Corporate Finance Problem Set 3

You have developed the following data on three stocks: Stock Standard Deviation Beta A 0.15 0.79 B 0.25 0.61 C 0.20 1.29 If you are a risk minimizer, you should choose Stock _____ if it is to be held in isolation and Stock _____ if it is to be held as part of a well-diversified portfolio. a. A; A b. A; B c. B; A d. C; A e. C; B

B. A;B

Inflation, recession, and high interest rates are economic events which are characterized as a. Company-specific risk that can be diversified away. b. Market risk. c. Systematic risk that can be diversified away. d. Diversifiable risk. e. Unsystematic risk that can be diversified away.

B; Market risk.

Which of the following statements is most correct? a. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio. b. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the nonmarket (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. c. The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. d. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock. e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.

D; A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock.

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.) a. When held in isolation, Stock A has greater risk than Stock B. b. Stock B would be a more desirable addition to a portfolio than Stock A. c. Stock A would be a more desirable addition to a portfolio than Stock B. d. The expected return on Stock A will be greater than that on Stock B. e. The expected return on Stock B will be greater than that on Stock A.

D; The expected return on Stock A will be greater than that on Stock B.

Which of the following statements is most correct? a. Market participants are able to eliminate virtually all market risk if they hold a large diversified portfolio of stocks. b. Market participants are able to eliminate virtually all company- specific risk if they hold a large diversified portfolio of stocks. c. It is possible to have a situation where the market risk of a single stock is less than that of a well diversified portfolio. d. Answers a and c are correct. e. Answers b and c are correct.

E; Answers b and c are correct.

Which of the following statements is most correct? a. The slope of the security market line is beta. b. A stock with a negative beta must have a negative required rate of return. c. If a stock's beta doubles its required rate of return must double. d. If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium. e. None of the above statements is correct.

E; None of the above statements is correct.

Which of the following statements is most correct? a. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events. b. Portfolio diversification reduces the variability of returns on an individual stock. c. When company-specific risk has been diversified, the inherent risk that remains is market risk which is constant for all securities in the market. d. A stock with a beta of -1.0 has zero market risk. e. The SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by the financial manager.

E; The SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by the financial manager.

Diversifiable risk, which is measured by beta, can be lowered by adding more stocks to a portfolio.

False

The Y-axis intercept of the SML indicates the return on the individual asset when the realized return on an average stock (beta = 1.0) is zero.

False

When a firm makes bad managerial judgments or has unforeseen negative events happen to it that affect its returns, these random events are unpredictable and therefore cannot be diversified away by the investor.

False

When adding new securities to an existing portfolio, the higher or more positive the degree of correlation between the new securities and those already in the portfolio, the greater the benefits of the additional portfolio diversification.

False

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the isolated risks of individual stocks. Thus, the relevant risk is an individual stock's contribution to the overall riskiness of the portfolio.

True

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the non-market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all market risk.

True

If the expected rate of return for a particular investment, as seen by the marginal investor, exceeds its required rate of return, we should soon observe an increase in demand for the investment, and the price will likely increase until a price is established that equates the expected return with the required return.

True

The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation.

True