Chapter 11 Financial Policies: Risk, Return and CAPM

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 Reason: Portfolio beta = 0.5 × 1.5 + 0.5 × 1 = 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% Reason: .05 + 1.5(.09 - .05) = 11%

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% Reason: βP = (2.5 + 1.5)/2 = 2 Expected return = 4% + 2(9%) = 22%

Which of the following are examples of unsystematic risk?

Changes in management Labor strikes

True or false: Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios.

False

What does the security market line depict?

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

Which of the following statements 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.

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

Systematic, or market, risk

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 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.

Why are the deviations of returns squared when computing variance?

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

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 Reason: The market-risk premium is the slope of the CAPM equation. Thus, if the market risk premium is negative, there is a negative relationship between expected return and beta.

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

above

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

decrease

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

does not matter

In the return equation, the unsystematic risk is denoted by:

epsilon

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

increase

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

maximize expected return and minimize risk

In a two-asset portfolio, a ________ covariance of returns between the two securities will lead to a reduction in the variance of the portfolio.

negative

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

not change

The CAPM can be used for which of the following:

portfolios individual securities

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

positive

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

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 Reason: 1.5/2.5 = .6

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

1.2

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

For every 3% movement in the market, the market must move by:

3%

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

7% Reason: The average excess annual return of U.S. common stocks over the risk-free rate was 7.2% over 1900-2010.

What is variance?

A measure of the squared deviations of a security's return from its expected return

What is the equation for the return on a company's stock?

Actual Return = Normal return + Risky return

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

False

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

Idiosyncratic Unique Unsystematic

Which of the following are examples of systematic risk?

Regulatory changes in tax rates Future rates of inflation

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

Systematic risk

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

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

What is expected return?

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

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

True

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

When its expected return plots below the SML

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

expected return; standard deviation

The expected returns of the existing securities in your portfolio ______ when new securities are added to the portfolio.

remain unchanged

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 measures the spread of the sample of returns?

variance

________________ measures the interrelationship between two securities.

variance

Another name for idiosyncratic risk is ______ risk.

diversifiable unsystematic

Which of the following statements are true about correlation?

Correlation measures the interrelationship between the returns of two securities. Correlation is related to covariance.

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

False Reason: While it is possible, it is highly unlikely that systematic risk (such as changes in interest rates) will affect all firms equally.

What is a normal return?

It is the return that shareholders predict or expect.

Systematic risk is sometimes referred to as:

market risk

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% Reason: .5 × 7% + .3 × -3% + .2 × 18% = 6.2%

A reasonable estimate for the US equity risk premium is __ %.

7%

What does a normal return depend upon?

All relevant information available to shareholders

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. Reason: It can increase or decrease depending on the correlation between the securities.

What is systematic risk?

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

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

Systematic, or market risk

What do covariance and correlation measure?

They both measure how two random variables are related.

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

Zero

The ______ return is equal to the ______ return and a(n) ______ part of the return.

actual; expected; unexpected

The historical market risk premium for equities has been ______.

positive

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

1

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

How can a positive relationship between 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.

Why can an investor holding a well-diversified portfolio of securities ignore the unsystematic risk of individual securities?

Because unsystematic risk should be eliminated through diversification

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

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

The standard deviation of a portfolio of two securities will be less than the weighted average of the standard deviation of the two securities when the correlation between the two securities ____.

is less than one

The formula for computing the correlation of the returns on Stocks A and B is equal to the Cov(Ra,Rb) divided by _____.

σA × σB Reason: Corr(RA,RB)= Cov(RA,RB)/σA × σB

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%

_____________ measures the interrelationship between two securities.

Covariance

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

The market-risk premium

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

The risk-free rate (RF) The risk premium

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.

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.

If future risk ______, the future equity risk premium ______.

decreases; may change increases; may change

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

no

The return on market minus the risk-free rate is the market risk ____________ .

premium

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 Reason: -.05/(.45 × .30) = -.37

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 unsystematic risk?

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

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 is an uncertain or risky return?

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

Which of the following are examples of idiosyncratic risk?

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

Which of the following statements are true about expected return?

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

True or false: Unsystematic risk is eliminated in a well-diversified portfolio of securities.

True

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

-1 and +1

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 Reason: .045/(.3 × .2) = .75

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

0.1243

By definition, the market's beta is ___.

1 Reason: The market's beta is 1 because beta is a measure of the movement of the security in relation to the market. So when the market moves 1%, the market moves 1%.

The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last step.

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

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% Reason: .5 × 10% + .5 × 15% = 12.5%

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

5%

What is a risk premium?

It is additional compensation for taking risk, over and above the risk-free rate.

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 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.

What does variance measure?

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

In the return equation, which of the following does epsilon (ε) refer to?

Part of risky return Unsystematic risk

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

What happens to the expected returns of the existing securities in your portfolio if new securities are added to your portfolio?

The expected returns of existing securities will not change.

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

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

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

The returns of the two securities are unrelated.

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

Future equity risk premiums may not be equal to past equity risk premiums due to which of the following factors?

The risk aversion of investors will change in the future. Future risk is different from historical risk.

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

Unsystematic risk Market risk

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

correlation covariance

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

increases; increases Reason: The expected return on the market will increase if the risk-free rate increases or if the market risk premium increases, because RMRM=RF- risk premium.

The standard deviation of the S&P 500 index is likely less than the weighted average of the individual securities in the index because the correlations between pairs of the securities are likely ____.

less than +1.

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

positive Reason: If investors are averse to risk, they will demand higher returns from the market, thereby meaning that the risk premium will be positive (greater than zero).