504 Ch. 11 - Risk and Return

PL Lumber stock is expected to return 22 percent in a booming economy, 15 percent in a normal economy, and lose 2 percent in a recession. The probabilities of an economic boom, normal state, or recession are 5 percent, 92 percent, and 3 percent, respectively. What is the expected rate of return on this stock? A. 14.84 percent B. 14.23 percent C. 14.51 percent D. 15.47 percent E. 15.26 percent

A. 14.84 percent Expected return = (.05 ×.22) + (.92 ×.15) + [.03 ×(-.02)] = .01484, or 14.84 percent

You would like to invest $24,000 and have a portfolio expected return of 11.5 percent. You are considering two securities, A and B. Stock A has an expected return of 18.6 percent and B has an expected return of 7.4 percent. Approximately how much should you invest in Stock A if you invest the balance in Stock B? A. $7,807 B. $8,786 C. $7,411 D. $7,137 E. $8,626

B. $8,786 E(RP) = .115 = .186x+ .074(1 -x) x =.3661 InvestmentA = .3661 × $24,000 = $8,786

You own a portfolio that is invested as follows: $13,700 of Stock A, $4,800 of Stock B, $16,200 of Stock C, and $9,100 of Stock D. What is the portfolio weight of Stock B? A. 8.47 percent B. 10.96 percent C. 9.80 percent D. 11.94 percent E. 13.08 percent

B. 10.96 percent WeightC = $4,800/($13,700 + 4,800 + 16,200 + 9,100) = .1096, or 10.96 percent

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

You want to create a $72,000 portfolio comprised of two stocks plus a risk-free security. Stock A has an expected return of 13.6 percent and Stock B has an expected return of 14.7 percent. You want to own $25,000 of Stock B. The risk-free rate is 3.6 percent and the expected return on the market is 12.1 percent. If you want the portfolio to have an expected return equal to that of the market, how much should you invest in the risk-free security? A. $12,921 B. $12,987 C. $13,550 D. $13,315 E. $12,775

C. $13,550 E(r)p = .121 = [(x / $72,000) ×.036] + {[($72,000 - x - 25,000) / $72,000 ] ×.136} + [($25,000 / $72,000) ×.147] x = $13,550

Blue Bell stock is expected to return 8.4 percent in a boom, 8.9 percent in a normal economy, and 9.2 percent in a recession. The probabilities of a boom, normal economy, and a recession are 6 percent, 92 percent, and 2 percent, respectively. What is the standard deviation of the returns on this stock? A. .38 percent B. .55 percent C. .13 percent D. .42 percent E. .06 percent

C. .13 percent Expected return = (.06 ×.084) + (.92 ×.089) + (.02 ×.092) = .0888 Variance = .06(.084-.0888)2 + .92(.089 -.0888)2 + .02(.092-.0888)2 = .000002 Standard deviation = .000002.5 = .0013, or .13 percent

Southern Wear stock has an expected return of 15.1 percent. The stock is expected to lose 8 percent in a recession and earn 18 percent in a boom. The probabilities of a recession, a normal economy, and a boom are 2 percent, 87 percent, and 11 percent, respectively. What is the expected return on this stock if the economy is normal? A. 14.79 percent B. 17.04 percent C. 15.26 percent D. 16.43 percent E. 11.08 percent

C. 15.26 percent E(R) = .151 = (.02 ×-.08) + (.87 ×x) + (.11 ×.18) x = .1526, or 15.26 percent

Which term 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

The risk-free rate is 3.7 percent and the expected return on the market is 12.3 percent. Stock A has a beta of 1.1 and an expected return of 13.1 percent. Stock B has a beta of .86 and an expected return of 11.4 percent. Are these stocks correctly priced? Why or why not? A. No, Stock A is underpriced and Stock B is overpriced. B. No, Stock A is overpriced and Stock B is underpriced. C. No, Stock A is overpriced but Stock B is correctly priced. D. No, Stock A is underpriced but Stock B is correctly priced. E. No, both stocks are overpriced. E(RA) = .037 + 1.1(.123 -.037) = .1316, or 13.16 percent E(RB) = .037 + .86(.123 -.037) = .1110, or 11.10 percent Stock A is overpriced because its expected return lies below the security market line. Stock B is underpriced because its expected return lies above the security market line.

C. No, Stock A is overpriced but Stock B is correctly priced. E(RA) = .037 + 1.1(.123 -.037) = .1316, or 13.16 percent E(RB) = .037 + .86(.123 -.037) = .1110, or 11.10 percent Stock A is overpriced because its expected return lies below the security market line. Stock B is underpriced because its expected return lies above the security market line.

Unsystematic risk can be defined by all of the following except: A. unrewarded risk. B. diversifiable risk. C. market risk. D. unique risk. E. asset-specific risk.

C. market risk

You own a $36,800 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 22.6 percent and has a beta of 1.48. Stock B has a beta of .72. What is the value of your investment in Stock A? A. $8,619 B. $12,333 C. $14,500 D. $13,558 E. $17,204

D. $13,558 βP = 1.0 = 1.48A+ [.72 × (1-A)] A = .368421 Investment in Stock A = $36,800 × .368421 = $13,558

The common stock of The DownTowne should return 23 percent in a boom, 16 percent in a normal economy, and lose 32 percent in a recession. The probabilities of a boom, normal economy, and recession are 5 percent, 90 percent, and 5 percent, respectively. What is the variance of the returns on this stock? A. .012453 B. .011663 C. .012691 D. .011345 E. .012914

D. .011345 Expected return = (.05 ×.23) + (.90 ×.16) + [.05 ×(-.32)] =.1395 Variance = .05(.23-.1395)2 + .90(.16-.1395)2 + .05(-.32 -.1395)2 = .011345

A stock has a beta of 1.48 and an expected return of 17.3 percent. A risk-free asset currently earns 4.6 percent. If a portfolio of the two assets has a beta of .98, then the weight of the stock must be ___ and the risk-free weight must be___. A. .56; .44 B. .34; .66 C. .44; .56 D. .66; .34 E. .72; .28

D. .66; .34 βP = .98 = x(1.48) + (1 -x)(0) x = .66 Stock weight is .66 and the risk-free weight is .34

Currently, the risk-free rate is 3.2 percent. Stock A has an expected return of 11.4 percent and a beta of 1.11. Stock B has an expected return of 13.7 percent. The stocks have equal reward-to-risk ratios. What is the beta of Stock B? A. 1.27 B. 1.33 C. 1.36 D. 1.08 E. 1.42

E. 1.42 (.114 -.032)/1.11 = (.137 -.032)/βB βB = 1.42

Ben & Terry's has an expected return of 13.2 percent and a beta of 1.08. The expected return on the market is 12.4 percent. What is the risk-free rate? A. 3.87 percent B. 4.24 percent C. 2.61 percent D. 3.29 percent E. 2.40 percent

E. 2.40 percent E(R)=.132=Rf+1.08(.124-Rf) Rf=.0240, or 2.40 percent

The security market line is a linear function that is graphed by plotting data points based on the relationship between the: 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