Possible Conceptual questions mostly on Risk and Bonds

Market Risk is also called....

SYSTEMATIC RISK OR NONDIVERSIFIABLE. This risk cannot be eliminated through diversification.

You are considering two securities. Security A has a historical average annual return of 7% and a standard deviation of 3%. Security B has a historical average annual return of 7% and a standard deviation of 9%. From this information you can conclude that:

Security B is more risky than Security A. You are considering two securities. Security A has a historical average annual return of 7% and a standard deviation of 3%. Security B has a historical average annual return of 7% and a standard deviation of 9%. From this information you can conclude that Security B is more risky than Security A. Both securities have the same return but security B is much riskier than security A since it has a higher standard deviation. Standard deviation measures dispersion around the mean for normally distributed securities and a higher number represents greater risk.

For a Treasury Security, what is the required rate of return?

Since treasuries are essentially free of default risk, the rate or return on a treasury security is considered the "risk-free" rate of return.

Your great grandparents placed $1 in an investment in 1925. Which of the following securities would have given them the highest average annual return over the past eight decades?

Small stocks Your great grandparents placed $1 in an investment in 1925. Small stocks would have given them the highest average annual return over the past eight decades. Investors can expect the risk-return tradeoff to hold. If you want to earn higher returns you have to assume a higher level of risk. When you rank these investments from lowest risk to highest risk you would see U.S. Treasuries with the lowest risk, large stocks next, and small stocks with the highest risk. And, the returns are consistent with that ranking with the lowest returns for T-bills, large stocks with higher returns, and small stocks yielding the highest return over that time period.

one of the top three bond rating firms?

Standard and Poor's

__________ risk is the only risk that matters to investors with broadly diversified portfolios.

Systematic

Do some firms have more market risk than others?

YES for example: Interest rate changes affect all firms, but which would be more affected: a) Retail food chain ----b) Commercial bank Note As we know, the market compensates investors for accepting risk - but only for market risk. Company-unique risk can and should be diversified away. So - we need to be able to measure market risk. ....This is why we have Beta.

A bond will sell at __________ if the required return is greater than the coupon rate.

a discount

BETA

a measure of market risk. Specifically, beta is a measure of how an individual stock's returns vary with market returns. It's a measure of the "sensitivity" of an individual stock's returns to changes in the market.

If a bons pays an annual coupon rate of 11% but investors required return is 8%, the bond will be priced at....

a premium to par value

In the event a firm goes bankrupt, an investment grade senior debenture bond is more likely to receive liquidation proceeds than:

a subordinated debenture

The beta for a portfolio is determined by calculating:

a weighted average of individual stock betas where the weights equal the percentage invested in each stock.

A security is considered to be "underpriced" when it lies....

above the SML

would a security with a beta of 1.32 be considered average risk, below-avergage risk, or above-average risk?

above-average risk, because any security with a beta greater than 1 is more volatile than the market.

Diversification is the process of:

combining assets to reduce risk and/or increase returns.

The present value of a bond's __________ determines the value of the bond.

coupon payment and maturity value

The cash flows to the investor associated with a bond are:

coupon payments and the maturity value.

Bonds pay fixed ______ (interest) payments at fixed intervals (usually every 6 months) and pay the ______ value at maturity.

coupon; par

The coupon rate on a bond is set based on the company's __________ and the overall market rates of interest.

credit rating

Unsecured bonds are also known as __________.

debenture bonds

As market interest rates increase, the value of a bond will __________ all other things equal.

decrease

Interest rate risk and the time to maturity have a relationship that is best described as:

direct

Firm-specific risk is the:

diversifiable risk of an asset.

if two stocks are PERFECTLY POSITIVELY correlated...

diversification has no effect on risk

You are considering buying stock in New England Bankshares Corporation. Which of the following are examples of risk that can be diversified away? a) risk resulting from an impending lawsuit against New England Bankshares. b) risk resulting from an increase in federal budget deficits c) risk resulting from a strike by New England's tellers. d) risk resulting from a possible increase in income taxes e) both (a) and (c).

e) both (a) and (c).

The greater the standard deviation, the _______ the uncertainty, and therefore, the _______ the RISK

greater; greater

suppose that the required rate of return on bonds of similar risk falls from 12% to 10%. The new price of these bonds will be _____ than the old price

higher

The riskiest stocks are those with the ___________ betas.

highest Because we expect greater returns when accepting greater risks, the stock with the highest beta should have the greatest return.

The higher the risk...

the higher the risk premium

If two stocks are PERFECTLY NEGATIVELY correlated.....

the portfolio is perfectly diversified

If a stocks beta is less than one, you can conclude that....

the risk associated with it is less than the market average Beta is a measure of risk relative to the market average. If a stocks beta is less than one, you can conclude that the risk associated with it is less than the market average.

A stock's holding period return represents:

the total return earned over a specific period through buying and selling an asset.

Unsystematic risk, asset-specific risk, and unique-risk are all terms for

the type of risk that can be eliminated through diversification. For this reason it is also called diversifiable risk. This type of risk should not be a factor since investors can eliminate it and therefore asset returns will typically not compensate investors for this type of risk in an efficient market.

Perfect diversification can be achieved when....

two stocks are perfectly negatively correlated. When one stock increases, the other will decrease

diversification cannot be achieved when....

two stocks have a correlation coefficient of 1.0 (perfectly positively correlated). Diversification cannot be achieved when two stocks have a coefficient equal to 1. This would mean that the stocks are perfectly correlated, and attempting to diversify with this portfolio would be equivalent to attempting to diversify by buying more of the same stock, which doesn't make any sense.

stocks that lie above the security market line are....

underpriced

Subordinated debentures are:

unsecured bonds with a junior claim on assets

We need to know how to price risk so ...

we will know how much extra return we should require for accepting extra risk.

__________ bonds allow the issuer the right (but not the obligation) to retire all outstanding bonds prior to maturity.

Callable

Market risk

(systematic risk) is nondiversifiable. This type of risk can not be diversified away. -Unexpected changes in interest rates. -Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle. We know how to reduce overall risk to only market risk through diversification.

Company-unique risk

(unsystematic risk) is diversifiable. This type of risk can be reduced through diversification. -A company's labor force goes on strike. -A company's top management dies in a plane crash. -A huge oil tank bursts and floods a company's production area.

Zero Coupon Bonds....

-always sell at a scout. -the only cash flow that occurs with a zero coupon comes at the end of the bonds life -do not pay coupon payments -P/YR should be 1 when dealing with zero coupon bonds

A stocks required return is equal to the risk-free rate of return when the stocks beta is ____

0 a stock with a beta of 0 has a required return equal to the risk-free rate of return

How to measure risk

1. VARIANCE 2. STANDARD DEVIATION -a scientific approach is to examine the stocks SD of returns -SD is a measure of the dispersion of possible outcomes 3. BETA We know how to measure risk, using standard deviation for overall risk and beta for market risk.

1. if you owned a share of every stock traded on the NYSE and NASDAQ, would you be diversified? 2. would you have eliminated all of your risk?

1.yes 2. NO common stock portfolios still have risk

Which of the following has a beta of zero?

A risk-free asset

Which of the following is the best description of systematic risk?

Any risk that will impact the value of all assets simultaneously. Systematic risk is risk that affects the whole system. Examples of systematic risk include recessions and changes in fiscal policy or monetary policy that impact all firms in some manner.

value..

Book Value: value of an asset as shown on a firm's balance sheet; historical cost. Liquidation value: amount that could be received if an asset were sold individually. Market value: observed value of an asset in the marketplace; determined by supply and demand. Intrinsic value: economic or fair value of an asset; the present value of the asset's expected future cash flows

__________ are an example of unsecured corporate debt.

Debentures

A stocks beta is a measure of its......?

Market Risk

Which type of risk can NOT be eliminated by diversification?

Market risk non-diversifiable risk. SYSTEMATIC is risk that an investor must assume that impacts the overall market or system.

The Bond Indenture

The bond contract between the firm and the trustee representing the bondholders. Lists all of the bond's features: coupon, par value, maturity, etc. Lists restrictive provisions which are designed to protect bondholders. Describes repayment provisions.

What is risk?

The possibility that an actual return will differ from out expected return uncertainty in the distribution of possible outcomes

What is the Required Rate of Return?

The return on an investment required by an investor given market interest rates and the investment's risk.

Company-unique risk is called ...

UNSYSTEMATIC RISK or DIVERSIFIABLE RISK. This risk can be eliminated through diversification

suppose that we begin with a portfolio consisting only of Type A securities. If we begin to add other types of securities to our portfolio, ________ risk declines

UNSYSYEMATIC diversification reduces a portfolios UNSYSTEMATIC or DIVERSIFIABLE risk

what so we calculate the risk-free rate of return from?

US Treasury Securities US Treasury securities are considered "risk-free" assets because the US government stands behind them. Because Treasury securities are risk-free by definition the yield on Treasury securities is equal to the risk-free rate of return

what type of risk can be diversified away in a portfolio?

Unique risk (company specific)

The realized rate of return is the:

actual return calculated on the investment.

Standard deviation measures

an asset's total risk and has both systematic risk and diversifiable risk when looking at a single asset.

A firm that has a beta = 1 has ..

average market risk. The stock is no more or less volatile than the market.

A security is considered to be "overpriced" when it lies....

below the SML

According to the capital asset pricing model, the appropriate measure for risk is:

beta

A stocks ______ is a measure of its market risk.

beta the higher the beta, the more the stocks value changes with respect to changes in the market

The security market line shows the relationship between ________ and the ______.

beta; required rate of return.

A long-term debt instrument issued by a business or government to raise capital is known as a:

bond

a convertible bond....

can be converted to stock at the holders option

Landon Industrial has issued a callable bond with a 6% coupon interest rate. Landon will probably call the bond when:

interest rates fall below 6%.

The top four categories of bond ratings are collectively known as __________.

investment-grade bonds Investment-grade bonds have a much lower risk of default than the lower rated bonds. The bottom five categories, which includes any bonds rated below Baa and BBB by Moody's and Standard and Poor's respectively, are known as speculative bonds or junk bonds. Junk bonds have to offer a higher return in order to compensate investors to assume a higher level of risk so they are also known as high-yield bonds.

Current yield

is just a quick measure of a bond's annual coupon relative to its market price, or "how much it pays relative to how much it costs."

A bonds is MORE desirable to investors when

it is convertible

what is true about two stocks that are perfectly positively correlated?

it is impossible to reduce the risk associated with a portfolio consisting of one of the stocks by adding share of the other stocks when two stocks are perfectly correlates, diversification is useless. That is, diversifying a portfolio consisting of one of these stocks by adding another one will not reduce company-unique risk (also called diversifiable risk or unsystematic risk)

A firm with a beta < 1 is ...

less volatile than the market.

A security is considered to be "correctly priced" when it....

lies along the security market line (SML).

A firm with a beta > 1 is ...

more volatile than the market.

The CAPM is a model of:

non-diversifiable risk of a security relative to all risky returns.

Market risk can also be called:

non-diversifiable risk. Market risk is also known as SYSTEMATIC risk and is the risk that an investor must assume that impacts the overall market or system.

The expected rate of return is the:

return forecasted to occur in the future.

In the event of bankruptcy:

senior debt is paid in full before subordinated debt is paid.

Washington Enterprises issued bonds in 2000. Five years later, in 2005, the company issued additional debt which had a lower priority than the debentures issued in 2000. The 2000 debentures are said to have __________, and the 2005 debentures are called __________.

seniority, subordinated debentures

The beta of a portfolio is the:

slope of the risk-return line, or the CAPM risk measure.

Under the capital asset pricing model, the relevant risk is:

systematic risk

This linear relationship between risk and required return is known as

the Capital Asset Pricing Model

in terms of the capital asset pricing model, the risk premium is equal to....

the difference between the required return on the security and the risk-free rate of interest. (kerf): jk = krt + b (km-krf)

The risk-return tradeoff principle in finance is:

the expectation of receiving higher returns for higher risk investments.

an increase in a bonds market price causes the....

yield to maturity to decrease coupon rate and par value do not change over the course of a bonds life. When a bonds market price increases, the yield to maturity decreases.

How can a company reduce its market risk?

you cannot reduce market risk a companys porfolio risk is composed of two types of risk: company-unique risk and market risk. Market risk is also called systematic or nondiversifiable risk. it CANNOT be mitigated through diversification. You can own as much stock as you like, but if the market collapses, the price of each stock will also fall. On the other hand, company-unique risk is reduced through diversification. If one company fails, its stock price will certainly fall; however, this does not lead to the price of every stock on the market decreasing as well.

US Treasury securities have a beat that is very near....

zero. US Treasury securities have a required return equal to the risk-free rate of interest. As a result, they have a beta that is zero, or very near zero