FIN 310 Exam 2 Ch 11 Exam Q's

C

Fill in the blanks: Standard deviation measures ______ risk, while beta measures ______ risk. A. Asset-specific; market-wide B. Market-wide; total C. Total; market-wide D. Total; asset-specific

D

Portfolio diversification eliminates which of the following? A. Total investment risk B. Reward for bearing risk C. Market-wide risk D. Unsystematic risk

CAPM indicates that, given Stock J's level of market risk (volatility is irrelevant since much of it can be diversified away), its expected return should be E[rJ] = rF + βJ * MRP = 2% + 0.90*6% = 7.4% Comparing that to the actual 8% expected return on Stock J, the actual expected return is too high given its risk. Stock J plots above the SML and is undervalued. In other words, its price must increase now so that its future expected return will drop to 7.4%. Alternatively, compare Stock J's reward-to-risk ratio to the SML slope. The reward-to-risk ratio for any asset is its risk premium divided by its beta: (E[ri] - rF) / βi For Stock J, the reward-to-risk ratio for J = (.08 - .02) / 0.90 = .0667 We know the market has βM =1, so the reward-to-risk ratio for the market is (.06) / 1 = .06 Since all assets must have the same reward-to-risk ratio, the reward-to-risk ratio for Stock J is too high, which means the stock plots above the SML and is undervalued. Its current price must increase until its reward-to-risk ratio is equal to the market reward-to-risk ratio.

Stock J has a volatility of 50%, a beta of 0.90, and an expected return of 8%. If the risk-free rate is 2% and the market risk premium is 6%, is this stock undervalued, correctly priced, or overvalued? Briefly explain why.

CAPM indicates that, given Stock Y's level of risk, its expected return should be E[rY] = rF + βY * MRP = .045 + 1.30*(.07) = .1360 or 13.60% Comparing that to actual 13% expected return on Stock Y, the actual expected return is too low given its risk. Stock Y plots below the SML and is overvalued. In other words, its price must decrease now so that its future expected return will increase to 13.60%. Alternatively, compare Stock Y's reward-to-risk ratio to the SML slope. The reward-to-risk ratio for any asset is its risk premium divided by its beta: (E[ri] - rF) / βi For Stock Y, the reward-to-risk ratio for Y = (.13 - .045) / 1.30 = .0654 We know the market has βM =1, so the reward-to-risk ratio for the market is (.07) / 1 = .07 Since all assets must have the same reward-to-risk ratio, the reward-to-risk ratio for Stock Y is too low, which means the stock plots below the SML is overvalued. Its current price must decrease until its reward-to-risk ratio is equal to the market reward-to-risk ratio.

Stock Y has a beta of 1.30 and an expected return of 13%. If the risk-free rate is 4.5% and the market risk premium is 7%, is this stock undervalued, correctly priced, or overvalued? Briefly explain or show why.

A

Which of the following statements is FALSE? A. Asset-specific risks can be easily diversified with highly correlated assets in a portfolio B. Asset-specific risks can be easily diversified with numerous assets in a portfolio C. Bearing risk is rewarded with higher expected returns D. Only market-wide risks, not asset-specific risks, should earn rewards

A

Which of the following statements is TRUE? A. If a portfolio has a positive investment in every asset, the standard deviation on the portfolio can be less than that on every asset in the portfolio. B. Labor strikes and part shortages are examples of market-wide systematic risks. C. Market-wide systematic risks can be significantly reduced by diversification. D. Asset-specific unsystematic risks can be substantially reduced with less numerous and less correlated assets in a portfolio.

A

Which of the following statements is TRUE? A. By investing in varied and numerous assets, an investor is able to virtually eliminate all asset-specific risks in her portfolio, both easily and cheaply. B. It is possible, but not very easy, for an investor to control market-wide risks in his portfolio, and increases in these market-wide risks are costly because they reduce expected returns. C. The most important characteristic in determining the expected return of a well-diversified portfolio is the total variance risks of the individual assets in the portfolio. D. When a portfolio has a positive investment in every one of its assets, its standard deviation cannot be less than that on every asset in the portfolio.

D

Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic firm-specific risk associated with an individual security? A. Security beta multiplied by the market rate of return B. Market risk premium C. Risk-free rate of return D. Zero