Corporate Finance 3320- Chapter 11

A model used to determine the required return on an asset, which is based on the proposition that any asset's return should be equal to the risk-free return plus a risk premium that reflects the asset's non- diversifiable risk.

Capital Asset Pricing Model (CAPM)

T/F A firm cannot change its beta through any managerial decision because betas are completely market determined

F

T/F All else equal, a risk averse investor choosing between two individual stocks to be held in isolation would prefer the stock with higher coefficient of variation.

F

T/F An investor who is risk averse requires lower rates of return for assets of higher risk.

F

T/F Because of differences in the expected returns of different securities, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation always will allow an investor to properly compare the relative risks of any two securities.

F

T/F In order to reduce risk, one should diversify into areas that are positively correlated with current areas of involvement.

F

T/F Suppose that two firms, A and B, have identical expected returns but Firm A has the possibility of a much higher return than Firm B. We can conclude from this that Firm A will have a higher coefficient of variation than Firm B

F

T/F The coefficient of correlation represents the standard deviation divided by the expected value.

F

T/F The only condition under which risk can be reduced to zero is to find securities that are perfectly negatively correlated (ρ= -1.0) with each other.

F

T/F The realized portfolio return is the weighted average of the relative weights of securities in the portfolio multiplied by their respective expected returns.

F

T/F When comparing two different stocks with the same expected return but different standard deviations, you must compute the coefficient of variation to determine which stock is preferred.

F

The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities.

Security Market Line (SML)

T/F A stock with above-average market risk will tend to be more volatile than an average stock, and it will have a beta which is greater than 1.0.

T

T/F If investors become more averse to risk, the slope of the Security Market Line (SML) will increase.

T

T/F If possible outcomes are D and probabilities are P, the standard deviation is defined as

T

T/F The coefficient of variation is useful in evaluating the total risk in situations where assets have different total risk and expected returns.

T

T/F We will generally find that the beta of a diversified portfolio is more stable over time than the beta of a single security.

T

The biggest reduction in risk would be achieved by combining two assets into a portfolio with a correlation coefficient equal to ____. a. -1.0 b. -0.5 c. 0 d. 0.5 e. 1.0

a. -1.0

Which of the following statements is most correct? a. An increase in expected inflation could be expected to increase the required return on a riskless asset and on an average stock by the same amount, other things held constant. b. A graph of the SML would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis. c. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations. d. If investors became more averse to risk, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks. e. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.

a. An increase in expected inflation could be expected to increase the required return on a riskless asset and on an average stock by the same amount, other things held constant.

Other things held constant, (1) if the expected inflation rate decreases, and (2) investors become more risk averse, the Security Market Line would shift a. Down and have steeper slope. b. Up and have less steep slope. c. Up and keep same slope. d. Down and keep same slope. e. Down and have less steep slope.

a. Down and have steeper slope.

Calculate the standard deviation of the expected dollar returns for Ditto Copier Center, given the following distribution of returns: Probability Return 0.2 $50 0.5 $20 0.3 -$15 a. $36.0 b. $23.0 c. $18.0 d. $13.0 e. $30.0

b. $23.0

Given the following information, determine which beta coefficient for Stock A is consistent with equilibrium: rs = 11.3%; rRF = 5%; rM = 10% a. 0.86 b. 1.26 c. 1.10 d. 0.80 e. 1.35

b. 1.26

You are an investor in common stock, and you currently hold a well-diversified portfolio which has an expected return of 12 percent, a beta of 1.2, and a total value of $9,000. You plan to increase your portfolio by buying 100 shares of AT&E at $10 a share. AT&E has an expected return of 20 percent with a beta of 2.0. What will be the expected return and the beta of your portfolio after you purchase the new stock? a. = 20.0%; βp = 2.00 b. = 12.8%; βp = 1.28 c. = 12.0%; βp = 1.20 d. = 13.2%; βp = 1.40 e. = 14.0%; βp = 1.32

b. = 12.8%; βp = 1.28

Which of the following statements is correct? a. If the returns on a stock could vary widely, and its standard deviation is large, then the stock will necessarily have a large beta coefficient. b. A stock that is more highly positively correlated with "The Market" than most stocks would not necessarily have a beta coefficient that is greater than 1.0. c. A stock's standard deviation of returns is a measure of the stock's "stand-alone" risk, while its coefficient of variation measures its risk if the stock is held in a portfolio. d. A portfolio that contained 100 low-beta stocks would be riskier than a portfolio containing 100 high-beta stocks. e. Negative betas cannot exist; if you calculate one, you made an error.

b. A stock that is more highly positively correlated with "The Market" than most stocks would not necessarily have a beta coefficient that is greater than 1.0.

You have developed the following data on three stocks: Stock Standard Deviation Beta A 0.15 0.79 B 0.25 0.61 C 0.20 1.29 If you are a risk minimizer, you should choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; A b. A; B c. B; A d. C; A e. C; B

b. A; B

Inflation, recession, and high interest rates are economic events which are characterized as a. Company specific risk that can be diversified away. b. Market risk. c. Systematic risk that can be diversified away. d. Diversifiable risk. e. Unsystematic risk that can be diversified away.

b. Market risk.

A measure of the extent to which the returns on a given stock move with the stock market.

beta coefficient, b

Consider the following information, and then calculate the required rate of return for the Scientific Investment Fund. The total investment in the fund is $2 million. The market required rate of return is 15 percent, and the risk-free rate is 7 percent. Stock Investment Beta A $ 200,000 1.50 B 300,000 -0.50 C 500,000 1.25 D 1,000,000 0.75 a. 14.3% b. 15.0% c. 13.1% d. 12.7% e. 10.3%

c. 13.1%

Given the following probability distribution, what is the expected return and the standard deviation of returns for Security J? State Prj rJ 1 0.2 10% 2 0.6 15 3 0.2 20 a. 15%; 6.50% b. 12%; 5.18% c. 15%; 3.16% d. 15%; 10.00% e. 20%; 5.00%

c. 15%; 3.16%

If the risk-free rate is 7 percent, the expected return on the market is 10 percent, and the expected return on Security J is 13 percent, what is the beta of Security J? a. 1.0 b. 1.5 c. 2.0 d. 2.5 e. 3.0

c. 2.0

The systematic (market) risk associated with an individual stock is most closely identified with the a. Standard deviation of the returns on the stock. b. Standard deviation of the returns on the market. c. Beta of the stock. d. Coefficient of variation of returns on the stock. e. Coefficient of variation of returns on the market.

c. Beta of the stock.

In a portfolio of three different stocks, which of the following could not be true? a. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation. b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. c. The beta of the portfolio is less than the beta of each of the individual stocks. d. The beta of the portfolio is greater than the beta of one or two of the individual stock's betas. e. None of the above (i.e., they all could be true, but not necessarily at the same time).

c. The beta of the portfolio is less than the beta of each of the individual stocks

Which type of risk can be eliminated through diversification? a. total risk b. market risk c. firm specific risk d. systematic risk e. none of the above

c. firm specific risk

A standardized measure of the risk per unit of return. It is calculated by dividing the standard deviation by the expected return

coefficient of variation (CV)

Distribution in which the number of possible outcomes is unlimited, or infinite

continuous probability distribution

A measure of the degree of relationship between two variables.

correlation coefficient,

Given the following probability distributions, what are the expected returns for the Market and for Security J? a. 10.0%; 11.3% b. 9.5%; 13.0% c. 10.0%; 9.5% d. 10.0%; 13.0% e. 13.0%; 10.0%

d. 10.0%; 13.0%

Which of the following statements is correct? a. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio. b. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the nonmarket (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. c. The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. d. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock. e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.

d. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock.

Choose the correct answer for the following: (1) Which is the best measure of risk for choosing an asset which is to be held in isolation? (2) Which is the best measure for choosing an asset to be held as part of a diversified portfolio? a. Variance; correlation coefficient. b. Standard deviation; correlation coefficient. c. Beta; variance. d. Coefficient of variation; beta. e. Beta; beta.

d. Coefficient of variation; beta

Which of the following statements is false? a. One key result of applying the Capital Asset Pricing Model is that the risk and return of an individual security should be analyzed by how that security affects the risk and return of the portfolio in which it is held. b. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the isolated risks of individual stocks. Thus, the relevant risk is an individual stock's contribution to the overall riskiness of the portfolio. c. The CAPM is built on expected conditions, although we are limited in most cases to using past data in applying it. Betas used in the CAPM which are calculated using historical data are always subject to changes in future volatility, and this is a limitation on the use of the CAPM. d. If the price of money increases due to greater anticipated inflation, the risk-free rate will reflect this fact. Although rRF will increase, it is possible that the SML required rate of return for a stock will decrease because the market risk premium (rM - rRF) will decrease. (Assume that beta remains constant.) e. Any change in beta is likely to affect the required rate of return on a security which implies that a change in beta will likely have an impact on the security's price.

d. If the price of money increases due to greater anticipated inflation, the risk-free rate will reflect this fact. Although rRF will increase, it is possible that the SML required rate of return for a stock will decrease because the market risk premium (rM - rRF) will decrease. (Assume that beta remains constant.)

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.) a. When held in isolation, Stock A has greater risk than Stock B. b. Stock B would be a more desirable addition to a portfolio than Stock A. c. Stock A would be a more desirable addition to a portfolio than Stock B. d. The expected return on Stock A will be greater than that on Stock B. e. The expected return on Stock B will be greater than that on Stock A.

d. The expected return on Stock A will be greater than that on Stock B.

The Security Market Line (SML) relates risk to return, for a given set of financial market conditions. If investors conclude that the inflation rate is going to increase, which of the following changes would be most likely to occur? a. The market risk premium would increase. b. Beta would increase. c. The slope of the SML would increase. d. The required return on an average stock, rA = rM, would increase. e. None of the indicated changes would be likely to occur.

d. The required return on an average stock, rA = rM, would increase.

Which of the following statements concerning measures of risk is correct? a. Combining stocks together in portfolios reduces risk as long as the correlation between the returns on the securities is not perfect (i.e. = 1.0 or = +1.0). b. Even if the correlation between the returns on two different securities is perfectly positive, if the securities are combined in the correct unequal proportions, the resulting portfolio can have less risk than either security held alone. c. The coefficient of variation, calculated as the expected return divided by the standard deviation, is a standardized measure of the correlation of risk and return. d. The tighter the probability distribution of expected future returns the smaller the risk of a given investment as measured by both the variance and the standard deviation. e. Variance is a measure of the variability of returns and because it involves squaring each deviation of the required return from the expected return, it is always larger than its square root, the standard deviation.

d. The tighter the probability distribution of expected future returns the smaller the risk of a given investment as measured by both the variance and the standard deviation.

The beta of any portfolio can be computed as the a. slope of the security market line b. sum of the betas for each asset held in the portfolio divided by the number of assets in the portfolio. c. the standard deviation of the expected returns of the portfolio minus the risk-free rate. d. weighted average of the betas for each asset held in the portfolio. e. None of the above

d. weighted average of the betas for each asset held in the portfolio.

Distribution in which the number of possible outcomes is limited, or finite.

discrete probability distribution

Assume that a new law is passed which restricts investors to holding only one asset. A risk-averse investor is considering two possible assets as the asset to be held in isolation. The assets' possible returns and related probabilities (i.e., the probability distributions) are as follows: Which asset should be preferred? a. Asset X, since its expected return is higher. b. Asset Y, since its beta is probably lower. c. Either one, since the expected returns are the same. d. Asset X, since its standard deviation is lower. e. Asset Y, since its coefficient of variation is lower and its expected return is higher.

e. Asset Y, since its coefficient of variation is lower and its expected return is higher.

Which of the following statements is most correct? a. The required return on a firm's common stock is determined by the firm's systematic (or market) risk. If its systematic risk is known, and if it is expected to remain constant, the analyst has sufficient information to specify the firm's required return. b. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of most other securities. c. If the returns of two firms are negatively correlated, one of them must have a negative beta. d. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only one stock. e. Statements b and c are both correct.

e. Statements b and c are both correct.

The condition under which the expected return on a security is just equal to its required return, and the price is stable.

equilibrium

The weighted average expected return on stocks held in a portfolio.

expected return on a portfolio

The rate of return expected to be realized from an investment; the mean value of the probability distribution of possible results.

expected value (return)

That part of a security 's risk associated with random outcomes generated by events or behaviors specific to the firm. It can be eliminated by proper diversification.

firm-specific (diversifiable) risk

That part of a security 's risk associated with economic (market) factors that systematically affect most firms. It cannot be eliminated by diversification.

market (nondiversifiable) risk

The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

market risk premium (RPM)

A listing of all possible outcomes, or events, with a probability (chance of occurrence) assigned to each outcome.

probability distribution

The return that is actually earned. The actual return usually differs from the expected return (r^).

realized rate of return

The chance that an outcome other than the expected one will occur.

risk

Risk-averse investors require higher rates of return to invest in higher risk securities.

risk aversion

The portion of the expected return that can be attributed to the additional risk of an investment. It is the difference between the expected rate of return on a given risky asset and the expected rate of return on a less risky asset.

risk premium (RP)

A measure of the tightness, or variability, of a set of outcomes.

standard deviation,

The standard deviation squared.

variance,