,500 - $6,500 = $3,000 Expected return = [($6,500/$9,500) × 0.112] + [($3,000/$9,500) × 0.081] = 10.22 percent calculate value of b calculate probability and multiply by expected return and sum

Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security?

Zero