# FIN Chpt 11

What is variance?

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

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

How can you tell if a portfolio is being effectively diversified?

A decrease in the portfolio standard deviation

What does a normal return depend upon?

All relevant information available to shareholders

What can not possibly be the correlation coefficient between the returns of two stocks?

Any number over -1 and 1

Systematic risk is measured by

Beta

What measures the interrelationship between two securities?

Covariance

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

Decrease

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

False

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

Increases; increases

What is unsystematic risk?

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

What is systematic risk?

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

What is a risk premium?

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

What does beta measure?

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

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

No

Systematic risk will ____ when securities are added to a portfolio

Not change

A security that is fairly priced will have a return that lies _____ the security market line.

On

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

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

Systematic

According to the capital asset pricing model, what is the expected return on a security with a beta of 1?

The expected return on the market

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

The market-risk premium

A portfolio consists of five securities that have individual betas of 1.38, 0.87, 1.02, 1.49, and 0.67. You do not know the portfolio weight of each security. What do you know with certainty?

The portfolio beta will be less than 1.49 and greater than 0.67

What is correct concerning the standard deviation of a portfolio?

The standard deviation of a portfolio can often be lowered by changing the weights of the securities in the portfolio.

True or False: The efficient set is a subset of the feasible set.

True

Amy has a portfolio with a beta of 1.26 but has decided to lower her investment risk. Adding which one of the following securities to her portfolio is most assuredly going to lower the risk of the portfolio?

U.S. Treasury bills

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

When its expected return plots below the SML

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

You must invest in stocks of more than one corporation

You plotted the monthly rate of return for two securities against time for the past 48 months. If the pattern of the movements of these two sets of returns rose and fell together the majority, but not all, of the time, then the securities have

a strong positive correlation

The systematic risk of the market is assigned a

beta of 1

Unsystematic risk

can be effectively eliminated through portfolio diversification

The beta of a security is calculated by dividing the

covariance of the security with the market by the variance of the market.

The correlation between stocks A and B is equal to the

covarianceAB divided by the product of the standard deviations of A and B

The primary purpose of portfolio diversification is to

eliminate asset-specific risk

The expected return on a portfolio

is limited by the returns on the individual securities within the portfolio.

Assume two securities are negatively correlated. If these two securities are combined into an equally weighted portfolio, the portfolio standard deviation must be

less than the weighted average of the standard deviations of the individual securities.

When computing the expected return on a portfolio of stocks the portfolio weights are based on the

market value of the total shares held in each stock

According to the capital asset pricing model, the expected return on a security is

positively and linearly related to the security's beta.

The principle of diversification tells us that

spreading an investment across many diverse assets will lower a portfolio's level of risk.

The market risk premium is computed by

subtracting the risk-free rate of return from the market rate of return.

The standard deviation of a portfolio will tend to increase when

the portfolio concentration in a single cyclical industry increases.

A stock with a beta of zero would be expected to have a rate of return equal to

the risk-free rate.

The intercept point of the security market line is the rate of return that corresponds to

the risk-free rate.

Well-diversified portfolios have negligible

unsystematic risks

A stock with an actual return that lies above the security market line has

yielded a higher return than expected for the level of risk assumed.

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

• Idiosyncratic • Unique • Unsystematic

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

• The risk free rate • The risk premium

The efficient set depends on the ____.

• Variances of individual securities • Expected returns of individual securities • Covariance between pairs of securities

What is an example of systematic risk?

A well respected chairman of the Federal Reserve suddenly resigns.

What does the characteristic line for a security show?

• It shows a security's variance of returns • It shows a security's return in relation to the market's return

What is the difference in the opportunity sets of the following portfolios: Portfolio A consists of two risky assets and Portfolio B consists of one risky and one risk-free asset?

A's opportunity set will be curved while B's will be a straight line

Assume the risk-free rate and the market risk premium are both positive. Trevor currently owns a portfolio consisting of risky and risk-free securities. The portfolio has an expected return of 11.2 percent, a standard deviation of 16.2 percent, and a beta of 1.21. He has decided that he would prefer a higher expected return. Which one of these actions should he take?

Increase the portfolio weight of the risky assets without affecting the total portfolio value

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

If a stock portfolio is well diversified, then the portfolio variance

may be less than the variance of the least risky stock in the portfolio.

The risk premium for an individual security is computed by

multiplying the security's beta by the market risk premium

If there is no diversification benefit derived from combining two risky stocks into one portfolio, then the

returns on the two stocks must move perfectly in sync with one another

What is 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 should decline by 4.53%

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

• Increase the correlation between two securities • Lower the return on individual securities • Increase the standard deviation of the securities

What does variance measure?

• It measures the riskiness of a security's return • It measures the spread of the sample of returns

A minimum variance portfolio will be characterized by its ____.

• Lowest possible standard deviation • Lowest possible variance

What is 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.

The surprise component of total return can be broken into which of these parts?

• Systematic portion • Unsystematic portion

Based on historical data, what is true of the market risk premium?

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

What is needed in order to compute the variance of a portfolio consisting of two stocks, A and B?

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

What are true about optimal portfolios?

• They offer the highest return for a given level of risk. • They provide the best risk-return trade-off • They offer the lowest risk for a given level of return

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

• Unsystematic risk • Market risk