Chapter 11 - Conceptual

What related to the security market line is correct?

A security with a beta of 1.54 will plot on the security market line if it is correctly priced.

What is the slope of the security market line?

Market risk premium

The addition of a risky security to a fully diversified portfolio:

may or may not affect the portfolio beta

The systematic risk principle states that the expected return on a risky asset depends only on what?

Market risk

A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. What will lower the overall expected rate of return on this stock?

A decrease in the probability of an economic boom

World United stock currently plots on the security market line and has a beta of 1.04. What will increase that stock's rate of return without affecting the risk level of the stock, all else constant

Increase in the market risk-to-reward ratio

What is the vertical intercept of the security market line?

Risk-free rate

You are assigned the task of computing the expected return on a portfolio containing several individual stocks. What is correct concerning this task?

The summation of the return deviation from the portfolio expected return for each economic state must equal zero.

The capital asset pricing model:

considers the time value of money

Systematic risk is:

measured by beta

If a security plots to the right and below the security market line, then the security has ____ systematic risk than the market and is _____.

more; overpriced

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.

Standard deviation measures _____ risk while beta measures _____ risk.

total; systematic

A risky security has less risk than the overall market. What must the beta of this security be?

> 0 but < 1

What portfolio will have a beta of zero?

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

What is an example of unsystematic risk?

A warehouse fire

Which one of the following statements is correct? A. A portfolio that contains at least 30 diverse individual securities will have a beta of 1.0. B. Any portfolio that is correctly valued will have a beta of 1.0. C. A portfolio that has a beta of 1.12 will lie to the left of the market portfolio on a security market line graph. D. A risk-free security plots at the origin on a security market line graph. E. An underpriced security will plot above the security market line.

An underpriced security will plot above the security market line.

What measures the amount of systematic risk present in a particular risky asset relative to that in an average risky asset?

Beta coefficient

What is the minimum required rate of return on a new investment that makes that investment attractive?

Cost of capital

Which one of the following statements is correct? A. The risk premium on a risk-free security is generally considered to be one percent. B. The expected rate of return on any security, given multiple states of the economy, must be positive. C. There is an inverse relationship between the level of risk and the risk premium given a risky security. D. If a risky security is correctly priced, its expected risk premium will be positive. E. If a risky security is priced correctly, it will have an expected return equal to the risk-free rate.

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

What is another example of systematic risk?

Decrease in gross domestic product

What best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?

Diversification

Mary owns a risky stock and anticipates earning 16.5 percent on her investment in that stock. What best describes the 16.5 percent rate?

Expected return

The security market line is a linear function which is graphed by plotting data points based on the relationship between what two variables?

Expected return and beta

The security market line is defined as a positively sloped straight line that displays the relationship between what two variables?

Expected return and beta

What best describes a portfolio?

Group of assets held by an investor

The expected return on a security depends on which of the following? I. risk-free rate of return II. amount of the security's unique risk III. market rate of return IV. standard deviation of returns

I and III only

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

Based on the capital asset pricing model, investors are compensated based on which of the following? I. market risk premium II. portfolio standard deviation III. portfolio beta IV. risk-free rate

I, III, and IV only

The expected return on a security is currently based on a 22 percent chance of a 15 percent return given an economic boom and a 78 percent chance of a 12 percent return given a normal economy. Which of the following changes will decrease the expected return on this security? I. an increase in the probability of an economic boom II. a decrease in the rate of return given a normal economy III. an increase in the probability of a normal economy IV. an increase in the rate of return given an economic boom

II and III only

What is an example of systematic risk?

Increase in consumption created by a reduction in personal tax rates

Stock A comprises 28 percent of Susan's portfolio. What applies to the 28 percent

Portfolio weight

Diversifying a portfolio across various sectors and industries might do more than one of the following. However, this diversification must do what?

Reduce the portfolio's unique risks

What describes systemic risk?

Risk that affects a large number of assets

Which one of the following is the best example of an announcement that is most apt to result in an unexpected return?

Statement by a firm that it has just discovered a manufacturing defect and is recalling its product

The risk premium for an individual security is based on what types of risk?

Systematic

Consider a portfolio comprised of four risky securities. Assume the economy has three states with varying probabilities of occurrence. What will guarantee that the portfolio variance will equal zero?

The portfolio expected rate of return must be the same for each economic state.

The expected rate of return on Delaware Shores, Inc. stock is based on three possible states of the economy. These states are boom, normal, and recession which have probabilities of occurrence of 20 percent, 75 percent, and 5 percent, respectively. What is correct concerning the variance of the returns on this stock?

The variance must be positive provided that each state of the economy produces a different expected rate of return.

What best exemplifies unsystematic risk?

Unexpected increase in the variable costs for a firm

Portfolio diversification eliminates what?

Unsystematic risk

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

Zero

The beta of a risky portfolio cannot be less than _____ nor greater than _____.

the lowest individual beta in the portfolio; the highest individual beta in the portfolio

A portfolio is comprised of 35 securities with varying betas. The lowest beta for an individual security is 0.74 and the highest of the security betas of 1.51. Given this information, you know that the portfolio beta:

will be greater than or equal to 0.74 but less than or equal to 1.51.

What is the computation of the risk premium for an individual security? E(r) is the expected return on the security, rf is the risk-free rate, β is the security's beta, and E(r)M is the expected rate of return on the market

β[E(r)M - rf]