Business Finance Ch. 11

Unsystematic risk will affect

- firms in a single industry - a specific firm

Which of the following are examples of unsystematic risk?

-Changes in management -Labor strikes

True or False: Labor strikes are an example of systematic risk:

False

What is the definition of expected return?

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

What is the equation for total return?

Total return = Expected return + Unexpected return

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.

The calculation of a portfolio beta is similar to the calculation of:

a portfolio's expected return

The CAPM can also be used for a portfolio by first determining the portfolio's _______

beta

The________ return on a portfolio is a combination of the expected returns on the assets in the portfolio.

expected

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

not change

True or false: Discounting a news item is the same as taking the present value of that item.

false

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

-Market risk -Unsystematic risk

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 for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5?

11%

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%

What is the equation for the capital asset pricing model?

Expected return on security = Risk-free rate + Beta × (Return on market - Risk-free rate)

What is unsystematic risk?

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

What is systematic risk?

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

____________ risk is the only risk important to the well diversified investor.

Systematic

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

The risk-free rate

How are the unsystematic risks of two different companies in two different industries related?

There is no relationship.

What is the Reward-to-Risk Ratio?

[E(RA) - Rf]/βA

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:

already knew about most of the news item

True or false: The standard deviation is the variance squared.

false

True or false: The surprise part of any announcement is the information the market uses to form the expectation of the return on the stock.

false

Systematic risk is also called ______________ risk.

market

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

positive

The true risk of any investment comes from _______________ .

surprises

Even if the portfolio is well diversified, the investor is still exposed to _____ risk.

systematic

Beta tells us the amount of ________ risk of an asset or portfolio relative to ______.

systematic; an average risky asset

To determine the appropriate required return for an investment, we can use _____________________.

the Security Market Line

If the standard deviation of a portfolio is __________?

the square root of the variance

The _____ is the news that influences the unanticipated return on the stock.

surprise

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

true

Which of the following are examples of systematic risk?

-Future rates of inflation -Regulatory changes in tax rates

The systematic risk principle argues that the market does not reward risks:

-that are diversifiable -that are borne unnecessarily

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

-Unsystematic -Diversifiable -Company-specific

The CAPM shows that the expected return for an asset depends on which three things?

-The reward for bearing systematic risk -The amount of systematic risk -The pure time value of money

The true risk of any investment comes from:

-surprises -unanticipated events

True or false: Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio increases.

false

True or false: Portfolio weights can be defined as the dollars invested in each asset.

false

An investment will have a negative NPV when its expected return is _______ ________ what the financial markets offer for the same risk.

less than

What is a risk premium?

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

If an asset has a reward-to-risk ratio of 6.0%, that means it has a __________ of 6.0% per unit of _______.

risk premium; systematic risk

What is the beta of the risk-free asset?

zero

What two factors determine a stock's total return?

-unexpected return -expected return

The capital asset pricing model is the equation of the security market line showing the relationship between expected return and__________

beta

Which of the following are examples of a portfolio?

-Investing $100,000 in the stocks of 50 publicly traded corporations -Investing $100,000 in a combination of US and Asian stocks -Investing $100,000 in a combination of stocks and bonds

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.

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

Which of the following statements is (are) true about variance?

-Variance is a measure of the squared deviations of a security's return from its expected return. -Standard deviation is the square root of variance.

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 types of risk is not reduced by diversification?

Systematic, or market risk systematic cannot be diversified away

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

The market-risk premium

According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?

The risk-free rate of return

The appropriate discount rate to use to evaluate a new project is the _____.

cost of capital

The minimum required return on a new project is known as the:

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:

declines

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

false

True or false: Calculating the expected return is the last step in the computation of variance.

false

True or false: Expected return and inflation are the two components of risky return in the total return equation.

false

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

false

True or false: The expected return of a portfolio is a combination of the weights of each asset in a portfolio.

false

True or false: The calculation of the portfolio beta is similar to the calculation of the portfolio weights.

false (The calculation of the portfolio beta is similar to the calculation of the expected return.)

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

positive 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).

A portfolio can be described by its portfolio weights which are defined as _____________________.

the percentage of dollars invested in each asset

The standard deviation is ___.

the square root of the variance

True or false: According to the capital asset pricing model (CAPM), the risk-free rate of return is the expected return on a security with a beta of zero.

true

True or false: Adding securities will reduce unsystematic risk only. Systematic risk is unaffected by diversification.

true

True or false: Labor strikes are an example of unsystematic risk.

true

True or false: The expected return is the return that an investor expects to earn on a risky asset in the future.

true

True or false: Unsystematic risk is specific only to a single company or industry.

true