Chapter 11 Financial Management

What does variance measure?

- It measures the spread of the sample of returns. - It measures the riskiness of a security's returns.

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

- Unsystematic - Idiosyncratic - Unique

Another name for idiosyncratic risk is ______ risk.

- unsystematic - diversifiable

What are the correlation coefficient's lowest and highest possible values?

-1 and +1

What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5?

.6

What is the correlation of returns between stocks A and B based on the following information? The standard deviation of returns is .30 for A and .20 for B and the covariance between A and B's returns is .045.

.75

If the variance of a security is 0.01545, what is the standard deviation?

0.1243

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

1

The computation of variance require four step. Place the steps in the correct order from the first step to the last step.

1. Calculating the expected return. 2. Calculate the deviation of each return from the expected return. 3. Square each deviation. 4. Calculate the average squared deviation.

Which one of the following cannot possibly be the correlation coefficient between the returns of two stocks?

1.2

If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities?

1.25

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

11%

What is the expected return of a portfolio consisting of stocks A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both the stocks.

12.5%

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?

13.6%

ABC has a beta of 2.5 and XYZ has a beta of 1.5. The risk-free rate is 4 percent and the market risk premium is 9 percent. What is the expected return on a portfolio that is equally invested in ABC and XYZ?

22%

If the variance of a portfolio is .0025, what is the standard deviation?

5%

What is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund? The expected returns are 7 percent, -3 percent, and 18 percent, respectively.

6.2%

A reasonable estimate for the US equity risk premium is

7%

What is a reasonable estimate for the U.S. equity risk premium?

7%

Which of the following will be true in a world with homogeneous expectations?

All investors will hold the market portfolio.

What does a normal return depend upon?

All relevant information available to shareholders

For a diversified investor, what is the best way to measure the systematic risk of an individual security?

Beta

What is the equation for the capital asset pricing model?

Expected return on a security = Risk-free rate+ beta x expected risk premium on market

A world where all investors possess the same estimates of expected returns, variances, and covariances is:

Imaginary

What will happen to the risk of a portfolio composed of two securities as more dollars are invested in the riskier asset?

It can increase or decrease.

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.

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.

What does the characteristic line for a security show?

It shows a security's return in relation to the market's return.

There is ______ correlation between the unsystematic risk of two companies from different industries.

No

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

Systematic, or market risk

Which of the following indexes is a good proxy for the market portfolio?

The Standard & Poor's 500 index

According to the capital asset pricing model, what is the expected return on a security with beta of 1?

The expected return on the market

A security has a beta of 1, the market risk premium is 8 percent, and the risk-free rate is 3 percent. What will happen to the expected return if the beta doubles?

The expected return will increase to 19% from 11%.

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

The market-risk premium

What is expected return?

The return that an individual expects to earn over the next period.

What can we conclude if the covariance between the returns of two securities is zero?

The returns of the two securities are unrelated.

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

The risk-free rate

What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is negative?

The variance will decrease.

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

There is no relationship.

What do covariance and correlation measure?

They both measure how two random variables are related

Why are the deviations of returns squared when computing variance?

This ensures that that the sum of the deviations is a positive number.

In practice, economists use proxies for the market portfolio instead of the actual market portfolio.

True

True or false: According to CAPM, if the historical market risk premium is negative, we cannot justify a positive relationship between a security's expected return and its beta.

True

According to the CAPM, when is a security considered overpriced?

When its expected return plots below the SML

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 covariance for two securities with returns that are unrelated to each other?

Zero

According to the CAPM, a security is considered underpriced when its expected return plots ___ the SML.

above

If investors have homogeneous expectations, they

all possess the same estimates regarding expected returns, variances, and covariances

When expressing covariance between two securities, the ordering of variables:

does not matter

The goal of a rational, wealth-maximizing investor in developing a portfolio is to maximize the ___ and minimize the ____.

expected return; standard deviation

If investors have homogeneous expectations, they will ___.

have similar estimates about the risk and return attributes of individual securities

The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.

increases; increases

Systematic risk is sometimes referred to as:

market risk

From an investor's perspective, an optimal portfolio will ___.

maximize expected return and minimize risk

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

not change

A bull market is characterized by ______ sentiment while a bear market is characterized by ______ sentiment of investors in the stock market.

optimistic; pessimistic

If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be:

positive

The historical market risk premium for equities has been

positive

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

positive

The return on market minus the risk-free rate is the market risk _____

premium

Beta measures the ____ risk of a security.

systematic

The standard deviation is ___.

the square root of the variance

Standard deviation measures ______ risk while beta measures ______ risk.

total; systematic

The SML will be ____ if the expected return on the market is higher than the risk-free rate.

upward sloping

Which of the following are examples of systematic risk?

- Regulatory changes in tax rates - Future rates of inflation

A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?

- The death of the CEO - A hosile takeover attempt by a competitor

Which of the following are examples of idiosyncratic risk?

- The death of the CEO of a publicly traded corporation - Management fraud leading to significant losses

What is an uncertain or risky return?

It is the portion of return that depends on information that is currently unknown.

What is a normal return?

It is the return that shareholders predict or expect.

The ___ line shows a security's return in relation to the market's return.

characteristic

As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?

- It may eventually be almost eliminated - It is likely to decrease

Which of the following are examples of information that may impact the risky return of a stock?

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

Two ways to measure the relationship between the returns of two securities are ______ and ______.

- covariance - correlation

What is Stock B's beta if the covariance between stock B and the market is 3.75, and variance of the market is 2.5?

1.5

What is the appropriate measure of risk for an individual security if an investor holds a diversified portfolio?

Beta

What does it mean if the returns of two stocks, A and B, are negatively correlated?

It means that, on average, if the returns of stock A are positive, the returns of stock B will be negative.

The risk of a large, diversified portfolio will ____ if a security with a negative beta is added to the portfolio.

decrease

If the expected return of a portfolio is 15 percent and the standard deviation of the portfolio is 10 percent, then the 68 percent probability range is ____ percent.

+5 to 25

If the covariance between stocks C and D is -.05, what is the correlation between these stocks? Assume the standard deviation of returns is .45 for Stock C and .30 for Stock D.

- .37

A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?

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

Which of the following are true if AIG's beta is -4.53?

- If the market rises 1%, AIG is should decline by about 4.53%. - If the market declines 1%, AIG should rise by about 4.53%.

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

- Market risk - Unsystematic risk

Which of the following statements are true about expected return?

- The actual return can be higher or lower than the expected return. - The expected return can be calculated as the average of the returns in previous periods. - The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes.

Based on historical data, which of the following are true about the market risk premium?

- The historical market risk premium for equities has been positive. - The historical market return for equities has been significantly higher (more than 5%) than the risk-free rate.

Which of the following are likely to be true if we observe the returns of two stocks in the same industry, such as Pfizer and Merck?

- The returns will be positively correlated over time. - The returns will move in the same direction (i.e. positive) but not by the same magnitude.

What are the two components of the expected return on the market (RM)?

- The risk-free rate (RF) - The risk premium

Which of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B?

- The variances of stocks A and B - The covariance between stocks A and B - The market value, in dollars, of the investments in stocks A and B

If the expected return is 10 percent and the standard deviation is 12 percent, what is the range of returns that will occur about 68 percent of the time?

-2% to 22%

What is the difference between a bull market and a bear market?

A bull market is characterized by rising prices while a bear market is characterized by falling prices.

True or false: Systematic risk will impact all securities in every portfolio equally.

False

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

Systematic, or market, risk

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

decrease

If the variance of a portfolio increases, then the portfolio standard deviation will _____.

increase

Which of the following measures the spread of the sample of returns?

variance