FIN 312 Exam 2
define market risk
risk factors common to the whole economy; also called systematic or nondiversifiable risk
define illiquidity
difficulty, cost, and/or delay in selling an asset on short notice without offering substantial price concessions
define diversification
spreading a portfolio over many investments to avoid excessive exposure to any one source of risk
define risk sharing
spreading risk across many investors so that each investor bears only a fraction of the total risk
define alpha
the abnormal rate of return on a security in excess of what would be predicted by an equilibrium model like the CAPM
define homogeneous expectations
the assumption that all investors agree on the probability distribution of future returns, so they all use the same input list
define capital market line (CML)
the capital allocation line that results when using the market index as the risky portfolio
define certainty equivalent rate
the certain return providing the same utility as a risky portfolio
define complete portfolio
the entire portfolio, including risky and risk-free assets
define portfolio opportunity set
the expected return-standard deviation pairs of all portfolios that can be constructed from a given set of assets
define insurance principle
the law of averages. The average outcome for many independent trials of an experiment will approach the expected value of the experiment
define beta
the measure of the systematic risk of a security. The tendency of a security's returns to respond to swings in the broad market
define utility
the measure of the welfare or satisfaction of an investor
define zero-beta portfolio
the minimum-variance portfolio uncorrelated with a chosen efficient portfolio
define market portfolio
the portfolio encompassing all assets in which each assets is held in proportion to its market value
define minimum-variance portfolio
the portfolio of risky assets with lowest possible variance
define efficient frontier of risky assets
the portion of the minimum-variance frontier that lies above the global minimum-variance portfolio
define separation property
the property that portfolio choice can be separated into two independent tasks: (1) determination of the optimal risky portfolio, which is a purely technical problem, and (2) the personal choice of the best mix of the risky portfolio and the risk-free asset
define mean-variance (M-V) criterion
the selection of portfolios based on the means and variances of their returns. The choice of the highest expected return portfolio for a given level of variance or the lowest variance portfolio for a given expected return.
define liquidity
the speed and ease with which an asset can be converted to cash
define indifference curve
a curve connecting all portfolios withe the same utility according to their means and standard deviaitons
define risk pooling
adding uncorrelated, risky investments to the portfolio
Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the following statements is most accurate? a. the expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn, Inc. b. the stock of Kaskin, Inc., has more total risk than the stock of Quinn, Inc. c. The stock of Quinn, Inc., has more systematic risk thatn that of Kaskin, Inc.
A, Beta is a measure of systematic risk. Since only systematic risk is rewarded, it is safe to conclude that the expected return will be higher for Kaskin's stock than for Quinn's stock.
What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the market is 15%? a. 15% b. more than 15% c. cannot be determined without the risk-free rate
A, The expected return of a stock with a β = 1.0 must, on average, be the same as the expected return of the market which also has a β = 1.0.
Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz? Portfolio E(r) Standard Deviation W 9% 21% X 5% 7% Y 15% 36% Z 12% 15% a. only portfolio W cannot lie on the efficient frontier b. only portfolio x cannot lie on the efficient frontier c. Only portfolio Y cannot lie on the efficient frontier. d. Only portfolio Z cannot lie on the efficient frontier. e. Cannot be determined from the information given.
Answer A, When plotting the above portfolios, only W lies below the efficient frontier as described by Markowitz. It has a higher standard deviation than Z with a lower expected return.
The correlation coefficients between several pairs of stocks are as follows: Corr(A, B) = 0.85; Corr(A, C) = 0.60; Corr(A, D) = 0.45. Each stock has an expected return of 8% and a standard deviation of 20%. If your entire portfolio is now composed of stock A and you can add some of only one stock to your portfolio, would you choose: a. B b. C c. D d. need more data
Answer is c, The correct choice is Stock D. Intuitively, we note that since all stocks have the same expected rate of return and standard deviation, we choose the stock that will result in lowest risk. This is the stock that has the lowest correlation with Stock A.
what do you think would happen to the expected return on stocks if investors perceived higher volatility in the equity market? relate your answer to equation 6.7 y* = E(rp) -rf / AO^2p
Assuming no change in risk tolerance, that is, an unchanged risk-aversion coefficient (A), higher perceived volatility increases the denominator of the equation for the optimal investment in the risky portfolio (Equation 6.7). The proportion invested in the risky portfolio will therefore decreases
T/F: stocks with a beta of zero offer an expected rate of return of zero
False, . β = 0 implies E(r) =rf, not zero
T\F: The CAPM implies that investors require a higher rate of return to hold highly volatile securities
False, Investors require a risk premium only for bearing systematic (undiversifiable or market) risk. Total volatility, as measured by the standard deviation, includes diversifiable risk
consider a portfolio that offers an expected rate of return 12%, standard deviation of 18% and t-bills offer a risk free 7% rate of return. What is the maximum level of risk aversion for which the risky portfolio is still preferred to T-bills?
U = E(r) - 0.5Aσ^2 The utility level for the risky portfolio is:U = 0.12 - 0.5 ×A × (0.18)2= 0.12 - 0.0162 ×A In order for the risky portfolio to be preferred to bills, the following must hold: 0.12 - 0.0162A > 0.07A <05/0.0162 = 3.09 A must be less than 3.09 for the risky portfolio to be preferred to bills
The market risk, beta, of a security is equal to a. the covariance between the security's return and the market return divided by the variance of the market's return b. the covariance between the security and market returns divided by the standard deviation of the market's returns. c. the variance of the security's returns divided by the covariance between the security and market returns. d. the variance of the security's returns divided by the variance of the market's returns.
a
What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the market is 15%? a. 15% b. more than 15% c. cannot be determined with the risk-free rate
a
kaskin, inc., stock has a beta of 1.2 and Quinn, inc., stock has a beta of .6. Which of the following statements is most accurate? a. the expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn Inc b. the stock of Kaskin Inc., has more total risk than the stock of Quinn inc c. the stock of Quinn Inc., has more systematic risk than that of Kaskin, Inc.
a
which of the following statements about the minimum-variance portfolio of all risky securities is valid? a. its variance must be lower than those of all other securities or portfolios b. its expected return can be lower than the risk-free rate c. it may be the optimal risky portfolio d. it must include all individual securities
a
when adding real estate to an asset allocation program that currently includes only stocks, bonds, and cash, which of the properties of real estate returns affect portfolio risk? a. standard deviation b. expected return c. correlation with returns of the other asset classes
a and c
which of the following factors reflect pure market risk for a given corporation? a. increased short-term interest rates b. fire in the corporate warehouse c. increased insurance costs d. death of the CEO e. increased labor costs
a and e
define capital allocation line (CAL)
a graph showing all feasible risk-return combinations of a risky and risk-free asset
define market price of risk
a measure of the extra return, or risk premium, that investors demand to bear risk. The ratio of the risk premium of the market portfolio to the variance of its return
define passive strategy
a portfolio decision that avoids any direct or indirect security analysis.
define mutual fund theoreum
a result associated with the CAPM, asserting that investors will choose to invest their entire risky portfolio in a market-index mutual fund
consider a risky portfolio. the end-of-the-year flow derived from the portfolio will be either $70,000 or $200,000 with equal probabilities of .5. The alternative risk-free investment in T-bills pays 6% per year. a. if you require a risk premium of 8%. how much will you be willing to pay for the portfolio? b. suppose that the portfolio can be purchases for the amount you found in (a). what will be the expected rate of return on the portfolio? c. now suppose that you require a risk premium of 12%. What is the price that you will be willing to pay? d. comparing your answers to (a) and (c), what do you conclude about the relationship between the required risk premium on a portfolio and the price at which the portfolio will sell?
a.((0.5*70000)+(0.5*200000))/(1+14%) =118421 b. 118421*(1+E(r)) =135000 Therefore, E(r) =14%. The portfolio price is set to equate the expected rate of return with the required rate of return. c. 6+12 = 18% 135000/(1+.18)=114407 d. For a given expected cash flow, portfolios that command greater risk premiums must sell at lower prices. The extra discount from expected value is a penalty for risk
define risk-free asset
an asset with a certain rate of return; often taken to be short-term T-bills.
define risk premium
an expected return in excess of that on risk-free securities. The premium provides compensation for the risk of an investment
define fair game
an investment prospect that has a zero risk premium
define risk neutral
an investor who finds the level of risk irrelevant and considers only the expected return of risk prospects
define risk lover
an investor who is willing to accept lower expected returns on prospects with higher amounts of risk
define risk averse
an investor who will consider risky portfolios only if they provide compensation for risk via a risk premium
define optimal risky portfolio
an investor's best combination of risky assets; the combination that maximizes the Sharpe ratio
In the context of the Capital Asset Pricing Model (CAPM), the relevant risk is a. unique risk b. market risk c. standard deviation of returns d. variance of returns
b
Which of the following statements are true? a. a lower allocation to the risky portfolio reduces the Sharpe (reward-to volatility) ratio. b. the higher the borrowing rate, the lower the Sharpe ratios of levered portfolios. c. with a fixed risk-free, doubling the expected return and standard deviation of the risky portfolio will double the Sharpe ratio. d. holding constant the risk premiums of the risky portfolio, a higher risk-free rate will increase the Sharpe ratio of investments with a positive allocation to the risky assets
b
The security market line (SML) is a. the line that describes the expected return-beta relationship for well-diversified portfolios only. b. also called the capital allocation line. c. the line that is tangent to the efficient frontier of all risky assets. d. the line that represents the expected return-beta relationship e. all of the options
d
Which statement is true regarding the capital market line (CML)? I) The CML is the line from the risk-free rate through the market portfolio. II) The CML is the best attainable capital allocation line. III) The CML is also called the security market line. IV) The CML always has a positive slope. a. I only b. II only c. III only d. IV only e. I, II, and IV
e
T/F: the standard deviation of the portfolio is always equal to the weighted average of the standard deviations of the assets in the portfolio
false
t/f: assume that expected returns and standard deviations for all securities (including the risk-free rate for borrowing and lending) are known. In this case, all investors will have the same optimal risky portfolio.
false
t/f: The CAPM implies that investors require a higher return to hold highly volatile securities
false, Investors require a risk premium only for bearing systematic (undiversifiable or market) risk. Total volatility, as measured by the standard deviation, includes diversifiable risk.
t/f: you can construct a portfolio with beta of 0.75 by investing 0.75 of the investment budget in T-bills and the remainder in the market portfolio.
false, Your portfolio should be invested 75% in the market portfolio and 25% in T-bills. Then: βP = (0.75 × 1) + (0.25 × 0) = 0.75
T/F: you can construct a portfolio with beta of .75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio
false, e. Your portfolio should be invested 75% in the market portfolio and 25% in T-bills. Then: β=(0.75 1) (0.25 0) 0.75
T/f stocks with a beta of zero offer an expected rate of return of zero.
false, β = 0 implies E(r) = rf, not zero.
define minimum-variance frontier
graph of the lowest possible portfolio standard deviation corresponding to each value of portfolio expected return
define security market line (SML)
graphical representation of the expected return-beta relationship
define expected return-beta (or mean beta) relationship
implication of the CAPM that security risk premiums (expected excess returns) will be proportional to beta
define input list
list of parameters such as expected returns, variances, and covariances necessary to determine the optimal risky portfolio
define unique risk
non-market or firm-specific risk factors that can be eliminated by diversification. Also called firm-specific, non-systematic risk, or diversifiable risk
define reward-to-volatility or Sharpe ratio
ratio of excess return to portfolio standard deviation
define Sharpe ratio
reward-to-volatility ratio; ratio of excess return to portfolio standard deviation
Which of the following choices best complete the following statement? Explain. A investor with a higher degree of risk aversion, compared to one with a lower degree, will most prefer investment portfolios. a. with higher risk premiums b. that are riskier (with higher standard deviations) c. with lowers Sharpe Ratio d. with higher Sharpe Ratio
with higher Sharpe Ratio
