Finance chap 7
The appropriate measure of risk for a diversified portfolio is beta
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The best measure of assessing systematic risk within an investment is its beta.
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Standard deviation is equal to the square root of variance.t
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The coefficient of variation divides the standard deviation of the returns of an asset by the expected rate of return of that asset.
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The income component of return for a common stock comes from the cash dividend a firm pays.
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The normal distribution is completely described by its mean and standard deviation where 50 percent of the distribution's probability is less than the mean and 50 percent greater than the mean.
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The rate of return that investors require for an investment depends on the risk associated with that investment.
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The standard deviation of a distribution cannot be a negative value.
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The variance of a distribution cannot be a negative value.
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The expected return on Kiwi Computers stock is 16.6 percent. If the risk-free rate is 4 percent and the expected return on the market is 10 percent, then what is Kiwi's beta?
2.10 (Expected Return of Kiwi = risk-free rate + Beta(Expected Return on the market - risk free rate) and further Beta = (Expected Return of Kiwi - risk free rate)/(the expected Return on the market - risk free rate) = (.166 - .04)/(.10-.04) = 2.10)
The expected return on KarolCo. stock is 16.5 percent. If the risk-free rate is 5 percent and the beta of
5.0%
Which of the following statement is incorrect?
The normal distribution is a skewed distribution that is completely described by its correlation coefficient and coefficient of variation. If two investments have the same expected return, investors prefer the riskiest alternative. With complete diversification, all of the systematic risk is eliminated from the portfolio. If you are building a portfolio, then you desire those assets to have a correlation coefficient of one.
Given the historical information in the chapter, the beta of a small stock should be greater than the beta of a corporate bond.
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If two assets with return on correlation coefficients is equal to one that make up a portfolio, then the portfolio does not take advantage of any diversification benefits.
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In a game of chance, the probability of winning a $50 prize is 40 percent, and the probability of winning a $100 prize is 60 percent. What is the expected value of a prize in the game?
$80. ($50(0.4) + $100 (0.6) = $80)
In a game of chance, the probability of winning a $50 is 40 percent and the probability of losing a $50 prize is 60 percent. What is the expected value of a prize in the game?
-$10 $50(0.4) - $50 (0.6) = -$10
Sayers purchased a stock with a coefficient of variation equal to 0.125. The expected return on the stock is 20 percent. What is the coefficient of variation for the stock?
0.000625 (CV = Standard Deviation/Expected return and Standard deviation = (CV)(Expected Return) = (.125)(.20) = 0.025. Further, Variance = (Standard Deviation)^2 = (0.025)^2 = .000625)
The expected return for the asset below is 18.75 percent. If the return distribution for the asset is described as in the following table, what is the variance for the asset's returns?
0.002969 ((0.1)(0.25 - 0.1875)2 + (0.2)(0.5 - 0.1875) 2 + (0.25)(0.25 - 0.1875)^2 = 0.002969)
Tommie has made an investment that will generate returns that are subject to the state of the economy during the year. Use the following information to calculate the standard deviation of the return distribution for Tommie's investment.
0.0467 (E(R) = (.30)(.13)+(.40)(.20)+(.30)(.25) = .194 and Standard Deviation = [.30(.13-.194)^2+.40(.20-.194)^2+.3(.25-.194)^2]^(1/2) = .046733 where ^(1/2) represents the square root.)
The expected return for the asset shown in the following table is 18.75 percent. If the return distribution for the asset is described as below, what is the standard deviation for the asset's returns?
0.054486
Elrond has made an investment that will generate returns that are subject to the state of the economy. Use the following information to calculate the standard deviation of the return distribution for Elrond's investment.
0.0557
Braniff Ground Services stock has an expected return of 9 percent and a variance of 0.25 percent. What is the coefficient of variation for Braniff?
0.5556 Coefficient of Variation (CV) = Standard Deviation/Expected Return = [(.0025)^(1/2)]/.09 = .5556 where ^(1/2) represents the square root.
The risk-free rate of return is currently 3 percent, whereas the market risk premium is 6 percent. If the beta of Lenz, Inc., stock is 1.8, then what is the expected return on Lenz?
13.80% Expected Return of Lenz = risk-free rate + Beta(Expected Return on the market - risk free rate) = .03+1.8(.06) = .138 where the expected return on the market must have been .09. Why? Because market risk premium = the expected return on the market - risk free rate = .09 - .03 = .06
George Wilson purchased Bright Light Industries common stock for $47.50 on January 31, 2010. The firm paid dividends of $1.10 during the last 12 months. George sold the stock today (January 30, 2011) for $54.00. What is George's holding period return?
16.00% (Total Return (R) = (P1-P0+CF1)/P0 = (54-47.50+1.10)/47.50 = 16%)
The beta of Elsenore, Inc., stock is 1.6, whereas the risk-free rate of return is 8 percent. If the expected return on the market is 15 percent, then what is the expected return on Elsenore?
19.20%
What is Principal Financial Group's coefficient of variation (CV) of possible returns given that the expected return is .17 and variance is .245717?
2.9159 (Remember that CV = Standard Deviation / Expected Return and therefore the square root of variance (standard deviation) is SQRT(.2457) = .4957 and CV = .4957 / .17 = 2.9159)
Francis purchased a stock one year ago for $20, and it is now worth $24. The stock paid a dividend of $3 during the year. What was the stock's rate of return from capital appreciation during the year? (Round your answer to the nearest percent.)
20% (Capital Appreciation Return = Capital gain (loss) = (24-20)/20=0.20)
The beta of RicciCo.'s stock is 3.2, whereas the risk-free rate of return is 9 percent. If the expected return on the market is 18 percent, then what is the expected return on RicciCo.?
37.80% (Expected Return of RicciCo = risk-free rate + Beta(Expected Return on the market - risk free rate) = .09+3.2(.18-.09) = .378)
Books Brothers stock was priced at $15 per share two years ago. The stock sold for $13 last year and now it sells for $18. What was the total return for owning Books Brothers stock during the most recent year? Assume that no dividends were paid. Round your answer to the nearest percent.
38% Total rate of return = ($18-$13)/$13 = 38.46% or 38% (rounded).
Cummins Inc has a beta of 2.67 and the expected market return is 0.2. In addition, Treasury bills (risk-free asset) are currently yielding 0.05. Find the expected return for Cummins Inc.
45.00%
James Burton purchased a stock for $45 one year ago. The stock is now worth $65. During the year, the stock paid a dividend of $2.50. What is the total return to James from owning the stock? (Round your answer to the nearest whole percent.)
50% (Total Return = (65-45+2.50)/45 = 50%)
Gwen purchased a stock one year ago for $25, and it is now worth $31. The stock paid a dividend of $1.50 during the year. What was the stock's rate of return income during the year?
6% (Income rate of return = 1.50/25 = .06)
The expected return on Mike's Seafood stock is 17.9 percent. If the expected return on the market is 13 percent and the beta for Mike's Seafood is 1.7, then what is the risk-free rate?
6.0% Expected Return of Mike's seafood (ER) = risk-free rate (Rf) + Beta (b)x[Expected Return on the market (ERM)- risk free rate (Rf)]. ER = Rf + b x (ERM - Rf) and .179 = Rf + 1.7(.13-Rf) and .179 = 1Rf + (1.7)(.13) - 1.7Rf and .179 = -.7Rf + .221 and Rf =(0.221-0.179 )/(0.7)= .06
L-3 Communications Holdings has a beta of 2. and the expected market return is 0.06. In addition, Treasury bills (risk-free asset) are currently yielding 0.06. Find the expected return for L-3 Communications Holdings.
6.00% Use CAPM where the cost of equity capital = Risk-free rate + Beta*(Market rate - Risk free rate) => the cost of equity capital for L-3 Communications Holdings = 0.06 + 2.*(0.06 - .06) = .06
Given the historical information in the chapter, which of the following investment classes had the greatest variability in returns?
Small U.S. Stocks
If you were to compare the returns of an individual stock to a market index, select the answer below that is most true.
The returns of the individual stock will show more variability than those of the market index.
Which of the following represents a plot of the relation between expected return and systemic risk?
The security market line
Which of the following statements is correct?
The variance of a distribution cannot be a negative value. The best measure of assessing systematic risk within an investment is its beta. The standard deviation is a measure of total risk. If an asset's price implies that the expected return is greater than that predicted by the CAPM, that asset will plot above the Security Market Line. A beta of 1 tells us that an asset has just as much systematic risk as the market.
The expected return for a portfolio without borrowing
all of the above. (should never be greater than the expected return of the asset with highest expected return. should never be less than the expected return of the asset with lowest expected return. may not be an event with even a positive probability of occurrence.)
Which of the following is the best measure of the systematic risk in a portfolio?
beta
A portfolio with a level of systematic risk the same as that of the market has a beta that is
equal to one
A beta higher than or lower than 0 tells us that the asset has more or less systematic risk than the market, respectively.
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A beta of 0 tells us that an asset has just as much systematic risk as the market.
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A beta of 1 indicates a risk-free security, such as a U.S. Treasury bill.
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Beta refers to the measure of unsystematic risk.
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By investing in only one asset, an investor can reduce the risk.
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Diversification by holding more than one asset with different risk characteristics can increase the risk of a portfolio.
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Diversified investors face only unsystematic risk.
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Diversified portfolios generally have more risk for a given level of return than the individual risky assets in the portfolio.
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If an asset's price implies that the expected return is greater than that predicted by the CAPM, that asset will plot below the Security Market Line.
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Investors can diversify away risk that is unique to the individual assets is called systematic or nondiversifiable risk.
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Investors whose portfolios are well diversified face systematic risk plus unsystematic risk.
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Most of the diversification benefit can often be achieved with as few as 2 or 3 assets.
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The Security Market Line illustrates how the expected return on an asset varies with total risk.
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The objective of diversification is to eliminate variation in returns that is common to all individual assets.
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The required rate of return on an asset depends only on the unsystematic risk associated with that asset.
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The risk that investors can diversify away, the risk that is common to all assets, is called systematic or nondiversifiable risk.
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The standard deviation is a measure of systematic risk.
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We diversify our investments across a number of different assets in the hope that the common variations (systematic risk) will cancel each other out
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When beta equals one and there is no systematic risk, and therefore the expected return equals the risk-free rate.
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With complete diversification, all of the systematic risk is eliminated from the portfolio.
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According to the CAPM, the expected return on the market portfolio is equal to the risk free rate plus the market risk premium.
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Complete diversification means that the portfolio is still subject to market risk.
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If the capital appreciation return from owning a stock is positive, then the total return from owning the same stock cannot be negative.
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If the price of an asset has not increased or decreased since the original purchase of the asset, then the total return of the asset (if no dividends were paid during the period) is equal to the capital appreciation component return.
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If you are building a portfolio, then you desire the assets in the portfolio to have relatively low positive correlations or zero correlations or negative correlations.
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If you know the risk-free rate, the market risk-premium, and the beta of a stock, then using the Capital Asset Pricing Model (CAPM) you will be able to calculate the expected rate of return for the stock.
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In order to keep the total return of a stock equal to 100 percent, the income component for that stock could be positive or zero.
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The capital appreciation component of a stock's return considers the change in price of a stock divided by the initial price of the stock.
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Utilizing the fact that values of two or more assets do not always move in the same direction at the same time in order to reduce the risk of a portfolio is called diversification.
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