Finance Chapter 10: Estimating Risk and Return

How is risk premium defined? A security's required return - Risk-free rate - Expected inflation premium Market return - Expected inflation premium Required return - Risk-free rate A security's required return - Market return

Required return - Risk-free rate

The required return on a security is equal to which of these? Select all that apply. Real interest rate + Risk-free rate + Security's risk premium Risk-free rate + Security's risk premium Real interest rate + Expected inflation premium + Security's risk premium Risk-free rate + Market risk premium

Risk-free rate + Security's risk premium Real interest rate + Expected inflation premium + Security's risk premium

Which one of these is commonly used as a proxy for the market portfolio? S&P Industrial Average U. S. Treasury Index S&P 500 Index Dow Jones Industrial Average

S&P 500 Index

Which of the following are sources for finding the beta of a stock? Select all that apply. Zacks Yahoo! Finance Value Line Investment Survey Nightly news broadcast

Zacks Yahoo! Finance Value Line Investment Survey

Which one of these formulas correctly computes the return required by an investor? i = (D1/P0) + g i = D0/P0 + g i = D1 + g i = (D0/P1) + g

i = (D1/P0) + g

A stock just paid an annual dividend of $1.34 which increases by 2 percent per year. How do you compute the required return if the stock is selling for $43 a share? i = [($1.34 × 1.02)/$43] + 0.02 i = ($1.34/$43) + 0.02 i = ($1.34 × 0.02)/$43 + 0.02 i = ($1.34 × 1.02)/$43

i = [($1.34 × 1.02)/$43] + 0.02

The CML represents a _______________ strategy that generates an investment opportunity.

passive

If the market is weak-form efficient, it renders useless which of the following? technical analysis insider trading fundamental analysis

technical analysis

A portfolio consists of $500 of stock A, $200 of stock B, and $600 of stock C. The stock betas are 1.3, 2.2, and 0.5 for stocks A, B, and C, respectively. How is the portfolio beta computed? βP = ($500/$800)(1.3) + ($200/$1,100)(2.2) + ($600/$700)(0.5) βP = (0.5 × 1.3) + (0.2 × 2.2) + (0.6 × 0.5) βP = (1.3 + 2.2 + 0.5)/3 βP = ($500/$1,300)(1.3) + ($200/$1,300)(2.2) + ($600/$1,300)(0.5)

βP = ($500/$1,300)(1.3) + ($200/$1,300)(2.2) + ($600/$1,300)(0.5)

How is a portfolio beta computed when the portfolio consists of $800 in stock A with a beta of 2.6 and $600 in a risk-free asset? βP = ($800/$800)(2.6) βP =($800/$600)(2.6) + ($600/$800)(0) βP = ($800/$1,400)(2.6) + ($600/$1,400)(1) βP = ($800/$1,400)(2.6) + ($600/$1,400)(0)

βP = ($800/$1,400)(2.6) + ($600/$1,400)(0)

You have a portfolio invested 40 percent in a stock A with a beta of 1.6, 30 percent in stock B, and 30 percent in a risk-free asset. What is the beta of stock B if the portfolio beta is equal to the market portfolio beta? 0.8 2.0 1.4 1.2

1.2 The market beta is 1 while the risk-free beta is zero. 1 = (0.4 × 1.6) + (0.3 × βB) + (0.3 × 0); βB = 1.2

You invest equal amounts of money in four stocks with betas of 1.4, 2.6, 0.3, and 0.7. What is the portfolio beta? 1.47 1.25 1.33 1.18

1.25 (1.4 + 2.6 + 0.3 + 0.7)/4 = 1.25; This can also be computed as a weighted average with each weight being 0.25. The arithmetic method works only because the weights are equal.

A stock sells for $18 a share, the next dividend will be $1.54 per share, and the dividend increases by 2.5 percent annually. What is the required return? 11.06 percent 8.56 percent 11.27 percent 8.77 percent

11.06 percent i = ($1.54/$18) + 0.025 = 0.1106 = 11.06%

If you buy a stock with a beta of 1.43 when the risk-free rate is 2.4 percent and the market rate is 8.7 percent, what is your expected rate of return? 18.27 percent 11.41 percent 10.04 percent 14.84 percent

11.41 percent E(R) = 0.024 + 1.43(0.087 - 0.024) = 0.1141 = 11.41%

There is a 5 percent chance of a depression, 25 percent chance of a recession, and a 70 percent chance of a normal economy. A stock will return 45 percent in a depression, 36 percent in a recession and 5 percent in a normal economy. What is the expected return? 7.75 percent 13.50 percent 11.25 percent 14.75 percent

14.75 percent E(R) = (0.05 × 0.45) + (0.25 × 0.36) + (0.70 × 0.05) = 0.1475 = 14.75%

If you buy a stock with a beta of 1.5 when the risk-free rate is 2% and the market rate is 12%, what is your expected rate of return? 14% 17% 10% 18%

17% E(R) = 0.02 + 1.5(0.12 - 0.02) = 0.17 = 17.00%

Which one of these best illustrates a probability distribution at it relates to next year's economy? 5 percent chance of a depression and 25 percent chance of a recession 25 percent chance the economy will grow at 5 percent or more 40 percent chance of recession; 60 percent chance of a normal economy 15 percent chance of a boom and 5 percent chance of a depression

40 percent chance of recession; 60 percent chance of a normal economy

A stock sells for $18 a share, the next dividend will be $1.54 per share, and the dividend decreases by 2.5 percent annually. What is the required return? 8.77% 6.05% 11.06% 8.56%

6.05% i = ($1.54/$18) - 0.025 = 6.05%

A stock has these expected returns: Boom economy =16 percent; Normal economy = 12 percent; Recession = -6 percent, There is a 30 percent chance of a boom and a 20 percent chance of a recession. What is the expected return? 3.2 percent 3.6 percent 9.1 percent 9.6 percent

9.6 percent E(R) = (0.30 × 0.16) + (0.50 × 0.12) + (0.20 × -0.06) = 0.096 = 9.6%

What type of security, if any, has a zero beta? A risk-free security No security can have a zero beta as all security's have some level of market risk. A highly-risky stock The market portfolio

A risk-free security

Which one of these defines the efficient market hypothesis (EMH)? A theory that explains the time delays inherent in an efficient securities market A theory that outlines all the conditions necessary for a securities market to be efficient A theory that determines the number of market makers necessary for an efficient market A theory that describes what types of information are reflected in current market prices

A theory that describes what types of information are reflected in current market prices

Which of the following will decrease the risk level of a firm? Select all that apply. Accepting a low-risk project Acquiring a less risky firm Selling the lowest-risk division Accepting riskier projects

Accepting a low-risk project Acquiring a less risky firm

Which of these is the study of the cognitive processes and biases associated with making financial and economic decisions? EMH theory Behavioral finance Executive options Managerial implications

Behavioral finance

Which one of these variables is used to measure compensable risk in the capital asset pricing model (CAPM)? Alpha, α Standard deviation, σ Beta, β Variance, σ^2

Beta, β Beta, β, is used in CAPM to measure compensable, or market, risk.

The capital allocation line provided by one-month T-bills and a broad index of common stocks is called the _______________ ________________ ______________ .

Blank 1: Capital Blank 2: Market Blank 3: Line

Which of these statements related to the capital asset pricing theory (CAPM) is (are) correct? Select all that apply. CAPM provides higher expected returns than those found on the efficient frontier. CAPM returns incorporate behavioral finance into efficient frontier returns. The key difference between CAPM returns and efficient frontier returns is the inclusion of a risk-free rate. The CAPM is derived from modern portfolio theory.

CAPM provides higher expected returns than those found on the efficient frontier. The key difference between CAPM returns and efficient frontier returns is the inclusion of a risk-free rate. The CAPM is derived from modern portfolio theory.

Beta measures which of these? The amount of firm-specific risk that exists in a single security The total risk of an individual security Comovement between a stock and the market portfolio Movement of a stock in response to a change in market interest rates

Comovement between a stock and the market portfolio

What type of relationship exists between risk and risk premiums? Indirect Inverse None Direct

Direct

A stock has these expected returns: Boom economy = 15 percent; Normal economy = 8 percent; Recession = -3 percent. The probabilities are: Boom = 10 percent; Normal = 85 percent; Recession = 5 percent. Illustrate the expected return calculation. E(R) = (0.15 × 0.08 × -0.03) + (0.10 × 0.85 × 0.05) E(R) = (0.10 × 0.15) + (0.85 × 0.08) + (0.05 × -0.03) E(R) = (0.10 × 0.15) × (0.85 × 0.08) × (0.05 × -0.03) E(R) = (0.15/0.10) + (0.08/0.85) + (-0.03/0.05)

E(R) = (0.10 × 0.15) + (0.85 × 0.08) + (0.05 × -0.03)

There is a 75 percent chance the economy will boom and 25 percent chance it will be normal. If it booms, a stock will return 23 percent but if it is normal, the stock will lose 15 percent. Illustrate the expected return calculation. E(R) = (0.25 - 0.15) × (0.75 + 0.25) E(R) = (0.75 + 0.23) × (0.25 - 0.15) E(R) = (0.75 × 0.23) + (0.25 × -0.15) E(R) = (0.75 × 0.23) × (0.25 × -0.15)

E(R) = (0.75 × 0.23) + (0.25 × -0.15)

The risk-free rate is 3.2 percent while the market risk premium is 8.9 percent. How is the expected return for a stock with a beta of 0.98 computed? E(R) = 0.032 + 0.98(0.089) E(R) = 0.032 + 0.98(0.089 - 0.032) E(R) = 0.032 - 0.098(0.089 - 0.032) E(R) = 0.032 - 0.098(0.089)

E(R) = 0.032 + 0.98(0.089)

A stock has a beta of 1.2, the market rate of return is 11.3 percent, and the risk-free rate is 4.2 percent. How is the expected return on the stock computed? Multiple choice question. E(R) = 0.042 + 1.2(0.113) E(R) = 0.042 + 1.2(0.113 - 0.042) E(R) = 0.042 + 1.2(0.113 + 0.042) E(R) = 0.042 - 1.2(0.113 - 0.042)

E(R) = 0.042 + 1.2(0.113 - 0.042)

Which of these are correct versions of the Capital Asset Pricing Model (CAPM)? Select all that apply. E(R) = Rf - β(RM) E(R) = Rf + β(Market risk premium) E(R) = Rf - β(Market risk premium) E(R) = Rf + β(RM - Rf)

E(R) = Rf + β(Market risk premium) E(R) = Rf + β(RM - Rf)

Which one of these should be used to estimate future stock performance? Geometric mean return Expected return Arithmetic mean return Total historical return

Expected return

The stock of a firm which sells goods that are price elastic tend to have lower betas. True False

False

Which one of these is a factor that most affects the level of a firm's beta? Firm size Firm's geographic location Firm's line of business Age of the firm

Firm's line of business

What information is needed to compute a beta for Stock A? Historical returns for both Stock A and the market portfolio Expected Stock A returns and historical market portfolio returns Historical Stock A returns only Historical market portfolio returns only

Historical returns for both Stock A and the market portfolio

Which of these are characteristics associated with a stock market bubble? Select all that apply. Investor enthusiasm Inflated bull market Sustainable price increases Period of steady prices

Investor enthusiasm Inflated bull market

Which one of these is an argument for market efficiency? Investors who are overly confident and thereby cause market prices to be overvalued based on their expectations The existence of market bubbles for an extended period of time Investors constantly seek mispriced stocks and cause that mispricing to disappear by their trades The research findings of behavioral finance advocates

Investors constantly seek mispriced stocks and cause that mispricing to disappear by their trades

The study of behavioral finance suggests that markets may not be priced efficiently for which one of these reasons? Investors may make irrational decisions. There is a lack of market participation. Investors are always pessimistic and thus prices are too low. New information is hard for investors to obtain and interpret.

Investors may make irrational decisions.

The market portfolio has which of these characteristics? Lies on the capital market line Is considered to be risk-free No firm-specific risk Is part of the efficient frontier

Lies on the capital market line No firm-specific risk Is part of the efficient frontier

Why do managers need to understand shareholder's required returns? Select all that apply. Managers must ensure firms adequately reward their investors. Managers must also be shareholders and thus they want to be adequately compensated. Managers must include shareholder returns in new project analysis. Managers must understand that increasing the risk level of a firm will increase the returns required by investors.

Managers must ensure firms adequately reward their investors. Managers must include shareholder returns in new project analysis. Managers must understand that increasing the risk level of a firm will increase the returns required by investors.

In the CAPM formula, what does the symbol RM stand for? Market rate of return Risk-free rate of return Beta Market risk premium

Market rate of return

Beta is a a measure of a stock's sensitivity to which type of risk? Firm-specific risk Market risk Total risk Diversifiable risk

Market risk

The security market line (SML) graphs required return against which risk measure? Market risk Firm-specific risk Total risk Diversifiable risk

Market risk

Which of these are characteristics of the security market line (SML)? Select all that apply. Passes through the market rate of return Upward-sloping function Vertical intercept at the market rate of return Always downward sloping

Passes through the market rate of return Upward-sloping function

How is a stock market bubble defined? Long period of rising prices followed by a period of slow growth Long, slow period of price increases followed by a slow decline in prices Period of overinflated prices followed by a dramatic collapse in prices Period of slowly rising prices that suddenly decline due to firm-specific risk

Period of overinflated prices followed by a dramatic collapse in prices

The standard deviation of expected returns with multiple economic states considers which of the following? Select all that apply. The squared value of each expected return The arithmetic average expected return Probability of occurrence for each state of the economy The expected return for each economic state

Probability of occurrence for each state of the economy The expected return for each economic state

Asset pricing can be described as which type of process? Process of analyzing market forces to determine a stock's current value Process of determining the spread required between a bid and asked price Process of directly specifying an equation that relates a stock's required return to an appropriate risk premium Process of determining the price required for an asset to be immediately liquidated

Process of directly specifying an equation that relates a stock's required return to an appropriate risk premium

Trading based on which one of these is an argument against market efficiency? New public information New privately-held information Psychological bias Past price trends

Psychological bias

What is the definition of an efficient market? Securities market where stock prices become stable over time Securities market where everyone who wants to participate in the market can participate Securities market in which prices fully reflect available information on each security Securities market where trades occur within ten minutes of an order being placed

Securities market in which prices fully reflect available information on each security

Which one of these can be used as a definition of an efficient market? Securities market where prices accurately value the risk-return relationship of each security given all available information Securities market where stock prices are unaffected by changes in a firm's level of risk Securities market where stocks are traded free of cost Securities market where any stock can be listed on any exchange

Securities market where prices accurately value the risk-return relationship of each security given all available information

Which one of these statements applies to the efficient market hypothesis (EMH)? Security prices overreact and then settle to a price reflective of the latest information. Security prices are random. Security prices only reflect historical and public information. Security prices fully reflect all available information.

Security prices fully reflect all available information.

Which of the following will increase the risk level of a firm? Select all that apply. Selling the lowest-risk division Accepting riskier projects Acquiring a riskier firm Accepting a low-risk project

Selling the lowest-risk division Accepting riskier projects Acquiring a riskier firm

Kate, a corporate controller, knows her firm's earnings are going to be less than the market expects. The firm's stock price includes all information except for this. What form of market efficiency exists? Semi-strong form Strong form Weak form

Semi-strong form

Which one of these correctly defines a level of market efficiency? Weak form: Prices reflect all public information Strong form: Prices reflect all historical and public information Weak form: Prices reflect all information, both public and private Semi-strong form: Prices reflect all historical and public information

Semi-strong form: Prices reflect all historical and public information

Which one of these defines the standard deviation of expected returns given multiple economic states? Sum of the square root of each return's deviation from the average × Probability of that return Sum of the square roots of each return's squared deviation from the average × Probability of that return Square root of the sum of each return's squared deviation from the average × Probability of that return Square root of each return's deviation from the average × Probability of that return

Square root of the sum of each return's squared deviation from the average × Probability of that return

How do you explain an expected return given multiple states of the economy? Weighted geometric average with the weights being the probabilities of occurrence Expected rate of return for the state most likely to occur Summation of each expected return multiplied by its probability of occurrence Weighted average with the weights being the expected returns

Summation of each expected return multiplied by its probability of occurrence

Which of these terms best describes an expected return with multiple states? Geometric mean return Arithmetic average return Weighted average return Historical mean

Weighted average return

How is the range of beta values defined for a portfolio of risky assets? The highest possible portfolio beta is defined as the highest beta of any security held in the portfolio. The lowest possible portfolio beta is defined as the beta of a risk-free asset, or zero. The highest portfolio beta is defined as the beta of the overall market, or 1.0. The lowest possible portfolio beta is defined as the lowest beta of any security held in the portfolio.

The highest possible portfolio beta is defined as the highest beta of any security held in the portfolio. The lowest possible portfolio beta is defined as the lowest beta of any security held in the portfolio.

What does a beta of 1.0 mean for an individual security? The security has 10 percent more market risk than the market portfolio. The security has the same amount of market risk as the market portfolio. The security has 10 times more market risk than the market portfolio. The security is considered to be risk-free.

The security has the same amount of market risk as the market portfolio.

What does it mean if a stock plots on a security market line (SML) graph to the left of the market portfolio? The stock is overpriced. The stock is underpriced. The stock has a beta less than 1 and has less market risk than the market portfolio. The stock has a beta greater than 1 and has more market risk than the market portfolio.

The stock has a beta less than 1 and has less market risk than the market portfolio.

Lucas was just charged with insider trading. What form of market efficiency cannot exist if this charge is true? Neither the weak-form nor the semi-strong form of efficiency can exist. The strong form of efficiency cannot exist. All forms of market efficiency can still exist. The weak form of efficiency cannot exist.

The strong form of efficiency cannot exist.

Which of these illustrates the definition of a probability distribution? It rained three-quarters of the day yesterday. There is a 60 percent chance of rain and a 40 percent chance of pure sunshine. The sun is shining today and is supposed to shine tomorrow. It may snow either today or tomorrow.

There is a 60 percent chance of rain and a 40 percent chance of pure sunshine.

If a stock has more market risk than the market portfolio and is overpriced, where will it plot on a security market line graph? To the left of the market portfolio and below the security market line To the right of the market portfolio and below the security market line To the left of the market portfolio and above the security market line To the right of the market portfolio and above the security market line

To the right of the market portfolio and below the security market line

How is required return defined? Total return investors demand as compensation for the risk taken The return on a security minus the risk-free rate Market rate of return, usually considered to be the S&P 500 return The historical average rate of return

Total return investors demand as compensation for the risk taken

Asset pricing can be defined as mathematically relating a security's required return to the security's level of risk. True False

True

The expected return is a forward-looking return that includes risk measures. True False

True

For firms to be able to sell shares of stock, their managers must understand the returns required by shareholders. True False

True Shareholders will only buy shares when they expect to be adequately compensated. Managers try to ensure that happens.

Which one of these correctly defines a portfolio beta? Assume varying amounts are invested in each security. A beta equal to the market portfolio beta Arithmetic average of the individual security betas The highest beta of any stock held in the portfolio Weighted average of the individual security betas

Weighted average of the individual security betas