Exam 1 - Chapter 5

When the stock market has bottomed out and is beginning to recover, the best portfolio to own is the one with a beta of

+2.0.

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

-1.0.

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

0.50.

Amanda has the following portfolio of assets.What is the beta of Amanda's portfolio?(Portion of Portfolio,Beta) ABC : $7,000, .85 ; DEF: $12,000 , .25; GHI : $6,000, 1.10

0.62

The beta of the market is

1.0.

Jonathan has the following portfolio of assets.(Portion of Portfolio,Beta) A: 25% Beta:1.70 \B: 40% Beta: 0.85\C: 35% Beta : 0.78

1.04

A portfolio consisting of four stocks is expected to produce returns of -9%, 11%, 13% and 17%, respectively, over the next four years. What is the standard deviation of these expected returns?

11.60%

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%?

12.72%

You have gathered the following information concerning a particular investment and conditions in the market. Risk-free rate : 2.5% ; Market Return : 11.0%; Beta of investment :1.35

13.98%.

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?

2.5%

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?

5.3%

The Franko Company has a beta of 1.90. By what percent will the required rate of return on the stock of Franko Company increase if the expected market rate of return rises by 3%?

5.70%

Small company stocks are yielding 10.7% while the U.S. Treasury bill has a 1.3% yield and a bank savings account is yielding 0.8%. What is the risk premium on small company stocks?

9.4%

Alexis has inherited $120,000 from her grandmother's estate. She has decided to invest $10,000 in each of 12 different industries. Because she has lower than average risk tolerance, she carefully seeks out stocks so that her portfolio will have a weighted average beta of .80.

Alexis is using a combination of modern and traditional portfolio management techniques.

Explain what beta measures and how investors can use beta.

Answer: 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." The CAPM shows that as beta increases, the required return for an investment increases.

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

Answer: 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.

Two assets have a coefficient of correlation of -.4.

Combining these assets will reduce risk.

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.

The returns on the stock of DEF and GHI companies over a 4 year period are shown below: Year DEF GHI 8% 11% 12% 9% -5% -9% 6% 13% From this limited data you should conclude that returns on

DEF and GHI are somewhat positively correlated.

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.

I and III only

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

I and III only

Traditional 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.

I, II , III and IV

Which of the following guidelines are appropriate for inclusion in a portfolio management policy? I. Diversify 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.

I, II and III only

Estimates of a stock's beta may vary depending on I. when the estimate was made. II. the risk-free rate of interest used. III. how many months of returns were used to estimate the beta. IV. the index used to represent market returns.

I, III and IV only

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

I, III and IV only

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.

I,II and III only

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

II and IV only

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

II, III and IV only

Which of the following statements concerning beta are correct? I. Stock with high standard deviations of returns will always high betas. 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.

II, III and IV only

Which of the following will always 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.

II, III and IV only

Melissa owns the following portfolio of stocks. What is the return on her portfolio?

Know how to calculate expected return from portfolio with amount invested and return on stock.

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.

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

Students 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.

Which of the following best describes the relationship between a stock's beta and the standard deviation of the stock's returns?

The relationship depends on the correlation between the stock's returns and the market's returns.

The statement "A portfolio is less than the sum of its parts." means

a diversified group of assets will be less volatile than the individual assets within the group.

Systematic risks

are forces that affect all investment categories.

A measure of systematic risk is

beta.

OKAY stock has a beta of 0.8. The market as a whole is expected to decline by 12% thereby causing OKAY stock to

decline by 9.6%.

Combining uncorrelated assets will

decrease the overall risk level of a portfolio.

American investors have several alternatives available to diversify their portfolios internationally. In terms of transaction costs, which of the alternatives below is least attractive?

direct investment in foreign stocks

The risk of a portfolio consisting of two uncorrelated assets will be

greater than zero but less than the risk of the more risky asset.

Large, professionally managed portfolios tend to

hold many of the same large, well-known companies.

The stock of ABC, Inc. has a beta of .80. The market rate of return is expected to increase by by 5%. Beta predicts that ABC stock should

increase in value by 4.0%.

Which one of the following conditions can be effectively eliminated through portfolio diversification?

increased government regulation of auto emissions

Which one of the following types of risk cannot be effectively eliminated through portfolio diversification?

inflation risk

A portfolio with a beta of 1.26

is considerably more risky than the overall market.

Modern portfolio theory does not consider diversifiable risk relevant because

it is easy to eliminate.

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

less than the average of 20% and 18%.

Beta is the slope of the best fit line for the points with coordinates representing the ________ and the ________ for each one of several years.

market rate of return; security's rate of return

In designing a portfolio, relevant risk is

nondiversifiable risk

Investors are rewarded for assuming

nondiversifiable risk.

The Capital Asset Pricing Model (CAPM) is a mathematical model that depicts the

positive relationship between risk and return.

Which one of the following will provide the greatest international diversification?

purchasing shares of an international mutual fund

The efficient frontier

represents the best attainable tradeoff between risk and return

Stock of Gould and Silber Inc. has a beta of -1. If the market declines by 10%, Gould and Silber would be expected to

rise by 10%.

When the Capital Asset Pricing Model is depicted graphically, the result is the

security market line

American depositary shares (ADS) are

shares of foreign companies traded on the U.S. markets.

A stock's beta value is a measure of

systematic risk.

In the real world, most of the assets available to investors

tend to be somewhat positively correlated.

Analysts commonly use the ________ to measure market return.

the Standard & Poor's 500 Index

Beta can be defined as the slope of the line that explains the relationship between

the return on a security and the return on the market.

Traditional portfolio management

typically centers on interindustry diversification.

If there is no relationship between the rates of return of two assets over time, these assets are

uncorrelated.

Portfolios falling to the left of the efficient frontier

would be desirable if only they were possible.