FIN 370 Chapter 13

You have $21,600 to invest in a stock portfolio. Your choices are Stock X with an expected return of 14.3 percent and Stock Y with an expected return of 8.1 percent. Your goal is to create a portfolio with an expected return of 12.5 percent. All money must be invested. How much will you invest in Stock X?

$15,329 E(Rp) = .125 = .143x + .081(1 − x) x = .70968, or 70.968% Investment in Stock X = .70968($21,600) Investment in Stock X = $15,329

As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk? -It is likely to increase. -It may eventually be almost totally eliminated. -It will not change. -It is likely to decrease.

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

Which of the following are examples of information that may impact the risky return of a stock? Select all that apply -The Fed's decision on interest rates at their meeting next week -The trend in sales growth over the last 10 years. -Last year's net income as a percentage of sales and gross fixed assets. -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 -The outcome of an application currently pending with the Food and Drug Administration

The risk-free asset has a beta of _____. -1.00 -0.00 -0.75 -3.00

0.00 Reason: The risk-free asset has a beta of zero, because it does not change with changes in the market portfolio.

By definition, what is the beta of the average asset equal to? -1 -0 -Between 0 and 1 -2

1

Suppose you put half of your money in Monster Beverage and half in IBM. What would the beta of this combination be if Monster Beverage has a beta of 1.52 and Pepsi has a beta of .55?

1.04 βp = (Wa × β) + (Wb × β) βp = (.50 × 1.52) + (.50 × .55) βp = .76 + .275 = 1.035

You decide to invest $20,500 in Bank of America and $14,500 in Twitter. What is the portfolio's beta? Bank of America beta: 1.27 Twitter beta: 1.96

1.553 Wa (Bank of America) = $20,500/($20,500 + $14,500) = 59% Wb (Twitter) = 1 − 59% = 41% βp = (Wa × β) + (Wb × β) βp = (.59 × 1.27) + (.41 × 1.96) βp = .7493 + .8036 = 1.553

Your portfolio has a beta of 1.24. The portfolio consists of 6 percent U.S. Treasury bills, 40 percent Stock A, and 54 percent Stock B. Stock A has a risk level equivalent to that of the overall market. What is the beta of Stock B?

1.56 βPortfolio = 1.24 = (.06)(0) + (.40)(1) + (.54βB) βB = 1.56

You own a portfolio equally invested in a risk-free asset and two different stocks. One of the stocks has a beta of 1.32. The total portfolio is equally as risky as the market. What is the beta of the second stock?

1.68 βp = 1.0 = (1/3)(0) + (1/3)(β2) + (1/3)(1.32) β2 = 1.68

The economy has been very volatile lately. There is a 40% chance of recession and a 60% chance of a boom. Stock A would have a return of −15% if there was a recession but, a 40% return in a boom economy. What is the expected return for Stock A?

18% E(RA) = .40 × − .15 + .60 × .40 E(RA) = − .06 + .24 E(RA) = .18 E(RA) = 18%

If risk-free investments are currently 6% and our expected return from Stock V was 14%. What is the risk premium on this investment?

8% Risk premium = Expected Return − Risk free rate Risk premium = 14% − 6% Risk premium = 8%

Asset A has an expected return of 17 percent and standard deviation of 5 percent. Asset B has an expected return of 15 percent and standard deviation of 5 percent. Which asset would a rational investor choose? -Asset A -Asset A or B since they both are equally risky -Asset B -Neither A or B since they are both risky

Asset A

Assets A and B each have an expected return of 10 percent. Asset A has a standard deviation of 12 percent while Asset B has a standard deviation of 13 percent. Which asset would a rational investor choose?

Asset A Reason: A is better as it offers the same return at a lower level of risk.

Which one of the following statements is accurate? -Unsystematic risk is rewarded when it exceeds the market level of unsystematic risk. -Eliminating unsystematic risk is the responsibility of the individual investor. -Standard deviation is a measure of unsystematic risk. -Beta measures the level of unsystematic risk inherent in an individual security. -An investor should expect to be rewarded for assuming unsystematic risk.

Eliminating unsystematic risk is the responsibility of the individual investor.

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

False

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

False

Which of the following are examples of a portfolio? Select all that apply -Investing $100,000 in a combination of U.S. and Asian stocks -Holding $100,000 investment in a combination of stocks and bonds -Investing $100,000 in the stocks of 50 publicly traded corporations -Holding $100,000 in cash to buy after five years 100 shares of the best performing stock on the NYSE

Investing $100,000 in a combination of U.S. and Asian stocks Holding $100,000 investment in a combination of stocks and bonds Investing $100,000 in the stocks of 50 publicly traded corporations

Which of the following statements regarding unsystematic risk is accurate? -It is related to the overall economy. -It is measured by standard deviation. -It is measured by beta. -It can be effectively eliminated by portfolio diversification. -It is compensated for by the risk premium.

It can be effectively eliminated by portfolio diversification.

Which of the following statements is true of a portfolio's standard deviation? -It is a weighted average of the standard deviations of the individual securities held in that portfolio. -It can be less than the weighted average of the standard deviations of the individual securities held in that portfolio. -It measures the amount of diversifiable risk inherent in the portfolio. -It serves as the basis for computing the appropriate risk premium for that portfolio. -It is a measure of that portfolio's systematic risk.

It can be less than the weighted average of the standard deviations of the individual securities held in that portfolio.

What does the security market line depict? -It depicts the relationship between the return on the S&P 500 and an individual security's return. -It depicts the relationship between expected return and the standard deviation of returns. -It depicts the relationship between systematic risk and unsystematic risk. -It is a graphical depiction of the capital asset pricing model. It shows the relationship between expected return and beta.

It is a graphical depiction of the capital asset pricing model. It shows the relationship between expected return and beta.

What is systematic risk? -It is a risk that pertains to a large number of assets. -It is a risk that affects only one or a few assets. -It is a risk that is caused by failure of the internal control system of a corporation. -It is a risk that increases in a systematic, gradual fashion.

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

What is an uncertain or risky return? -It is the portion of return that is unaffected by present or future information. -It is the portion of return that depends on information that is currently known. -It is the return that is classified as risky by bond rating agencies. -It is the portion of return that depends on information that is currently unknown.

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

What is the definition of expected return? -It is the variation in return during the last period. -It is the return that was earned in the past on a risky asset. -It is the return that an investor expects to earn on a risky asset in the future. -It is the expected variation in return on a risky asset.

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

With respect to returns, which one of the following statements is accurate? -The unexpected return is always negative. -The expected return includes the surprise portion of news announcements. -Over time, the average unexpected return will be zero. -Over time, the average return is equal to the unexpected return. -The expected return minus the unexpected return is equal to the total return.

Over time, the average unexpected return will be zero

The portfolio weight is _____.

The percentage of the total value that is invested in an asset.

The Capital Asset Pricing Model (CAPM) shows that the expected return for a particular asset depends on all of the following, except: -The pure time value of money -The return on a risk-less asset -The reward for bearing systematic risk -The amount of systematic risk

The return on a risk-less asset

According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero? -The return on market -Zero -The risk-free rate of return -The market risk premium

The risk-free rate of return Reason: Risk-free rate + 0 × Market risk premium = Risk-free rate

What are the two components of unexpected return (U) in the total return equation? Select all that apply -The expected return portion -The expected risk portion -The unsystematic portion -The systematic portion

The unsystematic portion The systematic portion

How are the unsystematic risks of two different companies in two different industries related? -There is a positive relationship. -There is no relationship. -The relationship can be either positive or negative. -There is a negative relationship.

There is no relationship

T or F: Risk-free assets have a beta of 0 and the market portfolio has a beta of 1.

True

If you wish to create a portfolio of stocks, what is the required minimum number of stocks? _You must invest in stocks of at least 10 corporations. -You must invest in stocks of more than one corporation. -You must invest in the stocks of at least 30 corporations. -You must invest in at least 2 stocks of 1 corporation.

You must invest in stocks of more than one corporation.

The calculation of a portfolio beta is similar to the calculation of _____. -a portfolio's standard deviation -the value of a put option -a portfolio's expected return -a portfolio's variance

a portfolio's expected return

When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market _____. -reversed its position based on the news -doesn't pay attention to news items -already knew about most of the news item

already knew about most of the news item

The _____________ coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset.

beta

The security market line is a positively sloped straight line that displays the relationship between expected return and ____________. -beta -WACC -risk -portfolio -market risk premium

beta

The cost of ______________ is the minimum required return on a new investment.

capital

The ________ explains the relationship between the expected return on a security and the level of that security's systematic risk. -capital asset pricing model -unsystematic risk equation -time value of money equation -market performance equation -expected risk formula

capital asset pricing model

The minimum required return on a new project when its risk is similar to that of projects the firm currently owns is known as the _____. -cost of capital -internal rate of return -dividend yield -payback period

cost of capital

Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio _____. -increases -fluctuates randomly -does not change -declines

declines

The increase in the number of stocks in a portfolio results in a(n) ____________ in the average standard deviation of annual portfolio returns.

decrease

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

decrease

When we ____________ an announcement or a news item, we say that it has less of an impact on price because the market already factored it in.

discount

The ________________ return is the return that an investor will probably earn on a risky asset in the future.

expected

True or false: The process to calculate a portfolio's beta is opposite of the process to calculate a portfolio's expected return.

false

According to the capital asset pricing model (CAPM), the amount of reward an investor receives for bearing the risk of an individual security depends upon the: -amount of total risk assumed and the market risk premium. -risk-free rate, the market rate of return, and the standard deviation of the security. -beta of the security and the market rate of return. -standard deviation of the security and the risk-free rate of return. -market risk premium and the amount of systematic risk inherent in the security.

market risk premium and the amount of systematic risk inherent in the security.

Buchi owns several financial instruments: stocks issued by seven different companies, plus bonds issued by four different companies. Her investments are best described as a(n): -collection -risk-free position -grouping -index -portfolio

portfolio

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

positive

The SML is very important because it tells us the "going rate" for bearing _____________ in the economy.

risk

Expected return is the return on a _______ asset expected in the future. -portfolio -risk-free -no-risk -risky -average

risky

The principle of diversification tells us that spreading an investment across a number of assets will eliminate ______ of the risk. -all -almost none -an insignificant portion -some

some

The _______________ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.

systematic

The principle of diversification tells us that, to a diversified investor, the only type of risk that matters is _____________ (systematic/unsystematic) risk.

systematic

When an investor is diversified only ________ risk matters. -diversifiable -unnatural -unsystematic -systematic

systematic

Which type of risk is unaffected by adding securities to a portfolio? -Systematic risk -Neither systematic nor unsystematic risk -Both systematic and unsystematic risk -Unsystematic risk

systematic risk

Which type of risk does not change as we add more securities to a portfolio? -Company-specific risk -Systematic, or market, risk -Idiosyncratic risk -Unsystematic, or diversifiable, risk

systematic, or market, risk

The systematic risk principle argues that the market does not reward risks _____. -that are systematic -that are dangerous -that are borne unnecessarily -in any circumstances

that are borne unnecessarily

To determine whether an investment has a positive NPV, you can compare the expected return on that new investment to what the financial market offers on an investment with _____. -half the variance -twice the standard deviation -the same beta -half the beta

the same beta

The standard deviation is _______. -the square root of the variance -equal to the sum of the deviations of actual returns from the average return -equal to the sum of deviations divided by the number of observations -the square of the variance

the square root of the variance

The true risk of any investment is the _____ portion. -unanticipated -risk-free -compounding -anticipated

unanticipated

The risk of owning an asset comes from: Select all that apply -expectations -unanticipated events -forecasts -surprises

unanticipated events surprises

The ____________ is the squared standard deviation.

variance

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

weight

Portfolio Beta is the ______________ average of the Betas of the investments included in the portfolio. -riskless -expected -geometric -arithmetic -weighted

weighted