FIN CHP 11

Assume you own a portfolio of diverse securities which are each correctly priced. Given this, the reward-to-risk ratio:

of each security must equal the slope of the security market line.

efficient markets involve

random price changes because we cannot predict surprises

Unsystematic or diversifiable risk

risk that can be eliminated by combining assets into portfolios - also known as "unique risk" or ASSET SPECIFIC RISK examples - labor strikes - part shortages

Beta = 1

stock has average risk

beta < 1

stock is less risky than average

beta >1

stock is riskier than average

the surprise components affect

stock prices

Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security?

Zero

reward-to-risk ratio

expected return per unit of systematic risk - slope of the line on graph

efficient markets result

from investors trading on unexpected news

the higher the beta the....... the risk premium should be

greater

portfolio standard deviation is NOT a weighted average of the standard deviation of the component of securities risk

if it were, there would be no benefit in diversification

Systematic risk

includes factors that affect large numbers of assets - also known as "non-diversifiable risk" or MARKET RISK examples - changes in GDP -inflation - interest rates

variance

weighted average of squared deviations (Ri-E(R))^2

beta p

weighted average of the Betas of the assets in the portfolio weights (wj)= % of portfolio invested in certain asset

the expected return of a portfolio is the

weighted average of the expected returns for each asset in the portfolio

weights=

% of portfolio invested in each asset

diversification

- reduces the variability of returns - caused by the offset of worse-than-expected returns from one asset by better-than-expected returns from another

A stock has an expected return of 17.7 percent, the risk-free rate is 6.40 percent, and the market risk premium is 7.3 percent. Required:What must the beta of this stock be?

1.548

Which one of the following describes systemic risk?

Risk that affects a large number of assets

announcements and news contain both

expected and surprise components

Beta

represents the stocks volatility relative to the market

Which one of the following terms best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?

Diversification

The security market line is a linear function which is graphed by plotting data points based on the relationship between which two of the following variables?

Expected return and beta

Based on the capital asset pricing model, investors are compensated based on which of the following? I. market risk premium II. portfolio standard deviation III. portfolio beta IV. risk-free rate

I, III, and IV only

You own a portfolio equally invested in a risk-free asset and two stocks. One of the stocks has a beta of 1.24 and the total portfolio is equally as risky as the market. Required: What must the beta be for the other stock in your portfolio?

1.76

A stock has a beta of 1.18, the expected return on the market is 10.3 percent, and the risk-free rate is 4.80 percent. Required: What must the expected return on this stock be?

11.29

You own a portfolio that has $3,145 invested in Stock A and $4,300 invested in Stock B. Assume the expected returns on these stocks are 12 percent and 18 percent, respectively. Required: What is the expected return on the portfolio?

15.47

total return=

expected return + systematic portion + unsystematic portion

total return=

expected return + unexpected return

Which one of the following is an example of systematic risk?

Increase in consumption created by a reduction in personal tax rates

The systematic risk principle states that the expected return on a risky asset depends only on which one of the following?

Market risk

Which one of the following is the slope of the security market line?

Market risk premium

Stock Y has a beta of 1.30 and an expected return of 14.6 percent. Stock Z has a beta of 0.75 and an expected return of 11.3 percent. Required: If the risk-free rate is 5.00 percent and the market risk premium is 7.50 percent, are these stocks correctly priced?

Stock Y: Overvalued Stock Z: Undervalued

The risk premium for an individual security is based on which one of the following types of risk?

Systematic

Which one of the following best exemplifies unsystematic risk?

Unexpected increase in the variable costs for a firm

Portfolio diversification eliminates which one of the following?

Unsystematic risk

can we define the relationship between the risk premium and beta so that we can estimate the expected return

YES reward-to-risk ratio

in equilibrium,

all assets and portfolios must have the same reward-to-risk ratio

expected component of news has

already been taken account of in the market

diversification can substantially reduce risk without

an equivalent reduction in expected returns

portfolio

collection of assets

as more stocks are added,

each new stock has a smaller risk-reducing impact on the portfolio standard deviation of the portfolio falls very slowly after about 40 stocks are included - all in all, a well diversified portfolio can eliminate about half the risk of owning a single stock

unexpected return (U)=

systematic portion (m) +unsystematic portion (E)

minimum level of risk that cannot be diversified away=

systematic risk - have to deal with the market risk

The beta of a risky portfolio (assuming no borrowing or shortselling) cannot be less than _____ nor greater than _____.

the lowest individual beta in the portfolio; the highest individual beta in the portfolio

the easier it is to trade on surprises,

the more efficient markets should be

the risk-return trade-off for a portfolio is measured by

the portfolio expected return and the standard deviation, just as with individual assets

expected returns are based on

the probabilities of possible outcomes

an assets risk and return impact how it affects

the risk and return of the portfolio

standard deviation

the square root of the variance

variance and standard deviation measure

the volatility of returns

Standard deviation measures _____ risk while beta measures _____ risk.

total; systematic