Financial Management Exam 3

Which of the following statement about risk is the most correct? A. Market participants are able to eliminate virtually all market risk if they hold a large diversified portfolio of stocks. B. Market participants are able to eliminate virtually all company-specific risk if they hold a large diversified portfolio of stocks. C. It is possible to have a situation where the market risk of a single stock is less than that of a well diversified.

*Answers B and C are correct. B. Market participants are able to eliminate virtually all company-specific risk if they hold a large diversified portfolio of stocks. C. It is possible to have a situation where the market* Market risk is not eliminated through diversification. If you hold a well diversified portfolio, the portfolio beta will most likely be close to 1. Any company with a relatively low beta (0.5 for example), might exhibit less market risk than a well diversified portfolio, whose beta would most likely be near 1.

Choose the most 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?

*Standard deviation; beta* Standard deviation measures total risk and is the most appropriate measure of risk for an asset that is held in isolation. Beta measures market risk and is the appropriate measure of risk for an asset that will be held in a diversified portfolio.

(T/F) The tighter (less variable) the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation.

*True* Smaller standard deviation indicates less variability.

Holding all other factors constant, (1) if the expected inflation rate decreases and (2) investors become more risk averse, the Security Market Line would shift:

*down and have a steeper slope.* When inflation decreases, the SML shifts down. When risk aversion increases, the slope fo the line increases.

What measures relative risk?

Coefficient of Variation = Standard Deviation / Expected Return