Ch. 11 Risk and Return

What is the expected return of a security with a beta of 1.2 if the risk-free rate is 4 percent and the expected return on the market is 12 percent?

4% + 1.2(12% - 4%) = 13.6%

What is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5?

Expected return for a security= 5 + 1.5 x (9 - 5) = 11%

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 expected return of a portfolio is a combination of the weights of each asset in a portfolio.

False; The expected return on a portfolio is a combination of the expected returns on the assets in the portfolio.

True or false: Portfolio weights can be defined as the dollars invested in each asset.

False; percentages

What does the security market line depict?

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

What is unsystematic risk?

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

What is systematic risk?

It is a risk that pertains to a large number of assets.

Which of the following types of risk is not reduced by diversification?

Systematic, or market risk; Systematic risk cannot be diversified away.

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

The market-risk premium; (expected return on the market minus the risk-free rate of return).

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.

What is the Reward-to-Risk Ratio?

[E(RA) - Rf] / βA

The appropriate discount rate to use to evaluate a new project is the _____.

cost of capital

The minimum required return on a new project is known as the:

cost of capital

The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.

positive; the higher the risk, the higher the expected return.

Even if the portfolio is well diversified, the investor is still exposed to _____ risk.

systematic

A portfolio can be described by its portfolio weights which are defined as _____________________.

the percentage of dollars invested in each asset

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

- that are diversifiable - that are borne unnecessarily

What is the beta of the risk-free asset?

0

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

1

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

False; Even if the portfolio is well diversified, the investor is still exposed to systematic risk

True or false: Expected return and inflation are the two components of risky return in the total return equation.

False; Market risk and unsystematic risk are the two components of risky return in the total return equation.

True or false: The calculation of the portfolio beta is similar to the calculation of the portfolio weights.

False; The calculation of the portfolio beta is similar to the calculation of the expected return.

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

The risk-free rate

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; Risk-free rate + 0 × Market risk premium = Risk-free rate

True or false: According to the capital asset pricing model (CAPM), the risk-free rate of return is the expected return on a security with a beta of zero. True

True

True or false: The expected return is the return that an investor expects to earn on a risky asset in the future.

True

True or false: It is possible for the unsystematic risk of a portfolio to be reduced almost to zero.

True; If enough securities are added, all the unsystematic risk of the securities in the portfolio should cancel one another out.

The calculation of a portfolio beta is similar to the calculation of:

a portfolio's expected return

The _____ return on a portfolio is a combination of the expected returns on the assets in the portfolio.

expected

An investment will have a negative NPV when its expected return is _______ ________ what the financial markets offer for the same risk.

less than

Systematic risk is also called ______________ risk.

market

The true risk of any investment comes from _______________ .

surprises

To determine the appropriate required return for an investment, we can use _____________________.

the Security Market Line

The return expected on an investment depends only on the asset's _____ risk.

systematic

Which of the following statements is (are) true about variance?

- Standard deviation is the square root of variance. - Variance is a measure of the squared deviations of a security's return from its expected return.

The CAPM shows that the expected return for an asset depends on which three things?

- The amount of systematic risk - The reward for bearing systematic risk - The pure time value of money

What are the two components of risky return (U) in the total return equation?

- Unsystematic risk - Market risk U = m + Ɛ

What is the definition of expected return?

It is the return that an investor expects to earn on a risky asset in the future.

If an asset has a reward-to-risk ratio of 6.0%, that means it has a __________ of 6.0% per unit of _______.

risk premium; systematic risk

Unsystematic risk will affect

- A specific firm - Firms in a single industry

______ risk is reduced as more securities are added to the portfolio

- Diversifiable - Company-specific - Unsystematic

Which of the following are examples of a portfolio?

- Investing $100,000 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 US and Asian stocks

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.

The true risk of any investment comes from:

-surprises -unanticipated events

What is a portfolio?

a group of assets held by an investor, holding a single asset would generally not be considered to be a portfolio.