Chapter 11 Return, Risk, and the Capital Asset Pricing Model

Which of the following are examples of systematic risk?

-future rates of inflation -regulatory changes in tax rates

A reasonable estimate for the US equity risk premium is

7%

What is a reasonable estimate for the U.S. equity risk premium?

7%

What is variance?

A measure of the squared deviations of a security's return from its expected return

What does a normal return depend upon?

All relevant information available to shareholders

Which of the following are reasons why an investor cannot attain a portfolio above the feasible or opportunity set?

An investor cannot increase the return on individual securities An investor cannot decrease the standard deviation of individual securities An investor cannot decrease the correlation between the two securities

For a diversified investor, what is the best way to measure the systematic risk of an individual security?

Beta Reason: Standard deviation measures total risk - both systematic and unsystematic.

What is the equation for the capital asset pricing model?

Expected return on a security = Risk-free rate+ beta x expected risk premium on market

True or false: Risk aversion means that investors will not take risks.

False Reason: Investors will take risks as long as they are adequately compensated for the risk

Future equity risk premiums may not be equal to past equity risk premiums due to which of the following factors?

Future risk is different from historical risk. The risk aversion of investors will change in the future.

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

Idiosyncratic Unique Unsystematic

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model.

What is a normal return?

It is the return that shareholders predict or expect.

What does it mean if the returns of two stocks, A and B, are negatively correlated?

It means that, on average, if the returns of stock A are positive, the returns of stock B will be negative.

What does beta measure?

It measures the risk of a security in relation to the overall market.

What is Stock B's beta if the covariance between stock B and the market is 3.75, and variance of the market is 2.5?

Reason: 3.75/2.5 = 1.5

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

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

What are the two components of the expected return on the market (RM)?

The risk-free rate (RF) The risk premium

What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is negative?

The variance will decrease

What do covariance and correlation measure?

They both measure how two random variables are related

What is the covariance for two securities with returns that are unrelated to each other?

Zero

According to the CAPM, a security is considered underpriced when its expected return plots ___ the SML.

above

Investors cannot attain a portfolio below the feasible set or opportunity set because they cannot ____.

increase the standard deviation of the securities increase the correlation between two securities lower the return on individual securities

Systematic risk will ____ when securities are added to a portfolio.

not change

Which of the following are examples of unsystematic risk?

1. Changes is management. 2. Labor strikes.

How many variance and covariance terms will be needed in order to calculate the variance of a portfolio consisting of 100 stocks?

100 variance terms and 9,900 covariance terms Rationale:Var terms = 100Cov terms = N2 - N = 100^2 - 100 = 9,900

For every 3% movement in the market, the market must move by:

3%

What will happen to the risk of a portfolio composed of two securities as more dollars are invested in the riskier asset?

It can increase or decrease.

What does the characteristic line for a security show?

It shows a security's return in relation to the market's return.

If the variance of a portfolio is .0025, what is the standard deviation?

Reason: σp= .0025.5= .05, or 5%

Which portfolio will an investor who is very risk averse select from the opportunity set of risky assets?

The minimum variance portfolio

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

The risk-free rate Reason: Beta is the independent variable and is plotted on the x-axis. The intercept is the risk-free rate.

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 Reason: Risk-free rate + 0 × Market risk premium = Risk-free rate

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

There is no relationship. Reason: Unsystematic risk is specific only to a single company or industry. Thus, one company's unsystematic risk will generally be unrelated to another company's systematic risk.

Why are the deviations of returns squared when computing variance?

This ensures that that the sum of the deviations is a positive number.

If investors have homogeneous expectations, they ___.

all possess the same estimates regarding expected returns, variances, and covariances Reason: Risk aversion is not a component of homogeneous expectations.

The standard deviation decreases over the ______ bending portion of the feasibility set.

backward

When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.

decrease

If future risk ______, the future equity risk premium ______.

decreases; may change increases; may change

The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.

increases; increases Reason: The expected return on the market will increase if the risk-free rate increases or if the market risk premium increases, because RM=RF- risk premium.

Systematic risk is sometimes referred to as:

market risk

The CAPM can be used for which of the following:

portfoliosindividual securities

The return on market minus the risk-free rate is the market risk

premium

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 the stocks.

(.5 x 10%) + (.5 x1 5%)= 12.5%

If the expected return of a portfolio is 15 percent and the standard deviation of the portfolio is 10 percent, then the 68 percent probability range is ____ percent.

+5 to 25 Reason: To have a 68 percent probability of occurring, the outcome must be between + and - one standard deviation of the mean. The mean is 15% and the SD is 10%, so investors can be 68% sure of a return between 5% (15%-10%) and 25% (15%+10%).

If the covariance between stocks C and D is -.05, what is the correlation between these stocks? Assume the standard deviation of returns is .45 for Stock C and .30 for Stock D.

-.05/(.45 × .30) = -.37

If the variance of a security is 0.01545, what is the standard deviation?

.1243

What is the difference between a bull market and a bear market?

A bull market is characterized by rising prices while a bear market is characterized by falling prices.

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

False Reason: The CAPM can also be used for a portfolio by first determining the portfolio's beta.

Which of the following are true if AIG's beta is -4.53?

If the market declines 1%, AIG should rise by about 4.53%. If the market rises 1%, AIG is should decline by about 4.53%.

What is unsystematic risk?

It is a risk that affects a single asset or a small group of assets

What is the market portfolio?

It is the market value weighted portfolio of all existing securities.

A minimum variance portfolio has the ____.

Lowest possible variance

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

Market risk Unsystematic risk U=m+e

In the context of a portfolio of two securities, the opportunity set ___.

Shows the range of risk-return combinations, based on various weights for the two securities

Which of the following are true about risk aversion?

The degree of risk aversion varies among investors. Investors who are more risk averse will tend to demand relatively higher compensation for taking risk. Risk aversion implies that investors will not take risks unless they are adequately compensated for it.

A security has a beta of 1, the market risk premium is 8 percent, and the risk-free rate is 3 percent. What will happen to the expected return if the beta doubles?

The expected return will increase to 19% from 11%. Reason: 3% + 2 × 8% = 19%, which is an increase of 8%

Based on historical data, which of the following are true about the market risk premium?

The historical market return for equities has been significantly higher (more than 5%) than the risk-free rate. The historical market risk premium for equities has been positive.

Why is the determination of the efficient set for 50 securities more complex than the determination of the efficient set for two securities?

The number of variance, return, and correlation calculations increases dramatically.

What can we conclude if the covariance between the returns of two securities is zero?

The returns of the two securities are unrelated

Which of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B?

The variances of stocks A and B The covariance between stocks A and B The market value, in dollars, of the investments in stocks A and B

True or false: According to CAPM, if the historical market risk premium is negative, we cannot justify a positive relationship between a security's expected return and its beta.

True Reason: The market-risk premium is the slope of the CAPM equation. Thus, if the market risk premium is negative, there is a negative relationship between expected return and beta.

According to the CAPM, when is a security considered overpriced?

When its expected return plots below the SML

When expressing covariance between two securities, the ordering of variables:

does not matter

A bull market is characterized by ______ sentiment while a bear market is characterized by ______ sentiment of investors in the stock market.

optimistic; pessimistic Reason: A bull market is characterized by rising prices (an optimistic sentiment) while a bear market is characterized by falling prices (a pessimistic sentiment).

Another name for idiosyncratic risk is ______ risk.

unsystematic diversifiable

If the expected return is 10 percent and the standard deviation is 12 percent, what is the range of returns that will occur about 68 percent of the time?

-2% to 22% 10% ± 12% = -2% to 22%

By definition, the market's beta is ___.

1 Reason: The market's beta is 1 because beta is a measure of the movement of the security in relation to the market. So when the market moves 1%, the market moves 1%.

A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?

An increase in the Federal funds rate An increase in the corporate tax rate

What is an uncertain or risky return?

It is the portion of return that depends on information that is currently unknown.

Which of the following statements are true about expected return?

The actual return can be higher or lower than the expected return. The expected return can be calculated as the average of the returns in previous periods. The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes.

The standard deviation is ___.

the square root of the variance

Standard deviation measures ______ risk while beta measures ______ risk.

total; systematic

True or false: In practice, economists use proxies for the market portfolio instead of the actual market portfolio.

true

Which of the following are likely to be true if we observe the returns of two stocks in the same industry, such as Pfizer and Merck?

-The returns will be positively correlated over time. -The returns will move in the same direction (i.e. positive) but not by the same magnitude.

Which of the following statements are true about variance?

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

Two ways to measure the relationship between the returns of two securities are ______ and ______.

-covariance -correlation

What does the backward bending portion of the feasibility set indicate?

A reduction in portfolio risk due to diversification benefits.

Why can an investor holding a well-diversified portfolio of securities ignore the unsystematic risk of individual securities?

Because unsystematic risk should be eliminated through diversification Reason: Unsystematic risk should be eliminated through diversification

What is the appropriate measure of risk for an individual security if an investor holds a diversified portfolio?

Beta Reason: Standard deviation measures total risk. The unsystematic portion can be diversified away, so beta is the appropriate measure of risk.

What is systematic risk?

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

Which type of risk is unaffected by adding securities to a portfolio?

Systematic risk Reason: Unsystematic risk can be reduced by diversification.

A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?

The death of the CEO A hosile takeover attempt by a competitor

What is expected return?

The return that an individual expects to earn over the next period.

True or false: Unsystematic risk is eliminated in a well-diversified portfolio of securities.

True Reason: Unsystematic risk is eliminated in a well-diversified portfolio of securities.

The range of risk-return combinations possible with a portfolio of securities is captured by the opportunity set, which is also known as the ______ set.

feasible

The historical market risk premium for equities has been ______.

positive

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

positive Reason: If investors are averse to risk, they will demand higher returns from the market, thereby meaning that the risk premium will be positive (greater than zero).

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

positive Reason: The security market line (SML) shows that the relationship between a security's expected return and its beta is positive; the higher the risk, the higher the expected return.

A minimum variance portfolio will be characterized by its ___.

• Lowest possible standard deviation • Lowest possible variance

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

1. The outcome of an application currently pending with the Food ad Drug Administration. 2. The Fed's decision on interest rate at their meeting next week.

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 Reason: Portfolio beta = 0.5 × 1.5 + 0.5 × 1 = 1.25

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

Systematic, or market risk Reason: Systematic risk cannot be diversified away.

Which type of risk does not change as we add more securities to a portfolio?

Systematic, or market, risk Reason: Unsystematic risk can be reduced by adding more securities to a portfolio.

The ____ line shows a security's return in relation to the market's return.

characteristic

The risk of a large, diversified portfolio will ____ if a security with a negative beta is added to the portfolio.

decrease Reason: The risk of a large, diversified portfolio will decrease if a security with a negative beta is added to the portfolio, because the security is expected to do well when the market does poorly.

If the variance of a portfolio increases, then the portfolio standard deviation will _____.

increase

Beta measures the ____ risk of a security.

systematic

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 percent, -3 percent, and 18 percent, respectively.

.5 × 7% + .3 × -3% + .2 × 18% = 6.2%

What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5?

.6 Rationale:1.5/2.5 = .6

What is the correlation of returns between stocks A and B based on the following information? The standard deviation of returns is .30 for A and .20 for B and the covariance between A and B's returns is .045. Multiple choice question.

045/(.3 × .2) = .75

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

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

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

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

Which of the following will be true in a world with homogeneous expectations?

All investors will hold the market portfolio. Reason: Investors would either hold the market portfolio or a combination of the market portfolio and the risk-free security.

True or false: A well-diversified portfolio will eliminate all risks.

False

True or false: Systematic risk will impact all securities in every portfolio equally.

False

What is a risk premium?

It is additional compensation for taking risk, over and above the risk-free rate

Which of the following two-asset portfolios displays characteristics that would allow it to be included in the efficient set of portfolios?

Portfolio A has a higher expected return and higher standard deviation than the minimum variance portfolio.

Portfolios A and B have an expected return of 10%. Portfolio A has a standard deviation of 6% while Portfolio B has a standard deviation of 13%. Which portfolio would a rational investor choose?

Reason: Portfolio A is better as it offers the same return at a lower level of risk.

Which of the following indexes is a good proxy for the market portfolio?

The Standard & Poor's 500 index Reason: The Dow Jones Industrial Average consists of only 30 securities, so it does not represent a broad market portfolio.

Based on the capital asset pricing model (CAPM) there is generally ___ relationship between beta and the expected return on a security.

a positive Reason: The market risk premium is the slope of the CAPM. As long as the market risk premium is positive, the relationship between beta and the expected return on a security will be positive.

If Portfolio P has a lower expected return but a higher standard deviation than the minimum variance portfolio, we say that Portfolio P is ______ by the minimum variance portfolio.

dominated

The _____ portfolio is the market value weighted portfolio of all existing securities.

market

From an investor's perspective, an optimal portfolio will ___.

maximize expected return and minimize risk

There is ______ correlation between the unsystematic risk of two companies from different industries.

no

True or false: It is possible for the unsystematic risk of a portfolio to be reduced to practically zero.

true Reason: If enough securities are added, all the unsystematic risk of the securities in the portfolio should cancel one another out.