Deck 6: Risk and Return

Question 1

Market risk refers to the tendency of a stock to move with the general stock market.A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

Answer 1

True

Question 2

If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

Answer 2

False

Question 3

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

Answer 3

False

Question 4

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data.

Question 5

Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation.

Question 6

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio.The risk of the asset held in isolation is not relevant under the CAPM.

Question 7

If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

Question 8

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

Question 9

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation.Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

Question 10

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

Question 11

Someone who is risk averse has a general dislike for risk and a preference for certainty.If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities.Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.

Question 12

Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

Question 13

Diversification will normally reduce the riskiness of a portfolio of stocks.

Question 14

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

Question 15

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10.However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation.

Question 16

The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

Question 17

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

Question 18

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

Question 19

An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

Question 20

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

Question 21

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

Question 22

A stock with a beta equal to −1.0 has zero systematic (or market) risk.

Question 23

If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase.If there is no change in investors' risk aversion, then the market risk premium (r_M − r_RF) will remain constant.Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.

Question 24

Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk.If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

Question 25

Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value.Because of its diversification, Portfolio B will by definition be riskless.

Question 26

A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

Question 27

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

Question 28

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate.

Question 29

The slope of the SML is determined by investors' aversion to risk.The greater the average investor's risk aversion, the steeper the SML.

Question 30

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio.It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

Question 31

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

Question 32

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

Question 33

If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

Question 34

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk.As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk.

Question 35

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Question 36

Portfolio A has but one security, while Portfolio B has 100 securities.Because of diversification effects, we would expect Portfolio B to have the lower risk.However, it is possible for Portfolio A to be less risky.

Question 37

The SML relates required returns to firms' systematic (or market) risk.The slope and intercept of this line can be influenced by a manager's actions.

Question 38

The slope of the SML is determined by the value of beta.

Question 39

If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.

Question 40

The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.

Question 41

Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?

A) Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta.
B) The beta of an "average stock," or "the market," can change over time, sometimes drastically.
C) Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
D) All of the statements above are true.
E) The fact that a security or project may not have a past history that can be used as the basis for calculating beta.

Question 42

Which of the following statements is CORRECT?

A) Suppose the returns on two stocks are negatively correlated.One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of −0.6.The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
B) Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future.That is, you are convinced that the market is about to rise sharply.You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
C) You think that investor sentiment is about to change, and investors are about to become more risk averse.This suggests that you should re-balance your portfolio to include more high-beta stocks.
D) If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline.
E) Paid-in-Full Inc.is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency.Paid-in-Full's revenues, profits, and stock price tend to rise during recessions.This suggests that Paid-in-Full Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.

Question 43

Stock X has a beta of 0.7 and Stock Y has a beta of 1.7.Which of the following statements must be true, according to the CAPM?

A) Stock Y's realized return during the coming year will be higher than Stock X's return.
B) If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
C) Stock Y's return has a higher standard deviation than Stock X.
D) If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y.
E) If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.

Question 44

The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return.The risk-free rate is 4.20%.Henry now receives another $5.00 million, which he invests in stocks with an average beta of 0.65.What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.)

A) 8.83%
B) 9.05%
C) 9.27%
D) 9.51%
E) 9.74%

Question 45

Gardner Electric has a beta of 0.88 and an expected dividend growth rate of 4.00% per year.The T-bill rate is 4.00%, and the T-bond rate is 5.25%.The annual return on the stock market during the past 4 years was 10.25%.Investors expect the average annual future return on the market to be 12.50%.Using the SML, what is the firm's required rate of return?

A) 11.34%
B) 11.63%
C) 11.92%
D) 12.22%
E) 12.52%

Question 46

If markets are in equilibrium, which of the following conditions will exist?

A) Each stock's expected return should equal its required return as seen by the marginal investor.
B) All stocks should have the same expected return as seen by the marginal investor.
C) The expected and required returns on stocks and bonds should be equal.
D) All stocks should have the same realized return during the coming year.
E) Each stock's expected return should equal its realized return as seen by the marginal investor.

Question 47

Brodkey Shoes has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%.The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%.Based on the SML, what is the firm's required return?

A) 13.51%
B) 13.86%
C) 14.21%
D) 14.58%
E) 14.95%

Question 48

DHF Company has a beta of 1.5 and is currently in equilibrium.The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%.Now the required return on an average stock increases by 30.0% (not percentage points).Neither betas nor the risk-free rate change.What would DHF's new required return be?

A) 14.89%
B) 15.68%
C) 16.50%
D) 17.33%
E) 18.19%

Question 49

Hazel Morrison, a mutual fund manager, has a $40 million portfolio with a beta of 1.00.The risk-free rate is 4.25%, and the market risk premium is 6.00%.Hazel expects to receive an additional $60 million, which she plans to invest in additional stocks.After investing the additional funds, she wants the fund's required and expected return to be 13.00%.What must the average beta of the new stocks be to achieve the target required rate of return?

A) 1.68
B) 1.76
C) 1.85
D) 1.94
E) 2.04

Question 50

Assume that two investors each hold a portfolio, and that portfolio is their only asset.Investor A's portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0.Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk.However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0.

Question 51

Which of the following statements is CORRECT?

A) Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities.
B) The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically.
C) If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0.This is especially true if the company finances with more debt than the average firm.
D) During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.
E) If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0.

Question 52

The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Question 53

Which of the following statements is CORRECT?

A) If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio.
B) The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns.One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta.However, this historical beta may differ from the beta that exists in the future.
C) The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
D) It is theoretically possible for a stock to have a beta of 1.0.If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, r_RF.
E) The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.