Principles of Finance - Chapter 13 and Smartbook

By definition, what is the beta of the average asset equal to?

1

An asset has an average return of 10.67 percent and a standard deviation of 22.65 percent. What is the most you should expect to lose in any given year with a probability of 16 percent?

-11.98% Explanation: Maximum loss = 10.67% − 22.65% Maximum loss = −11.98%

The cost of _________is the minimum required return on a new investment.

Capital

What is unsystematic risk?

It is a risk that affects a single asset or a small group of assets

The risk-free rate is 2.3 percent and the market expected return is 12 percent. What is the expected return of a stock that has a beta of .87?

10.74% Explanation: E(R) = .023 + .87(.120 − .023) E(R) = .1074, or 10.74%

If risk-free investments are currently 6% and our expected return from Stock V was 14%. What is the risk premium on this investment?

8% Explanation: Risk premium = Expected Return − Risk free rate Risk premium = 14% − 6% Risk premium = 8%

Labor strikes Changes in management

Labor strikes Changes in management

Systematic risk will ____ when securities are added to a portfolio.

Not change

The increase in the number of stocks in a portfolio results in a(n) _____________ in the average standard deviation of annual portfolio returns.

decrease

(Select all that apply) A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?

-An increase in the corporate tax rate -An increase in the Federal funds rate

(Click and drag on elements in order) Place the steps in the computation of variance in the correct order from the first step to the last step. -Calculate the expected return -Multiply each squared deviation by its probability -The result is the variance -Determine the squared deviation from the expected return

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

You purchased a stock at a price of $47.28. The stock paid a dividend of $1.83 per share and the stock price at the end of the year is $53.23. What is the capital gains yield?

12.58% Explanation: Capital gains yield = ($53.23 − 47.28)/$47.28 Capital gains yield = .1258, or 12.58%

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%

You purchased a stock at a price of $54.09. The stock paid a dividend of $1.91 per share and the stock price at the end of the year was $60.35. What was the total return for the year?

15.10% Explanation: Total return = ($60.35 − 54.09 + 1.91)/$54.09 Total return = .1510, or 15.10%

The economy has been very volatile lately. There is a 40% chance of recession and a 60% chance of a boom. Stock A would have a return of −15% if there was a recession but, a 40% return in a boom economy. What is the expected return for Stock A?

18% Explanation: E(RA) = .40 × − .15 + .60 × .40 E(RA) = − .06 + .24 E(RA) = .18 E(RA) = 18%

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

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

True or false: A well-diversified portfolio will eliminate all risks.

False

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

Which type of risk is unaffected by adding securities to a portfolio?

Systematic risk

Which type of risk does not change as we add more securities to a portfolio?

Systematic, or market, risk

(Select all that apply) A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?

The death of the CEO A hostile takeover attempt by a competitor

What is the expected return on a security with beta of 1?

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

(Select all that apply) What are the two components of unexpected return (U) in the total return equation?

The systematic portion The unsystematic portion

How are the unsystematic risks of two different companies in two different industries related?

There is no relationship.

What is the equation for total return as a function of expected and unexpected returns?

Total Return = Expected Return + Unexpected Return

(Select all that apply) ______ risk is reduced as more securities are added to the portfolio

Unsystematic Unique Diversifiable

Based on the capital asset pricing model (CAPM) there is generally ___ relationship between beta and the expected return on a security.

a positive Reason: The market risk premium is the slope of the CAPM. As long as the market risk premium is positive, the relationship between beta and the expected return on a security will be positive.

The ___________ is the excess return an asset earns based on the level of risk taken.

alpha

What is the term for the excess return an asset earns based on the level of risk taken?

alpha

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

The variance of a portfolio ___________ (is/isn't) generally a simple combination of the variances of the assets in the portfolio.

isn't

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

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 _____ 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.

squared

The principle of diversification tells us that, to a diversified investor, the only type of risk that matters is _______________ (systematic/unsystematic) risk.

systematic

The true risk of any investment is the _____ portion.

unanticipated

Select all that apply The risk of owning an asset comes from:

unanticipated events surprises

The ________ is the squared standard deviation.

variation

(Select all that apply) 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

Select all that apply Which of the following are examples of a portfolio?

-Holding $100,000 investment in a combination of stocks and bonds -Investing $100,000 in the stocks of 50 publicly traded corporations -Investing $100,000 in a combination of U.S. and Asian stocks

If a security's expected return is equal to the expected return on the market, its beta must be ____.

1

You have a portfolio that is invested 15 percent in Stock A, 34 percent in Stock B, and 51 percent in Stock C. The betas of the stocks are .60, 1.15, and 1.44, respectively. What is the beta of the portfolio?

1.22 Explanation: βPortfolio = .15(.60) + .34(1.15) + .51(1.44) βPortfolio = 1.22

Over a certain period, large-company stocks had an average return of 13.09 percent, the average risk-free rate was 2.68 percent, and small-company stocks averaged 17.85 percent. What was the risk premium on small-company stocks for this period?

15.17% Explanation: Small-company stock risk premium = 17.85% − 2.68% Small-company stock risk premium = 15.17%

What are the arithmetic and geometric average returns for a stock with annual returns of 19 percent, 9 percent, −4 percent, and 13 percent?

9.25%; 8.91% Explanation: Arithmetic Return = (.19 + .09 − .04 + .13)/4 Arithmetic Return = .0925, or 9.25% Geometric Return = [(1 + .19) × (1 + .09) × (1 − .04) × (1 + .13)] ¼ − 1 Geometric Return = .0891, or 8.91%

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

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

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 Reason: The processes are similar.

Which of the following statements is true of a portfolio's standard deviation?

It can be less than the weighted average of the standard deviations of the individual securities held in that portfolio.

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model.

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

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.

(Select all that apply) As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?

It is likely to decrease. It may eventually be almost totally eliminated.

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.

(Select all that apply) Which of the following are examples of systematic risk?

Regulatory changes in tax rates Future rates of inflation

What is the slope of the security market line (SML)?

The market-risk premium

(Select all that apply) Which of the following are examples of information that may impact the risky return of a stock?

The outcome of an application currently pending with the Food and Drug Administration. The Fed's decision on interest rates at their meeting next week

What is the intercept of the security market line (SML)?

The risk-free rate

(Select all that apply) What are the two components of the market risk premium?

The risk-free rate The expected return on the market

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 calculation of a portfolio beta is similar to the calculation of _____.

a portfolio's expected return

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

Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio _____.

declines

When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.

decrease

When we _____________ an announcement or a news item, we say that is has less of an impact on price because the market already factored it in.

discount

The _________ return is the return that an investor will probably earn on a risky asset in the future.

expected

What two factors determine a stock's total return?

expected return and unexpected return

The _____________ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.

systematic

When an investor is diversified only ________ risk matters.

systematic

The systematic risk principle argues that the market does not reward risks _____.

that are borne unnecessarily

The portfolio weight is _____.

the percentage of the total value that is invested in an asset

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 standard deviation is ___.

the square root of the variance

The percentage of a portfolio's total value that is invested in a particular asset is the portfolio _______________.

weight