Chapter 11

Unsystematic risk will affect

- firms in a single industry - a specific firm

Which of the following are examples of unsystematic risk?

- labor strikes - changes in management

Which of the following are examples of systematic risk?

- regulatory changes in tax rates - future rates of inflation

The systematic risk principle argues that the market does not reward risks:

- that are borne unnecessarily - that are diversifiable

Which of the following are examples of information that may impact the risky return of a stock?

- the outcome of an application currently pending with the Food and Drug Administration - The Fed's decision on interest rates at their meeting next week.

Suppose you have a portfolio comprised of the following 2 assets. If you have 60% invested in asset A and 40% in asset B, what is the Beta of your portfolio? Asset Beta Portfolio % A 1.25 60% B 0.75 40%

1.05 (1.25 x 0.60) + (.75 x .40) = 1.05

If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities?

1.25 Portfolio beta = .5 x 1.5 + .5 x 1 = 1.25

What is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5?

11% 5+1.5 x (9-5) = 11

What is the expected return of a security with a beta of 1.2 if the risk-free rate is 4% and the expected return on the market is 12%

13.6% 4% + 1.2(12% - 4%) = 13.6%

What is the expected return on this asset? State Probability E(R) Boom 0.25 10% Normal 0.50 4% Bust 0.25 -6%

3.0% (.25)x(10%) + (.5)x(4%) + (.25)x(-6%) = 3.0%

ABC has a beta of 2.5 and XYZ has a beta of 1.5. The risk free rate is 4% and the market premium is 9%. What is the expected return on a portfolio that is equally investes in ABC and XYZ?

Beta = (2.5 +1.5)/2 = 2 Expected return = 4% +2(9%) = 22%

What is the equation for the capital asset pricing model?

Expected return on security = Risk-free rate + Beta x (Return on market - Risk-free rate)

True or False: The surprise is information the market uses to form the expectation of the return on the stock?

False

What is systematic risk?

It is a risk that pertains to a large number of assets

To determine the appropriate required return for an investment, we can use _____.

The Security Market Line

What is the slope of the security market line (SML)?

The market-risk premium (expected return on the market minus the risk-free rate of return)

If you wish to create a portfolio of stocks, what is the required minimum number of stocks?

You must invest in stocks of at least 2 corporations - a portfolio is a group of assets held by an investor. thus, to have a portfolio, one needs to have at least 2 assets.

When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market:

already knew about most of the news item

The appropriate discount rate to use to evaluate a new project is the ____.

cost of capital

True or False: a well-diversified portfolio will eliminate all risks.

false

what is a risk premium?

is the difference between the return on a risky investment and that on a risk-free investment, and we calculated the historical risk premiums on some different investments.

Systematic risk is also called _____ risk.

market

Systematic risk will ____ when securities are added to a portfolio

not change adding securities will reduce unsystematic risk only.

If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be:

positive

The security market line (SML) shows that the relationship between a security's expected return and its beta is _____.

positive

The standard deviation is ___.

the square root of the variance

How are the unsystematic risks of two different companies in two different industries related?

there is no relationship

Which of the following are examples of a portfolio

- investing $100,000 in a combination of stocks and bonds - Investing $100,000 in the stocks of 50 publicly traded corporations - Investing $100,000 in a combination of US and Asian stocks

Which of the following are examples of systematic risk?

-future rates of inflation -regulatory changes in tax rates

The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last step.

1. Calculate the expected return 2. Calculate the deviation of each return from the expected return 3. Square each deviation 4. Calculate the average squared deviation

What is the expected return of a portfolio consisting of stocks A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both stocks.

12.5%

If the variance of a portfolio is 0.0025, what is the standard deviation?

5% √.0025 = 5%

What is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund? The expected returns are 7%, -3%, and 18%, respectively.

6.2% (.5 x 7%) + (.3 x -3%) + (.2 x 18%) = 6.2%

What is the definition of expected return?

It is the return that an investor expects to earn on a risky asset in the future.

Which of the following types of risk is not reduced by diversification?

Systematic, or market risk - can not be diversified in anyway

A portfolio can be described by its portfolio weights which are defined as ___.

The percentage of dollars invested in each asset

What is the intercept of the security market line (SML)?

The risk-free rate

How are the unsystematic risks of two different companies int two different industries related?

There is no relationship.

True or False: it is possible for the unsystematic risk of a portfolio to be reduced almost to zero.

True - If enough securities are added, all the unsystematic risk of the securities in the portfolio should cancel one another out.

What two factors determine a stock's total return?

Unexpected return Expected return

Given the following probability distribution for the returns of a portfolio, what is the standard deviation of the portfolio? State Probability E(R) Boom 0.25 10% Normal 0.50 4% Bust 0.25 -6%

5.74% Mean return = (.25 x .1) + (.5 x .04) + (.25 x (-0.06)) = .03 Standard deviation = [(.25 x (1.03)^2) + (.5 x (.04 - .03)^2) + .25 x (-.06 - .03)^2) ^.5] = 0.0574

statements that are true about variance

- standard deviation is the square root of variance - Variance is a measure of the squared deviations of a security's return from its expected return. - Variance is an assessment of volatility

What are two components of risky return in the total return equation?

Market risk Unsystematic Risk

An investment will have a negative NPV when its expected return is ____ ___ what the financial markets offer for the same risk.

less than

The true risk of any investment comes from _________?

- Surprises - Unanticipated events

_____ risk is reduced as more securities are added to the portfolio

- Unsystematic - Diversifiable - Company-specific

What does the security market line depict?

- it is a graphical depiction of the capital asset pricing model

As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?

- It may eventually be almost totally eliminated. - It is likely to decrease

The calculation of a portfolio beta is similar to the calculation of:

A portfolio's expected return

The risk of owning an asset comes from:

Surprises unanticipated events

When an investor is diversified only _ risk matters.

Systematic

According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?

The risk-free rate of return

What is the beta of the risk-free asset?

Zero

What is the Reward-to-Risk Ratio?

[E(Ra)-Rf] / Ba A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns.

Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio:

declines

True or False: Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios.

false

If an asset has a reward-to-risk ratio of 6.0%, that means it has a ___ of 6.0% per unit of ___.

risk premium; systematic risk