CHAPTER 8: RISK & RETURN

Financial markets do not reward investors for taking ...................... risks, because a rational investor can eliminate this risk, at virtually not cost, by having a ..................... portfolio.

- diversifiable; diversified

- The graphical linear function depicting the relationship between beta and the expected returns is called the:

- security market line

Which one of the following terms best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?

. Diversification

You own a $46,000 portfolio comprised of four stocks. The values of stocks A, B, and C are $5,600, $16,700, and $11,400, respectively. What is the portfolio weight of stock D?

26.74 percent

Blue Lagoon stock is expected to produce the following returns given the various states of the economy. What is the expected return on this stock?

3.90 percent

A stock has an expected return of 17.2 percent and a beta of 1.59. The risk-free rate is 5.1 percent. What is the slope of the security market line?

7.61 percent

Which of the following is used by the CAPM to estimate the expected return? I- The pure time value of money II- The reward for bearing systematic risk III- The amount of systematic risk

I , II and III

Which of the following behaviors would be an evidence of investors risk aversion? I- Investors require higher rates of returns for investments that demonstrate higher variability of returns. II- when investors become more risk averse, they require higher market risk premium, which should increase the slope of the security market line. III- Investors required rate of return will decrease as a response to an increase in the total systematic risk in the market

I and II

Which of the following best define the portfolio weight?

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

The security market line indicates that investors are compensated for which of the following? I- diversifiable risk II- market risk III- unsystematic risk IV- systematic risk

- II and IV only

Investors risk aversion is defined as:

- Investors prefer less risk to more risk, all else being equal. They also require more compensation for taking more risk.

The variance and standard deviation of a portfolio .............. equal to weighted averages of the corresponding characteristics of the individual securities. For most portfolios, the standard deviation is generally ............... the weighted average of the standard deviations of the securities in the portfolio.

- are not; less than

Which of the following statement is true regarding the beta coefficient:

- beta is a measure of systematic risk, the higher the beta the higher the expected return.

The slope of the security market line (SML) is called the:

- reward to risk ratio.

- The risk premium for a security is based on the ..................... associated with the security.

- systematic risk

A .................... risk factor tends to affect a large number of assets to a greater or lesser degree. However, an ............... risk factor affects only a single or small group of assets.

- systematic; unsystematic

The actual return on a security consists of two parts: the expected return and the unexpected return. The risk of an asset comes from the ........................ part.

- unexpected

Courtney has a portfolio comprised of 48 percent stock A, 21 percent stock B, and 31 percent stock C. What is her expected rate of return if the economy is in recession? State of Probability Returns Economy of State Stock A Stock B Stock C Boom .15 18 % 14 % 10 % Normal .75 12 8 11 Recession .10 -11 2 14

-0.52 percent

You own a $210,000 portfolio that is invested in stock A and B. The portfolio beta is equal to the market beta. Stock A has an expected return of 18.7 percent and has a beta of 1.42. Stock B has a beta of 0.88. What is the value of your investment in stock A?

. $46,667

What is the beta of the following portfolio?

. 1.08

Which one of the following portfolios will have a beta of zero?

. A portfolio comprised solely of U. S. Treasury bills.

- Which of the following terms can be used to describe unsystematic risk? I. asset-specific risk II. diversifiable risk III. market risk IV. unique risk

. I, II, and IV only

Which one of the following statements is correct?

. If a risky security is correctly priced, its expected risk premium will be positive

Which one of the following is the slope of the security market line?

. Market risk premium

Assume you own a portfolio of diverse securities which are each correctly priced. Given this, the reward-to-risk ratio:

. of each security must equal the slope of the security market line.

A portfolio is equally invested in 2 stocks and a risk-free security. Stock A is equally as risky as the market and stock B has a beta of 1.24. What is the portfolio beta?

0.75

Currently, the risk-free rate is 3.5 percent. Stock A has an expected return of 9.6 percent and a beta of 1.08. Stock B has an expected return of 13.5 percent. The stocks have equal reward-to-risk ratios. What is the beta of stock B?

1.77

Which one of the following is the best example of unsystematic risk?

A warehouse fire

Which one of the following statements is correct?

An underpriced security will plot above the security market line.

The capital asset pricing model states that the expected return on a security depends on which of the following? I- pure time value of money II- the amount of unsystematic risk as measured by beta III- the reward for bearing systematic risk as measured by the market risk premium IV- the reward for bearing risk as measure by the standard deviation V- the amount of systematic risk

I, III, and V only

Which one of the following is an example of systematic risk?

Increase in consumption created by a reduction in personal tax rates

Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security?

Zero

The amount of systematic risk present is a particular risky asset relative to the systematic risk present in a market portfolio is called the:

beta coefficient

The equation that is represented graphically by the security market line is called the:

capital asset pricing model

An investor's portfolio is the ....................... the investor owns. The percentages of a portfolio's total value invested in each asset are the ................................

combination of assets; portfolio weights

Risk that is eliminated by diversification is .................... or ................... risk. However, there is a minimum level of risk in a portfolio of common stocks which cannot be eliminated by diversification; this minimum level is referred to as ......................... or ...................... risk.

diversifiable - unsystematic; non-diversifiable - systematic

The process of investing is a portfolio of several assets to reduce risk is called ..................... . The standard deviation of a portfolio decreases as the number of securities in the portfolio ................

diversification; increase

For a group of securities that are correctly priced, the reward-to-risk ratio should be:

equal to 1.00 for the combination of the securities

- The slope of the security market line (SML) gives the excess return on the market over the risk-free rate, therefore it is called:

market risk premium

Diversifying a portfolio of equity across sectors and markets will tend to

reduce the firm-specific risk

Beta measures the amount of an asset's systematic risk relative to the ................... risk for the average asset (market portfolio). The average stock (market portfolio) has a beta of .................

systematic; 1.00

A ............................. risk has an impact on all the stocks in a portfolio, and cannot be diversified away; this risk is also called ..........................

systematic; non-diversifiable

- The systematic risk principle states that the reward for bearing risk depends only on ......................risk. Thus the expected return for an asset depends only on its ........................ risk

systematic; systematic

The goal of diversification is to eliminate:

unsystematic risk

In a fairly large portfolio, the ...................... risk associated with one stock typically has no impact on the portfolio total risk. In this case, it would be reasonable to expect that the effects of ..................... risk on various stocks would offset each other, thereby eliminating the risk to the investor arising from this source of risk.

unsystematic; unsystematic d- diversifiable; non-diversifiab