fin 357 chapter 13

The risk of owning an asset comes from:

- unanticipated events - surprises

what is the order of steps in 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 the variance

the weighted average of the standard deviations of the assets in Portfolio c is 12.9%. which of the following are possible values for the standard deviation of the portfolio? 10.9% 12.9% 14.9%

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

marks company believes there is a 60% chance of a recession and a 40% of a boom. In the case of a recession, the company expects to earn a 2% return. In the case of a boom, mark's company expects to earn 22%. What is marks company's expected return?

= 10% (0.6 * 0.02) +(0.4 * 0.22)

what is the expected return of a security with a beta of 1.2 if the risk-free rate is 4% and the expected rate of return on the market is 12%?

= 13.6% E(Ri) = R(f) + [[E(Rm) - R(f)] * Bi] = 0.04 + [[0.12 - 0.04] * 1.2]

the variance of a portfolio is 0.0025, what is the standard deviation

= 5% variance = sd^2 sd = sqrt(Variance) sd = sqrt(0.0025)

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

= 6.2% total return = a1 return + a2 return + a3 return a1 return = 0.035= (50,000/ 50,000 + 30,000 + 20,000) * 0.07 a2 return = -0.009= (30,000/ 50,000 + 30,000 + 20,000) * -0.03 a3 return = 0.036= (20,000/ 50,000 + 30,000 + 20,000) * 0.18

consider the following two assets: expected return: x = 5.8% y = 14.2% Beta x = 0.8 y = 1.8 the risk free rate is 1%. what is the reward-to-risk ration for asset y?=

= 7.3% [E(Ra) - Rf] / Beta (0.142 - 0.010 / 1.8 )

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 Chi's portfolio weight is:

= 75% 1,200 / (1,200 + 400)

you have estimated the following returns for companies x and y: return in recession: x = -3% y = -8% return in boom: x = 20% y = 30% if boom and recession have an equal probability of occurring, what is the expected return on a portfolio consisting of 80% company x and 20 % company y?

= 9% r = x return + y return x return = 0.068= 0.8 * [(0.5 * -0.03) + (0.5 * 0.2)] y return = 0.022= 0.2 * [(0.5 * -0.08) + (0.5 * 0.3)]

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% expected return = risk-free rate + (Beta * return premium) = 4 + (2*9) beta = 2 =(ABC beta + XYZ beta) /2 = (2.5 +1.5)/ 2

what is variance

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

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.

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 are examples of unsystematic risk? a.) labor strikes b.) changes in management c.) changes in the federal tax code d.) the expected rate of inflation in next year

a and b

which of the following are examples of systematic risk? a.) regulatory changes in tax rates b.) an increase in competition in the industry c.) future rates of inflation d.) labor strikes

a and c

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

a portfolio's expected return the weighted average of the variances of the securities in the portfolio

Based on the capital asset pricing model (CAPM) there is generally a _____ relationship between beta and the expected return on a security?

a positive

As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk? a.) it is likely to increase b.) it may eventually be almost totally eliminated c.) it is likely to decrease d.) it will not change

b and c since financial securities tend to be less than perfectly positively correlated, the addition of more securities to a portfolio will likely decrease unsystematic risk

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

cost of capital

the increase in the number of stocks in a portfolio results in a _______ in the average standard deviation of annual portfolio returns

decrease

what two factors determine a stock's total return?

expected return and unexpected return

what is the equation for the capital asset pricing model?

expected return on security = risk-free rate + [Beta * (return on market - risk-free rate)] E(Ri) = R(f) + [[E(Rm) - R(f)] * Bi]

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

false

true or false: systemic risk can be eliminated by diversification

false

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

false you cannot eliminate systemic risk or market risk

According to the CAPM, which of the following is not a true statement regarding the market portfolio.

federal reserve actions that affect the economy a change in the yield on T-bills a strengthening of a country's currency according to the CAPM, a security's return is a function of the pure time value of money (risk-free rate), the reward for bearing systematic risk (risk premium on the market), and the amount of systematic risk present in the security (measured by beta).

what does the security market line(SML) graph?

it depicts the relationship between expected return and risk as measured by the beta coefficient

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 E(Ri) = R(f) + [[E(Rm) - R(f)] * Bi] = R(f) --> Bi = 0

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

less than

systematic risk will ____ when securities are added to a portfolio

not change

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

positive

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

size this knowledge would be useful in calculating return

which type of risk is unaffected by adding securities to a portfolio

systematic risk

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

that are borne unnecessarily the market only rewards systematic risk

expected return

the return on a risky asset expected in the future

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

the risk premium and the risk free rate R(f)

what are the two components of unexpected return (U) in the total return requation

the unsystematic portion and the systematic portion

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

there is no relationship

true or false: it is possible for the unsystematic risk of a portfolio to be reduced to practically zero

true

___________ can be effectively eliminated by portfolio diversification.

unsystematic risk

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