Finance Chapter 11

The addition of a risky security to a fully diversified portfolio: A. must decrease the portfolio's expected return. B. must increase the portfolio beta. C. may or may not affect the portfolio beta. D. will increase the unsystematic risk of the portfolio. E. will have no effect on the portfolio beta or its expected return.

C) MAY or MAY NOT affect the portfolio beta.

Stock A comprises 28 percent of Susan's portfolio. Which one of the following terms applies to the 28 percent? A. Portfolio variance B. Portfolio standard deviation C. Portfolio weight D. Portfolio expected return E. Portfolio beta

C) Portfolio weight

Which one of the following best exemplifies unsystematic risk? A. Unexpected economic collapse B. Unexpected increase in interest rates C. Unexpected increase in the variable costs for a firm D. Sudden decrease in inflation E. Expected increase in tax rates

C) Unexpected increase in the variable costs for a firm

The capital asset pricing model: A. assumes the market has a beta of zero. B. rewards investors based on total risk. C. considers the time value of money. D. applies to portfolios but not to individual securities. E. assumes the market risk premium is constant over time.

C) considers the TIME VALUE of money.

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. An increase in the rate of return in a recessionary economy B. An increase in the probability of an economic boom C. A decrease in the probability of a recession occurring D. A decrease in the probability of an economic boom E. An increase in the rate of return for a normal economy

D) A decrease in the probability of an economic boom

Which one of the following is the best example of systematic risk? A. Discovery of a major gas field B. Decrease in textile imports C. Increase in agricultural exports D. Decrease in gross domestic product E. Decrease in management bonuses for banking executives

D) Decrease in gross domestic product (GDP)

The security market line is defined as a POSITIVELY sloped straight line that displays the relationship between which two of the following variables? A. Beta and standard deviation B. Systematic and unsystematic risk C. Nominal and real returns D. Expected return and beta E. Risk premium and beta

D) Expected return and beta

Which one of the following statements is correct? A. The risk premium on a risk-free security is generally considered to be one percent. B. The expected rate of return on any security, given multiple states of the economy, must be positive. C. There is an inverse relationship between the level of risk and the risk premium given a risky security. D. If a risky security is correctly priced, its expected risk premium will be positive. E. If a risky security is priced correctly, it will have an expected return equal to the risk-free rate.

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

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? A. An increase in the risk-free rate B. Decrease in the security's beta C. Overpricing of the stock in the market place D. Increase in the market risk-to-reward ratio E. Decrease in the market rate of return

D) Increase in the market risk-to-reward ratio

The systematic risk principle states that the expected return on a risky asset depends only on which one of the following? A. Unique risk B. Diversifiable risk C. Asset-specific risk D. Market risk E. Unsystematic risk

D) Market risk

Which one of the following is the best example of an announcement that is most apt to result in an unexpected return? A. A news bulletin that the anticipated layoffs by a firm will occur as expected on December 1 B. Announcement that the CFO of the firm is retiring June 1st as previously announced C. Announcement that a firm will continue its practice of paying a $3 a share annual dividend D. Statement by a firm that it has just discovered a manufacturing defect and is recalling its product E. The verification by senior management that the firm is being acquired as had been rumored

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

27. The risk premium for an individual security is based on which one of the following types of risk? A. Total B. Surprise C. Diversifiable D. Systematic E. Unsystematic

D) Systematic

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? A. The expected rate of return on the portfolio must be positive. B. The arithmetic average of the betas for each security held in the portfolio must equal 1.0. C. The portfolio beta must be 1.0. D. The summation of the return deviation from the portfolio expected return for each economic state must equal zero. E. The standard deviation of the portfolio must equal 1.0.

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

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? A. The variance must decrease if the probability of occurrence for a boom increases. B. The variance will remain constant as long as the sum of the economic probabilities is 100 percent. C. The variance can be positive, zero, or negative, depending on the expected rate of return assigned to each economic state. D. The variance must be positive provided that each state of the economy produces a different expected rate of return. E. The variance is independent of the economic probabilities of occurrence.

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

Portfolio diversification ELIMINATES which one of the following? A. Total investment risk B. Portfolio risk premium C. Market risk D. Unsystematic risk E. Reward for bearing risk

D) Unsystematic risk

Systematic risk is: A. totally eliminated when a portfolio is fully diversified. B. defined as the total risk associated with surprise events. C. risk that affects a limited number of securities. D. measured by beta. E. measured by standard deviation.

D) measured by beta.

Standard deviation measures _____ risk while beta measures _____ risk. A. systematic; unsystematic B. unsystematic; systematic C. total; unsystematic D. total; systematic E. asset-specific; market

D) total; systematic

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(r)M is the expected rate of return on the market. A. E(r)M - rf B. E(r) - E(r)M C. E(r) - (E(r)M + rf) D. β[E(r)M - rf] E. β[E(r) - rf]

D) β[E(r)M - rf]

The beta of a risky portfolio cannot be less than _____ nor greater than _____. A. 0; 1 B. 1; the market beta C. the lowest individual beta in the portfolio; market beta D. the market beta; the highest individual beta in the portfolio E. the lowest individual beta in the portfolio; the highest individual beta in the portfolio

E) the LOWEST individual beta in the portfolio; the HIGHEST individual beta in the portfolio

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: A. must be 1.0 because of the large number of securities in the portfolio. B. is the geometric average of the individual security betas. C. must be less than the market beta. D. will be between 0 and 1.0. E. will be greater than or equal to 0.74 but less than or equal to 1.51.

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

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? A. Expected return B. Real return C. Market rate D. Systematic return E. Risk premium

A) Expected return

If a security plots to the RIGHT and BELOW the security market line, then the security has ____ systematic risk than the market and is _____. A. more; overpriced B. more; underpriced C. less; overpriced D. less; underpriced E. less; correctly priced

A) MORE; overpriced

Which one of the following describes systemic risk? A. Risk that affects a large number of assets B. An individual security's total risk C. Diversifiable risk D. Asset specific risk E. Risk unique to a firm's management

A) Risk that affects a LARGE number of assets

Which one of the following is the best example of unsystematic risk? A. Inflation exceeding market expectations B. A warehouse fire C. Decrease in corporate tax rates D. Decrease in the value of the dollar E. Increase in consumer spending

B) A warehouse fire

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? A. Squared deviation B. Beta coefficient C. Standard deviation D. Mean E. Variance

B) Beta coefficient

Which one of the following is an example of systematic risk? A. Major layoff by a regional manufacturer of power boats B. Increase in consumption created by a reduction in personal tax rates C. Surprise firing of a firm's chief financial officer D. Closure of a major retail chain of stores E. Product recall by one manufacturer

B) Increase in consumption created by a reduction in personal tax rates

Which one of the following is the slope of the security market line? A. Risk-free rate B. Market risk premium C. Beta coefficient D. Risk premium on an individual asset E. Market rate of return

B) Market risk premium

A risky security has LESS RISK than the overall market. What must the beta of this security be? A. 0 B. >0but<1 C. 1 D. > 1 E. The beta cannot be determined based on the information provided.

B. >0 but <1

Which one of the following statements related to the security market line is correct? A. An underpriced security will plot below the security market line. B. A security with a beta of 1.54 will plot on the security market line if it is correctly priced. C. A portfolio with a beta of 0.93 will plot to the right of the overall market. D. A security with a beta of 0.99 will plot above the security market line if it is correctly priced. E. A risk-free security will plot at the origin.

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

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? A. The portfolio beta must be 1.0. B. The portfolio expected rate of return must be the same for each economic state. C. The portfolio risk premium must equal zero. D. The portfolio expected rate of return must equal the expected market rate of return. E. There must be equal probabilities that the state of the economy will be a boom or a bust.

B. The portfolio expected rate of return must be the SAME for each economic state.

Which one of the following portfolios will have a beta of zero? A. A portfolio that is equally as risky as the overall market. B. A portfolio that consists of a single stock. C. A portfolio comprised solely of U. S. Treasury bills. D. A portfolio with a zero variance of returns. E. No portfolio can have a beta of zero.

C) A portfolio comprised solely of U. S. Treasury bills.

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? A. Systematic B. Unsystematic C. Diversification D. Security market line E. Capital asset pricing model

C) Diversification

Which one of the following best describes a portfolio? A. Risky security B. Security equally as risky as the overall market C. New issue of stock D. Group of assets held by an investor E. Investment in a risk-free security

D) Group of assets held by an investor

Which one of the following statements is correct? A. A portfolio that contains at least 30 diverse individual securities will have a beta of 1.0. B. Any portfolio that is correctly valued will have a beta of 1.0. C. A portfolio that has a beta of 1.12 will lie to the left of the market portfolio on a security market line graph. D. A risk-free security plots at the origin on a security market line graph. E. An underpriced security will plot above the security market line.

E) An underpriced security will plot above the security market line.

Which one of the following is the minimum required rate of return on a new investment that makes that investment attractive? A. Risk-free rate B. Market risk premium C. Expected return minus the risk-free rate D. Market rate of return E. Cost of capital

E) Cost of capital

The security market line is a linear function which is graphed by plotting data points based on the relationship between which two of the following variables? A. Risk-free rate and beta B. Market rate of return and beta C. Market rate of return and the risk-free rate D. Risk-free rate and the market rate of return E. Expected return and beta

E) Expected return and beta

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? A. Increase the expected risk premium B. Reduce the beta of the portfolio to zero C. Increase the security's risk premium D. Reduce the portfolio's systematic risk level E. Reduce the portfolio's unique risks

E) Reduce the portfolio's unique risks

Which one of the following is the vertical intercept of the security market line? A. Market rate of return B. Individual security rate of return C. Market risk premium D. Individual security beta multiplied by the market risk premium E. Risk-free rate

E) Risk-free rate

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? A. Security beta multiplied by the market rate of return B. Market risk premium C. Security beta multiplied by the market risk premium D. Risk-free rate of return E. Zero

E) Zero

Assume you own a portfolio of diverse securities which are each correctly priced. Given this, the reward- to-risk ratio: A. for the portfolio must equal 1.0. B. for the portfolio must be less than the market risk premium. C. for each security must equal zero. D. of each security is equal to the risk-free rate. E. of each security must equal the slope of the security market line.

E) of each security must EQUAL the slope of the security market line.

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 A. I and IV only B. II and III only C. I, II, and IV only D. II, III, and IV only E. I, II, III, and IV

I. asset-specific risk II. diversifiable risk IV. unique risk

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 A. I and III only B. II and IV only C. I, II, and III only D. I, III, and IV only E. I, II, III, and IV

I. market risk premium III. portfolio beta IV. risk-free rate

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 A. I and III only B. II and IV only C. II, III, and IV only D. I, III, and IV only E. I, II, III, and IV

I. risk-free rate of return III. market rate of return

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? I. an increase in the probability of an economic boom II. a decrease in the rate of return given a normal economy III. an increase in the probability of a normal economy IV. an increase in the rate of return given an economic boom A. I and II only B. I and IV only C. II and III only D. I, III, and IV only E. I, II, III, and IV

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

Principle of Diversification

diversification can substantially reduce risk without an equivalent reduction in expected returns

Portfolio

collection of assets

Systematic risk

factors that affect a large number of assets - "market risk" - EX: changes in GDP, inflation, interest rates

Security Market Line (SML)

representation of market equilibrium

Unsystematic risk

risk factors that affect a LIMITED number of assets - diversifiable risk - "unique risk" - EX: labor strikes, part shortages