chapter 13 learn smarts (with answers)

A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of unsystematic risks?

- a hostile takeover attempt by a competitor - the death of a CEO

a firm faces many risks. which of the following examples of unsystematic risks faces by a firm?

- a hostile takeover attempt by a competitor -the death of a CEO

what are the two components of the expected return on the market (Rm)?

- the risk-free rate -the risk premium

steps of the computation of variance

1. calculate the expected return 2. determine the squared deviation from the expected return 3. multiply each squared deviation by its probability 4. the result is variance

Marks Company believes there is a 60% chance of a recession and a. 40% chance of a boom. in the case of recession, the company expects to earn a 2% return. in the case of boom, the company expects to earn 22%. what is Marks Company expected return?

10% ------- = (.02)(.60)+(.22)(.40) = .1 = 10%

if the variance of a portfolio is .0025, what is the standard deviation?

5% .0025^.5 = .5 = 5%

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

Unsystematic/diversifiable/unique risk

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

a portfolios expected return

what is unsystematic risk?

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

what is systemic risk?

a risk that pertains to a large number of assets

How can a positive relationship between the expected return on a security and its beta be justified?

because the difference between the return on the market and the risk-free rate is likely to be positive

the increase in the number of stocks in a portfolio results in a(n) ________________ in the average standard deviation.

decline

historical return data indicated that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio

declines

when new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to

decrease

the standard deviation is

the square root of the variance

how are then unsystematic risk of two different companies in two different industries related?

there is no relationship

The risk of owning an asset comes from:

- unanticipated events - surprises

Asset A has an expected return of 17% and a standard deviation of 5%. Asset B has an expected return of 15% and standard deviation of 5%. Which asset would a rational investor choose?

Asset a

what is a risk premium?

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

true or false: a well-diversified portfolio will eliminate all risks

false

what is an uncertainty or risky return?

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

what type of risk does not change as we add more securities to a portfolio?

systematic/market risk

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 FDA - the Fed's decision on interest rates at their meeting next week

which of the following are examples of systematic risk?

- future rates of inflation -regulatory changes in tax rates

which of the following are examples of unsystematic risk?

- labor strikes - changes in management

what are two components of unexpected return in the total return equation?

- the unsystematic portion - the systemic portion

by definition, what is the beta of the average asset equal to?

1

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 securities beta is 1.5?

11% ----- .05 +1.5(.09-.05) = 11%

If a security's expected return is equal to the risk-free rate of return, and the market-risk premium is greater than 0, what can you conclude about the value of the security's beta based on CAPM?

it is equal to 0

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

positive

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

what is variance?

a measure of the squared deviations of a security's return from its expected return

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

false

true or false: systematic risk can be eliminated by diversification?

false

true or false: systematic risk will impact all securities in every portfolio equally

false

If the variance of a portfolio increases, then the portfolio standard deviation will _________

increase

what is the slope of the security market line (SML)

the market-risk premium

John's portfolio consists of $1,200 worth of Chi Corporation common stock and $400 worth of Lambda Corporation common stock. Lambda's portfolio weight is 25% and the Chi's portfolio weight is:

75% 1200+400 = 1600 Chi: 1200/1600 = .75

If a security's expected return is equal to the expected return on the market, its beta must be _____.

1

what is the equation for the capital asset pricing model?

expected return on security = risk-free rate + beta(return on market - riskfree rate)

what equation for total return as a function of expected and unexpected returns?

total return = expected return + unexpected return

what is the expected return of a portfolio consisting of stocks A and B if the expected return is 10% for A and 15% for B? assume you equally invested in each stock(.5)

12.5% E(Rp) = w1R1 + w2R2+... E(Rp) = (.5)(.10) + (.5)(.15) = .125 = 12.5%

consider the following assets: X: Expected Return 5.8%, Beta .8 Y: Expected Return 14.2%, Beta 1.8 if the risk free rate is 1%, what is the reward to risk ratio for Asset X?

6% -------- risk-to-reward ratio: (5.8 -1)/.8 = 6%

what is the definition of expected return

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

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

less than

The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. which of the following are the possible values for the standard deviation of the portfolio? a. 10.9% b. 14.9% c. 12.9% check all that apply

10.9% and 12.9% standard deviation is less than or equal to the weighted average of the standard deviations of the assets in the portfolio

the minimum required return on a new project when its risk is similar to that of the projects the firm current owns is known as the:

cost of capital

which of the following are examples of a portfolio?

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

according to CAPM, which of the following events would affect the return on a risky asset

- strengthening of the country currency - federal reserve actions that affect the economy - a change in the yield on t-bills

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

A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?

- an increase in the corporate tax rate - an increase in the federal funds rate

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 elminated

ABC has a beta of 2.5 and XYZ has a beta of 1.5. The Risk-free rate is 4 percent and the market risk premium is 9 percent. What is the expected return on a portfolio that is equally invested in ABC and XYZ?

22%

what is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund? the expected returns are 7%, -3% and 18%.

6.2% ---------- i. find weights 50,000+30,000+20,000 = 100,000 50,000/100000 = .5 30,000/100000 = .3 20,000/100000 = .2 ii. Rp = w1R1+w2R2+... Rp = (.5)(.07)+(.3)(-.03)+(.2)(.18) = .062 = 6.2%

you have estimated the following returns for Companies X and Y: X: Return in recession -3%; return in boom 20% Y: Return in recession -8%; return in boom 30% if boom and recession have equal probability(.5) of occurring, what is the expected return on a portfolio consisting of 80% company X and 20% company Y?

9% ------------ i. R(X): (-.03)(.80)+(.20)(.80) = .136 R(Y): (-.08)(.80)+(.30)(.20) = .044 ii. E(Rp) = w1R1+w2R2 (x is 1; y is 2) E(Rp) = (.5)(.136)+(.5)(.044) = .09 = 9%

it would be useful to understand how the _________ of the risk premium on a risky Asset is determined

size

when an investor is diversified only _________ risk matters

systematic

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

that are borne unnecessarily (unsystematic risk)