Chapter 5 investments

The stock of a technology company has an expected return of 15% and a standard deviation of 20%. The stock of a pharmaceutical company has an expected return of 13% and a standard deviation of 18%. A portfolio consisting of 50% invested in each stock will have an expected return of 14 % and a standard deviation A) less than the average of 20% and 18%. B) the average of 20% and 18%. C) greater than the average of 20% and 18%. D) the answer cannot be determined with the information given.

A

Explain the relationship between correlation, diversification, and risk reduction.

Correlation is a statistic that measures the relationship between returns on assets. Positively correlated assets move together; negatively correlated opposites move in opposite directions. Diversification reduces risk most effectively when the assets have low or negative coefficients of correlation. Learning Outcome: F-12 Discuss the implications of systematic risk in financial markets and its role in shaping investment choices

Dr. Zweibel's portfolio consists of four stocks: AZMN, 35%, beta 2.4; MKR, 20%, beta 1.6; ABDE, 25%, beta 1.8; and SBUK, 20%, beta 2.1. Compute Dr. Z's portfolio beta. Does he seem to be a conservative or aggressive investor?

Portfolio beta = (.35 × 2.4) + (.20 × 1.6) + .25 × 1.8) + (.20 × 2.1) = 2.03. A beta higher than 2 would make Dr. Z either a very aggressive investor, or one who is very confidently optimistic about the future direction of the market. Learning Outcome: F-12 Discuss the implications of systematic risk in financial markets and its role in shaping investment choices

Explain what beta measures and how investors can use beta.

Students should mention some or all of the following. ∙ Beta measures nondiversifiable (market) or systematic risk. ∙ Beta measures how a security will perform in relation to the market. ∙ The higher the beta, the riskier the security. ∙ The beta for the market is 1; stocks may have positive or negative betas. ∙ Stocks with betas greater than 1 are more responsive to changes in the market than is the market. ∙ Beta is derived from the slope of the "characteristic line."

Explain the differences in how modern and traditional theories of portfolio management approach the issue of diversification.

The modern approach to portfolio diversification uses computers to analyze a large number of investment alternatives, mathematically seeking minimum correlation and maximum return. Ideally these methods identify portfolios on the efficient frontier with minimum portfolio betas or standard deviations for the expected level of return. The traditional approach to diversification uses human judgment and experience to choose a diversified combination of stocks and other securities across industry lines and possibly national borders. When done well, this approach also reduces risk without excessively sacrificing return. The traditional approach may lead to overinvestment in the stocks of large, well-known companies because they most readily come to mind for the manager, because the manager fears criticism for omitting them, or wants to avoid blame for less conventional choices (window dressing).

American depositary shares (ADS) are A) shares of foreign companies traded on the U.S. markets. B) shares of American companies traded on foreign markets. C) foreign currency deposits in American banks. D) American currency deposits in foreign banks

a

Beta can be defined as the slope of the line that explains the relationship between A) the return on a security and the return on the market. B) the returns on a security and various points in time. C) the return on stocks and the returns on bonds. D) the risk free rate of return versus the market rate of return.

a

In the real world, most of the assets available to investors A) tend to be somewhat positively correlated. B) tend to be somewhat negatively correlated. C) tend to be uncorrelated. D) tend to be either perfectly positively or perfectly negatively correlated.

a

Modern portfolio theory does not consider diversifiable risk relevant because A) it is easy to eliminate. B) it is impossible to eliminate. C) its effects are unpredictable. D) its effects are too small to make a difference in portfolio returns.

a

OKAY stock has a beta of 0.73. The market as a whole is expected to decline by 20% thereby causing OKAY stock to A) decline by 14.6%. B) decline by 20.7%. C) increase by 14.6%. D) increase by 20.7%.

a

The Capital Asset Pricing Model (CAPM) includes which of the following in its base assumptions? I. Investors should earn a minimum return equal to the risk-free rate. II. Investors in the market should earn a return greater than the return on the overall market. III. Investors should be rewarded for the amount of risk they assume. IV. Investors should earn a return located above the Security Market Line. A) I and III only B) II and IV only C) I, II and III only D) I, III and IV only

a

The Capital Asset Pricing Model (CAPM) is a mathematical model that depicts the A) positive relationship between risk and return. B) standard deviation between a risk premium and an investment's expected return. C) exact price that an investor should be willing to pay for any given investment. D) difference between a risk-free return and the expected rate of inflation.

a

Which one of the following types of risk cannot be effectively eliminated through portfolio diversification? A) inflation risk B) labor problems C) materials shortages D) product recalls

a

A portfolio consisting of four stocks is expected to produce returns of 9%, 11%, 3% and 17%, respectively, over the next four years. What is the standard deviation of these expected returns? respectively, over the next four years. What is the standard deviation of these expected returns? A) 5.00% B) 5.77% C) 25.00% D) 33.33%

b

Amanda has the following portfolio of assets. What is the beta of Amanda's portfolio? A) 1.06 B) 1.10 C) 1.13 D) 3.02

b

Combining uncorrelated assets will A) increase the overall risk level of a portfolio. B) decrease the overall risk level of a portfolio. C) not change the overall risk level of a portfolio. D) cause the other assets in the portfolio to become positively related.

b

Marco owns the following portfolio of stocks. What is the expected return on his portfolio? A) 4.7% B) 6.6% C) 8.4% D) 8.7%

b

Over the long term, a portfolio consisting of an S&P 500 index and an EAFE index will generally produce ________ returns and have ________ risk than a portfolio comprised solely of the S&P 500 index. A) higher; more B) higher; less C) lower; more D) lower; less

b

Portfolios falling to the left of the efficient frontier A) have too much risk for the expected return. B) would be desirable if only they were possible. C) do not use all of the assets in the portfolio. D) fall within the set of feasible portfolios.

b

Security A has a beta of .99, security B has a beta of 1.2, and security C has a beta of -1.0. This information indicates that A) security A has the highest degree of market risk. B) security B has 20% more systematic risk than the market. C) security C has the highest degree of market risk. D) security C would be the best investment if a strong bull market is expected.

b

Small company stocks are yielding 15.7% while the U.S. Treasury bill has a 4.3% yield and a bank savings account is yielding 3.8%. What is the risk premium on small company stocks? A) 7.6% B) 11.4% C) 11.9% D) 15.7%

b

Systematic risks A) can be eliminated by investing in a variety of economic sectors. B) are forces that affect all investment categories. C) result from random firm-specific events. D) are unique to certain types of investment.

b

The efficient frontier A) is represented by the rightmost boundary of the feasible set of portfolios. B) represents the best attainable tradeoff between risk and return. C) includes all feasible sets of portfolios based on risk and return characteristics. D) provides the highest level of risk for the lowest level of return.

b

The risk-free rate of return is 2% while the market rate of return is 12%. Parson Company has a historical beta of .85. Today, the beta for Delta Company was adjusted to reflect internal changes in the structure of the company. The new beta is 1.38. What is the amount of the change in the expected rate of return for Delta Company based on this revision to beta? A) 8.5% B) 5.3% C) 12.2% D) 14.0%

b

The stock of ABC, Inc. has a beta of 1.10. The market rate of return is expected to increase in value by 5%. ABC stock should A) increase in value by 0.5%. B) increase in value by 5.5%. C) decrease in value by 0.5%. D) decrease in value by 5.5%.

b

Traditional portfolio management A) concentrates on only the most recent "hot" sectors of the market. B) typically centers on interindustry diversification. C) uses portfolio betas and standard deviations to minimize risk. D) is based on statistical measures to develop the portfolio plan.

b

Which of the following represent systematic risks? I. the president of a company suddenly resigns II. the economy goes into a recessionary period III. a company's product is recalled for defects IV. the Federal Reserve unexpectedly changes interest rates A) I, II and IV only B) II and IV only C) I and III only D) I, II and III only

b

Which of the following will lower a portfolio's beta? I. Diversify among different types of securities and across industry and geographic lines. II. Add investments with low betas to the portfolio. III. Hold more cash or Treasury Bills in the portfolio. IV. Reduce the percentage of the portfolio invested in high beta securities. A) I, II and IV only B) II, III and IV only C) I, II and III only D) I, II, III and IV

b

A measure of systematic risk is A) standard deviation. B) correlation coefficient. C) beta. D) variance.

c

A stock's beta value is a measure of A) interest rate risk. B) total risk. C) systematic risk. D) diversifiable risk.

c

American investors have several alternatives available to diversify their portfolios internationally. In terms of transaction costs, which of the alternatives below is least attractive? A) mutual funds with an international focus. B) stocks of U.S. based companies with extensive foreign sales and/or operations. C) direct investment in foreign stocks. D) American Depositary Shares

c

Estimates of a stock's beta may vary depending on I. when the estimate was made II. the standard deviation of the stock's returns III. how many months of returns were used to estimate the beta IV. the index used to represent market returns. A) I, II and IV only B) II and IV only C) I, III and IV only D) I, II and III only

c

Investors are rewarded for assuming A) total risk. B) diversifiable risk. C) nondiversifiable risk. D) any type of risk.

c

Jonathan has the following portfolio of assets. What is the beta of Jonathan's portfolio? A) 1.08 B) 1.11 C) 1.13 D) 1.15

c

Melissa owns the following portfolio of stocks. What is the return on her portfolio? A) 8.0% B) 9.0% C) 9.8% D) 10.9%

c

The Franko Company has a beta of 1.09. By what percent will the rate of return on the stock of Franko Company increase if the market rate of return rises by 3%? A) 1.91% B) 2.75% C) 3.27% D) 4.09%

c

The best stock to own when the stock market is at a peak and is expected to decline in value is one with a beta of A) +1.5. B) +1.0. C) -1.0. D) -0.5.

c

The beta of the market is A) -1.0. B) 0.0. C) 1.0. D) undefined.

c

The market rate of return increased by 8% while the rate of return on XYZ stock increased by 4%. The beta of XYZ stock is A) -2.0. B) -0.40. C) 0.50. D) 2.0.

c

The optimal portfolio for an individual investor is represented by the point that lies on the A) lowest possible utility curve and connects to the efficient frontier. B) utility curve which is just tangent to the right side of the feasible set of risk-return options. C) utility curve which is just tangent to the efficient frontier. D) utility curve which represents the highest possible rate of return within the feasible set of risk-return options.

c

The risk of a portfolio consisting of two uncorrelated assets will be A) equal to zero. B) greater than the risk of the least risky asset but less than the risk level of the more risky asset. C) greater than zero but less than the risk of the more risky asset. D) equal to the average of the risk level of the two assets.

c

The statement "A portfolio is less than the sum of its parts." means: A) it is less expensive to buy a group of assets than to buy those assets individually. B) portfolio returns will always be lower than the returns on individual stocks. C) a diversified group of assets will be less volatile than the individual assets within the group. D) for reasons that are not well understood, the value of a portfolio is less than the sum of the values of its components.

c

When the Ccapital Asset Pricing Model is depicted graphically, the result is the A) standard deviation line. B) coefficient of variation line. C) security market line. D) alpha-beta line.

c

Which of the following best describes the relationship between a stock's beta and the standard deviation of the stock's returns? A) The higher the standard deviation, the higher the beta. B) The higher the standard deviation, the lower the beta. C) There is no particular relationship between a stock's standard deviation of returns and it's beta. D) Standard deviation and beta are different ways of measuring the same thing.

c

Which of the following guidelines are appropriate for inclusion in a portfolio management policy? I. Ddiversify among different types of securities and across industry and geographic lines. II. Determine the risk level and financial situation of the individual investor. III. Utilize beta to help align the portfolio to the risk level of the investor. IV. Minimize the standard deviation of each security in the portfolio. A) I, II and IV only B) II, III and IV only C) I, II and III only D) I, II, III and IV

c

Which of the following measures or concepts are deliberately used by modern portfolio theory? I. beta II. inter industry diversification III. efficient frontier IV. correlation A) II and III only B) I and IV only C) I, III and IV only D) I, II, III and IV

c

Which of the following represent unsystematic risks? I. the president of a company suddenly resigns II. the economy goes into a recessionary period III. a company's product is recalled for defects IV. the Federal Reserve unexpectedly changes interest rates A) I, II and IV only B) II and IV only C) I and III only D) I, II and III only

c

Which one of the following conditions can be effectively eliminated through portfolio diversification? A) a general price increase nationwide B) an interest rate reduction by the Federal Reserve C) increased government regulation of auto emissions D) change in the political party that controls Congress

c

You have gathered the following information concerning a particular investment and conditions in the market. According to the Capital Asset Pricing Model, the required return for this investment is A) 8.85%. B) 11.48%. C) 13.98%. D) 14.85%.

c

Returns on the stock of First Boston and Midas Metals for the years 2010-2013 are shown below. a. Compute the average annual return for each stock and a portfolio consisting of 50% First Boston and 50% Midas. b. Compute the standard deviation for each stock and the portfolio. c. Are the stocks positively or negatively correlated and what is the effect on risk? Answer:

c. The two stocks are negatively correlated. The return on the 50/50 portfolio is half way between the returns for each stock, but the standard deviation is much lower than for either stock, indicating that the portfolio has much less risk than the individual stocks.

A portfolio with a beta of 1.06 A) is 106% more risky than the overall market. B) has less risk than the lowest risk security held within that portfolio. C) is 6% more risky than a risk-free asset. D) is slightly more risky than the overall market.

d

According to MSN money, the stock of Orange Corporation has a beta of 1.5, but according to Yahoo Finance it is 1.75. The expected rate of return on the market is 12% and the risk free rate is 2%. What is the difference between the required rates of return calculated using each of these betas? A) 1.50% B) 1.75% C) 2.0% D) 2.5%

d

Analysts commonly use the ________ to measure market return. A) the Dow Jones Industrial Average B) the rate of return on 10 year Treasury bonds C) some large, mainstream company such as General Electric D) the Standard & Poor's 500 Index

d

Beta is the slope of the best fit line for the points with coordinates representing the ________ and the ________ for each one of several years. A) rate of return; level of risk for an individual security B) rate of inflation; rate of return for an individual security C) risk level of a stock; market rate of return D) market rate of return; security's rate of return

d

If there is no relationship between the rates of return of two assets over time, these assets are A) positively correlated. B) negatively correlated. C) perfectly negatively correlated. D) uncorrelated.

d

The investment choice of an individual is affected by I. their tolerance for risk. II. their prior investment experience. III. their marginal tax bracket. IV. the stability of their income. A) II and III only B) II, III and IV only C) I, III and IV only D) I, II, III and IV

d

Two assets have a coefficient of correlation of -.4. A) Combining these assets will increase risk. B) Combining these assets will have no effect on risk. C) Combining these assets may either raise or lower risk. D) Combining these assets will reduce risk.

d

What is the expected return on a stock with a beta of 1.09, a market risk premium of 8%, and a risk-free rate of 4%? A) 4.36% B) 8.36% C) 8.72% D) 12.72%

d

When the stock market has bottomed out and is beginning to recover, the best portfolio to own is the one with a beta of A) 0.0. B) +0.5. C) +1.5. D) +2.0.

d

Which of the following factors comprise the CAPM? I. dividend yield II. risk-free rate of return III. the expected rate of return on the market IV. risk premium for the firm A) I and III only B) II and IV only C) III and IV only D) II, III and IV only

d

Which of the following statements about the Security Market Line are correct? I. The intercept point is the risk-free rate of return. II. The slope of the line is beta. III. An investor should accept any return located above the SML line. IV. A beta of 1.0 indicates the risk-free rate of return. A) I and II only B) III and IV only C) II, III and IV only D) I, III and IV only

d

Which of the following statements concerning beta are correct? I. Adding stocks with high betas to a portfolio increases the portfolio's risk. II. The higher the beta, the higher the expected return. III. A beta can be positive, negative, or equal to zero. IV. A beta of .35 indicates a lower rate of risk than a beta of -0.50. A) II and III only B) I and IV only C) II, III and IV only D) I, II, III and IV

d

Which one of the following will provide the greatest international diversification? A) directly purchasing a foreign stock B) purchasing stock of a U.S. multinational firm C) purchasing an ADS D) purchasing shares of an international mutual fund

d

n designing a portfolio, relevant risk is A) total risk. B) unsystematic risk. C) event risk. D) nondiversifiable risk.

d

raditional portfolio managers prefer well-known companies because I. stocks of well-known firms tend to be less risky than stocks of lesser-known firms. II. individuals are more apt to purchase a mutual fund if it contains stocks of well-known firms. III. window dressing encourages the purchase of well-known stocks. IV. institutional investors tend to exhibit "herd-like" behavior. A) I only B) I and II only C) II and III only D) I, II , III and IV

d

A stock with a beta of 1.3 is less risky than a stock with a beta of 0.42. t or f

f

According to the CAPM, the required rate of a return on a stock can be estimated using only beta and the risk-free rate. t or f

f

Adding stocks with higher standard deviations to a portfolio will necessarily increase the portfolio's risk. t or f

f

An efficient portfolio maximizes the rate of return without consideration of risk. t or f

f

Beta is more useful in explaining an individual security's return fluctuations than a large portfolio's return fluctuations. t or f

f

Beta measures diversifiable risk while standard deviation measures systematic risk. t or f

f

By plotting the efficient frontier, investors can find the unique portfolio that is ideal for all investors. t or f

f

Coefficients of correlation range from a maximum of +10 to a minimum of -10. t or f

f

Diversifiable risk is also called systematic risk. t or f

f

Historical betas are always reliable predictors of future return fluctuations. t or f

f

In severe market downturns different asset classes become less correlated. t or f

f

Maximum international diversification can be achieved by investing solely in U.S. multinational corporations. t or f

f

Portfolio betas will always be lower than the weighted average betas of the securities in the portfolio. t or f

f

Portfolio objectives should be established independently of tax considerations. t or f

f

Portfolios located on the efficient frontier may not be part of the feasible set. t or f

f

Risk can be totally eliminated by combining two assets that are perfectly positively correlated. t or f

f

Standard deviation is a measure that indicates how the price of an individual security responds to market forces. t or f

f

The Dow Jones Industrial Average of thirty stocks is a suitable proxy for market returns in the CAPM. t or f

f

The betas of most stocks are constant over time. t or f

f

A beta of 0.5 means that a stock is half as risky the overall market. t or f

t

A negative beta means that on average a stock moves in the opposite direction of the market. t or f

t

A portfolio that offers the lowest risk for a given level of return is known as an efficient portfolio. t or f

t

A portfolio with a beta of 1.5 will be 50% more volatile than the market portfolio. t or f

t

An investment portfolio should be built around the needs of the individual investor. t or f

t

Both modern portfolio theory and traditional portfolio management result in diversified portfolios, but they take different approaches to diversification. t or f

t

Both the efficient frontier and beta are important aspects of MPT. t or f

t

Correlation is a measure of the relationship between two series of numbers. t or f

t

For stocks with positive betas, higher risk stocks will have higher beta values. t or f

t

If the actual rate of return on an investment portfolio is constant from year to year, the standard deviation of that portfolio is zero. t or f

t

In the Capital Asset Pricing Model, beta measures a stock's sensitivity to overall market returns. t or f

t

Investing globally offers better diversification than investing only domestically. t or f

t

It is relatively easy to obtain the beta for actively traded stocks. t or f

t

Market return is estimated from the average return on a large sample of stocks such as those in the Standard & Poor's 500 Stock Composite Index. t or f

t

Negatively correlated assets reduce risk more than positively correlated assets. t or f

t

Portfolio objectives should be established before beginning to invest. t or f

t

Portfolios located on the efficient frontier are preferable to all other portfolios in the feasible set. t or f

t

Studies have shown that investing in different industries as well as different countries reduces portfolio risk. t or f

t

The CAPM estimates the required rate of return on a stock held as part of a well diversified portfolio. t or f

t

The basic theory linking portfolio risk and return is the Capital Asset Pricing Model. t or f

t

The index used to represent market returns is always assigned a beta of 1.0. t or f

t

The transaction costs of investing directly in foreign-currency-denominated assets can be reduced by purchasing American Depositary Shares (ADSs). t or f

t

nvesting in emerging markets is an effective means of diversifying a U.S. portfolio. t or f

t

How can individuals who manage their own portfolios reconcile some of the most useful aspects of traditional portfolio management and modern portfolio theory?

tudents should include these key points. Investors should carefully consider how much risk they are willing to bear when seeking higher returns. They should diversify across industry lines, not necessarily limiting themselves to well-known or U.S. based companies. While some aspects of modern portfolio theory might require mathematical training and computing power beyond the reach of most individual investors, they should pay attention to the betas of assets within their portfolio and their effect on the overall portfolio beta. They should evaluate alternative portfolios and keep choices in line with their desired level of risk.