Deck 8: Risk and Rates of 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 it will have a beta which is greater than 1.0.

Answer 1

True

Question 2

For an investment in a stock, the probability of the return being -10.0% is 0.3, 10.0% is 0.4, and 30.0% is 0.3. Given the probability distributions, what is the expected rate of return for the investment?

A) 10.0%
B) 9.5%
C) 15.0%
D) 12.5%
E) 13.0%

Answer 2

A

Question 3

A stock might be quite risky if held by itself, but if much of this total (stand-alone) risk can be eliminated through diversification, then its relevant risk-that is, its contribution to the portfolio's risk-is much smaller than its irrelevant risk.

Answer 3

False

Question 4

Market portfolio contains only unsystematic risk, therefore market risk premium represents the return that investors require to be compensated for, taking an average amount of relevant, or unsystematic, risk.

Question 5

The relevant risk, the risk for which investors should be compensated, is that portion of the total risk that cannot be diversified away.

Question 6

Systematic risk is diversifiable, so it is an investment's relevant risk. Unsystematic risk is nondiversifiable risk and therefore not relevant.

Question 7

The probability distribution of the payoffs on an investment refers to a _____.

A) listing of all payoffs and then determining the chance that each payoff will occur
B) measure of the tightness, or variability, of a set of payoffs
C) standardized measure of the risk per payoff
D) listing of the degree of relationship between two payoffs
E) measure of the extent to which the payoffs move with the capital market

Question 8

Risk is indicated by variability, whether the variability is considered positive or negative. Both the positive and negative outcomes must be evaluated when considering risk.

Question 9

A stock's standard deviation determines how the stock affects the riskiness of a diversified portfolio, therefore it is a better measure of a stock's relevant risk than is the beta coefficient, which measures total, or stand-alone, risk.

Question 10

The standard deviation is calculated as the weighted average of all the deviations from the expected value, and it indicates how far above or below the expected value the actual value is expected to be.

Question 11

The greater the variability of the possible returns on an investment, _____.

A) the lesser the expected return
B) the lower the standard deviation of the investment
C) the higher the actual return on the investment
D) the riskier the investment
E) the lower the beta of the investment

Question 12

A firm can affect its beta risk by changing the composition of its assets and by modifying its use of debt financing, but external factors do not have any bearing on a firm's beta.

Question 13

For a risk averse investor, other things held constant, the higher a security's risk, the higher the return investors demand, and thus the less they are willing to pay for the investment.

Question 14

A listing of all possible outcomes, or events, with a chance of occurrence assigned to each is called a probability distribution.

Question 15

The only condition under which the unsystematic portfolio risk can be reduced to zero is to combine securities that are perfectly negatively correlated (r = −1.0) with each other.

Question 16

The expected rate of return of an investment _____.

A) equals one of the possible rates of return for that investment
B) equals the required rate of return for the investment
C) is the mean value of the probability distribution of possible returns
D) is the median value of the probability distribution of possible returns
E) is the mode value of the probability distribution of possible returns

Question 17

Short-term investments have higher maturity risks as compared to long-term investments.

Question 18

Liquidity risk is an unsystematic risk and can be diversified by the investors.

Question 19

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.

Question 20

The chance of receiving an actual return that differs from the one that is expected is called _____.

A) probability distribution
B) beta
C) risk
D) change in beta
E) payoff

Question 21

Darren has the option of investing in either Stock A or Stock B. The probability of the return of Stock A being 25% is 0.45, 14% is 0.25, and 4% is 0.30. The probability of the return of Stock B being 30% is 0.30, 9% is 0.25, and 2% is 0.30. Given the probability distributions for the two investments, what is the expected rate of return for Stock A and Stock B?

A) 13.65%; 12.85%
B) 14.75%; 13.75%
C) 15.95%; 11.85%
D) 16.80%; 11.45%
E) 17.82%; 11.95%

Question 22

Which of the following statements about beta is correct?

A) Firms with greater systematic risk volatilities than the market have betas that are less than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are greater than 1.0.
B) Firms with greater systematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are less than 1.0.
C) Firms with greater systematic risk volatilities than the market have betas that are less than zero, and firms with smaller systematic risk volatilities than the market have betas that are greater than zero.
D) Firms with greater unsystematic risk volatilities than the market have betas that are less than 1.0, and firms with smaller unsystematic risk volatilities than the market have betas that are greater than 1.0.
E) Firms with greater unsystematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller unsystematic risk volatilities than the market have betas that are less than 1.0.

Question 23

Which of the following statements about correlation is correct?

A) If the returns from two stocks are perfectly positively correlated and the two stocks have equal variance, an equally weighted portfolio of the two stocks will have a variance, which is less than that of the individual stocks.
B) If a stock has a negative correlation with market, its systematic risk is more than the market risk.
C) Stocks with no correlation will have minimum diversification benefits.
D) The weaker the positive correlation two stocks exhibit, the more risk can be reduced when they are combined in a portfolio.
E) Risk is reduced when negatively related stocks are combined to form portfolios as long as the correlation coefficient is not equal to -1.

Question 24

A portfolio would offer maximum diversification benefits when _____.

A) the constituent stocks have a coefficient of correlation of 0
B) the constituent stocks have a coefficient of correlation of +1
C) the constituent stocks have a coefficient of correlation of -1
D) the constituent stocks have a coefficient of variation of 0
E) the constituent stocks have a coefficient of variation of -1

Question 25

A portfolio is made up of Stocks A, B, C, and D in the proportion of 20%, 30%, 25%, and 25% respectively. The nondiversifiable risks of the stocks as measured by their betas are 0.4, 1.2, 2.5, and 1.75 for Stock A, B, C, and D respectively. The expected returns of the stocks are 12%, 24%, 30%, and 28% respectively. Measure the beta of the portfolio.

A) 1.8
B) 1.9
C) 1.5
D) 1.4
E) 1.3

Question 26

The expected returns for Stocks A, B, C, D, and E are 7%, 10%, 12%, 25%, and 18% respectively. The corresponding standard deviations for these stocks are 12%, 18%, 15%, 23%, and 15% respectively. Based on their coefficients of variation, which of the securities is least risky for an investor? Assume all investors are risk-averse and the investments will be held in isolation.

A) A
B) B
C) C
D) D
E) E

Question 27

Which of the following statements is true about the beta of a portfolio?

A) If the beta of a portfolio doubles, its required return also doubles.
B) If a stock has a negative beta, its required return is negative.
C) Higher beta stocks have more company-specific risk, but do not necessarily have more market risk.
D) If a portfolio's beta increases from 1.2 to 1.5, its required rate of return will increase by an amount equal to its market risk premium.
E) If the beta of a stock is three, the stock's relevant risk is thrice as volatile as the market portfolio.

Question 28

Dividing the standard deviation of the returns of a stock by the stock's expected return gives us the stock's _____.

A) variance
B) risk premium
C) coefficient of variation
D) beta
E) correlation coefficient

Question 29

Which of the following statements about diversification is correct?

A) Portfolio diversification reduces the variability of returns on an individual stock.
B) When the company specific risk has been diversified, the inherent risk that remains is the market risk, which is constant for all securities in the market.
C) A stock with a beta of −1.0 has maximum nondiversifiable risk.
D) When two perfectly positively correlated stocks with the same risk are combined, the portfolio risk is equal to the risk associated with the individual stocks.
E) The systematic risk of a stock with a beta of zero is equal to the market risk.

Question 30

Diversification refers to the _____.

A) reduction of the stand-alone risk of an individual investment, measured by its beta coefficient, by combining it with other investments in a portfolio
B) reduction of the stand-alone risk of an individual investment, measured by the standard deviation of its returns, by combining it with other investments in a portfolio
C) reduction of the systematic risk of an individual investment, measured by its beta coefficient, by combining it with other investments in a portfolio
D) reduction of the systematic risk of an individual investment, measured by the standard deviation of its returns, by combining it with other investments in a portfolio
E) reduction of the unsystematic risk of an individual investment, measured by its coefficient of variation, by combining it with other investments in a portfolio

Question 31

Which of the following is a measure of the extent to which the returns on a given stock move with the stock market?

A) Beta coefficient
B) Standard deviation
C) Coefficient of variation
D) Correlation coefficient
E) Probability distribution of expected returns

Question 32

The standard deviation of the returns of Stock A is 45.85%, and the standard deviation of the returns of Stock B is 52.7%. Which of the following statements about the stocks is correct?

A) Stock A has less tight probability distribution, and hence lower total risk.
B) Stock A has tighter probability distribution, and hence lower total risk.
C) Stock B has less tight probability distribution, and hence lower total risk.
D) Stock B has tighter probability distribution, and hence lower total risk.
E) Stock B has lower risk, but nothing can be said about the probability distribution.

Question 33

For Investment A, the probability of the return being 20.0% is 0.5, 10.0% is 0.4, and -10.0% is 0.1. Compute the standard deviation for the investment with the given information. (Round your answer to one decimal place.)

A) 85.0%
B) 15.0%
C) 34.0%
D) 17.0%
E) 9.0%

Question 34

The difference between the expected rate of return on a given risky asset and the expected rate of return on a less risky asset is known as the _____.

A) standard deviation of returns
B) variance of returns
C) actual rate of return
D) risk premium
E) risk adjusted return

Question 35

The variance of the returns of Stock X is 62.5%, and the expected return from the stock is 18%. Calculate the coefficient of variation of the stock. (Round your answer to two decimal places.)

A) 3.47
B) 0.44
C) 0.29
D) 2.27
E) 1.82

Question 36

Which of the following portfolios would have no diversification benefits?

A) A portfolio consisting of two perfectly positively correlated stocks
B) A portfolio consisting of two perfectly negatively correlated stocks
C) A portfolio consisting of two completely uncorrelated stocks
D) A portfolio consisting of two stocks with the same standard deviation of returns
E) A portfolio consisting of two stocks with the same beta coefficient

Question 37

In a given portfolio, replacing an existing investment with a lower beta investment results in _____.

A) an increase in the expected rate of rate return of the portfolio
B) a decrease in the actual rate of return of the portfolio
C) a decrease in the required rate of return of the portfolio
D) an increase in the systematic risk of the portfolio
E) the portfolio beta moving toward 1.0

Question 38

Which of the following is the only risk that is relevant to a rational, diversified investor?

A) Diversifiable risk
B) Stand-alone risk
C) Market risk
D) Unsystematic risk
E) Firm-specific risk

Question 39

A measure of the tightness, or variability, of a set of returns of an investment is known as the _____.

A) correlation coefficient of the investment
B) standard deviation of the returns of the investment
C) beta of the investment
D) coefficient of variation of the investment
E) probability distribution of the returns of the investment

Question 40

The larger the standard deviation of returns of an investment, _____.

A) greater is the chance that the investment will outperform the market
B) lesser is the chance that the realized return will be negative
C) greater is the chance that the realized return will be negative
D) lesser is the chance that the realized return will differ significantly from the expected return
E) greater is the chance that the realized return will differ significantly from the expected return

Question 41

Which of the following statements about the security market line (SML) and investor's risk aversion is correct?

A) The steeper the slope of the line, the lesser the average investor's risk aversion, and thus the greater the return investors require as compensation for risk.
B) The steeper the slope of the line, the greater the average investor's risk aversion, and thus the greater the return investors require as compensation for risk.
C) The steeper the slope of the line, the lesser the average investor's risk aversion, and thus the lesser the return investors require as compensation for risk.
D) The steeper the slope of the line, the greater the average investor's risk aversion, and thus the lesser the return investors require as compensation for risk.
E) The less steep the slope of the line, the greater the average investor's risk aversion, and thus the lesser the return investors require as compensation for risk.

Question 42

The beta coefficient of Zed Corporation is equal to 0.7 and the required rate of return on the stock equals 12 percent. If the expected return on the market is 12.5 percent, what is the risk-free rate of return? (Round off the answer to two decimal places.)

A) 11.56%
B) 10.83%
C) 9.52%
D) 12.25%
E) 8.89%

Question 43

If the risk-free rate is 7 percent, the expected return on the market is 10 percent, and the expected return on Security J is 13 percent, what is the beta of Security J?

A) 1.0
B) 1.5
C) 2.0
D) 2.5
E) 3.0

Question 44

Steve Brickson currently has an investment portfolio that contains four stocks with a total value equal to $80,000. The portfolio has a beta (β) equal to 1.4. In order to earn higher returns, Steve wants to invest an additional $20,000 in a stock that has β equal to 2.4. After Steve adds the new stock to his portfolio, what will the portfolio's beta be?

A) 1.6
B) 1.8
C) 1.9
D) 2.0
E) 2.1

Question 45

The type of security that generates a return that is closest to a risk-free rate of return is a _____.

A) treasury bill
B) treasury note
C) commercial paper
D) corporate bond
E) corporate stock

Question 46

Which of the following statements about beta is correct?

A) If the returns on a stock vary widely, then its standard deviation is large, and as a result, the stock will also have a large beta coefficient.
B) A stock's standard deviation of returns is a measure of the stock's stand-alone risk, while its beta measures its unsystematic risk.
C) A portfolio that contains 100 high-beta stocks will not be riskier than a portfolio containing 100 low-beta stocks.
D) A stock that is perfectly positively correlated with the market would not have a beta coefficient that is greater than one.
E) A stock with a negative beta has very high firm-specific risk.

Question 47

Which of the following statements about beta and risk is correct?

A) A security's beta measures its diversifiable (systematic, or market) risk relative to that of other securities.
B) If the returns of two firms are negatively correlated, one of them must have a negative beta.
C) 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 one stock.
D) Combining stocks with perfectly positively correlated stock returns into a portfolio is less risky than holding an individual stock since the portfolio will benefit from diversification.
E) If two stocks have the same standard deviation and the correlation coefficient between the returns of two stocks equals zero, an equally weighted portfolio of the two stocks will have a standard deviation equal to that of the individual stocks.

Question 48

The Security Market Line (SML) relates risk of individual securities to their required rate of return. If investors conclude that the inflation rate is going to increase, which of the following change would occur?

A) The market risk premium would increase.
B) The beta of the stock would increase.
C) The slope of the SML would become steeper.
D) The standard deviation of the stock would increase.
E) The required return of an average stock would increase.

Question 49

The market for a stock is said to be in equilibrium when the _____.

A) expected return on the stock is equal to its required return
B) expected return on the stock is equal to the risk-free rate
C) expected return on the stock is equal to the market risk premium
D) expected return on the stock is equal to the market return
E) expected return on the stock is equal to its historical return

Question 50

The risk-free rate is 5%, the market risk premium is 8%, and the market return is 13%. Stock Y's beta is 1.85 and the standard deviation of its returns is 62.5%. What should be the stock's expected rate of return to make the investor indifferent toward buying or selling the stock?

A) 11.66%
B) 12.82%
C) 15.54%
D) 12.50%
E) 19.80%

Question 51

Which of the following statements about risk-return relationship is correct?

A) An increase in the expected inflation would lead to an increase in the required return on all the risky assets by the same amount, assuming all other things were held constant.
B) A graph of the SML would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.
C) As a result of change in investors' risk aversion, the required rate of return on low-beta stocks is impacted more when compared to the required rate of return on high-beta stocks.
D) If investors became more averse to risk, then the slope of the SML would become less steep.
E) The market risk premium is lower for higher beta stocks and higher for lower beta stocks.

Question 52

Stock A's beta is 2.1. The risk-free rate is 6%, and the market return is 13%. The expected rate of return of Stock A is 15.5%. Based on the above information, which of the following statements is true?

A) An investor should buy Stock A because its expected rate of return is less than the required rate of return.
B) An investor should buy Stock A because its expected rate of return is more than the required rate of return.
C) An investor should not buy Stock A because its expected rate of return is more than the required rate of return.
D) An investor should not buy Stock A because its expected rate of return is less than the required rate of return.
E) An investor should be indifferent towards buying or selling the stock.

Question 53

The risk-free rate of return is 4%, and the market return is 10%. The betas of Stocks A, B, C, D, and E are 0.85, 0.75, 1.20, 1.35, and 0.5 respectively. The expected rates of return for Stocks A, B, C, D, and E are 7%, 9%, 9.5%, 12.1%, and 14% respectively. Which of the above stocks would an investor be indifferent towards buying or selling?

A) A
B) B
C) C
D) D
E) E

Question 54

Other things held constant, if the expected inflation rate decreases, and at the same time investors become more risk averse, the Security Market Line (SML) would shift _____.

A) down and have a steeper slope
B) up and have a less steep slope
C) up and keep the same slope
D) down and keep the same slope
E) down and have a less steep slope

Question 55

A stock has a beta coefficient, β, equal to 1.20.The risk premium associated with the market is 9 percent, and the risk-free rate is 5 percent. Application of the capital asset pricing model indicates that the stock's appropriate return should be _____.

A) 9.8%
B) 5.2%
C) 12.5%
D) 15.8%
E) 17.2%

Question 56

That part of a security's risk associated with random outcomes generated by events or behaviors, specific to the firm is also known as the _____.

A) nondiversifiable risk
B) unsystematic risk
C) market risk
D) systematic risk
E) relevant risk

Question 57

Other things held constant, if the investors become less risk averse, the new security market line (SML) would _____.

A) not be affected
B) shift down
C) shift up
D) have a steeper slope
E) have a less steep slope

Question 58

Assume you are considering combining two investments to form a portfolio and you are very concerned with the risk that will result from the combination. If you want to attain the greatest effect from diversification, you would prefer that the assets _____.

A) are negatively related
B) are positively related
C) are not related
D) have a negative coefficient of variation
E) have a positive coefficient of variation

Question 59

The part of a security's risk associated with economic factors that affect all firms to some extent is also known as the _____.

A) diversifiable risk
B) unsystematic risk
C) stand-alone risk
D) market risk
E) business risk

Question 60

Stock A has a beta (β) equal to 2.1 and Stock B has a beta equal to 0.7. Based on this information, according to the capital asset pricing model (CAPM), which of the following statements is correct?

A) The required rate of return for Stock A, rA, should be 2.1 times the required rate of return for Stock B, rB.
B) The risk premium associated with Stock A, RPA, should be 2.1 times the risk premium associated with Stock B, RPB.
C) The required rate of return for Stock A, rA, should be three times the required rate of return for Stock B, rB.
D) The risk premium associated with Stock A, RPA, should be three times the risk premium associated with Stock B, RPB.
E) The required rate of return for Stock A, rA, should be three times the risk premium associated with Stock A, RPA

Question 61

Which of the following risks is irrelevant for the purpose of determining the risk premium of a security?

A) Political risk
B) Exchange rate risk
C) Maturity risk
D) Business risk
E) Inflation risk

Question 62

Which of the following risks is relevant for the purpose of determining the risk premium of a security?

A) Financial risk
B) Inflation risk
C) Default risk
D) Stand-alone risk
E) Business risk

Question 63

The risk that is limited to a particular industry is also known as _____.

A) unsystematic risk
B) non-diversifiable risk
C) market risk
D) relevant risk
E) combined risk

Question 64

Which of the following statements about market risk and firm-specific risk is true?

A) Market risk is an unsystematic risk, whereas firm-specific risk is systematic risk.
B) Market risk is not rewarded with additional returns, whereas firm-specific risk is rewarded with additional returns.
C) Market risk is a diversifiable risk, whereas firm-specific risk is a nondiversifiable risk.
D) Market risk is a relevant risk, whereas firm-specific risk is an irrelevant risk.
E) Market risk includes default risk, whereas firm-specific risk includes maturity risk.

Question 65

Diversifiable risk includes _____.

A) maturity risk
B) liquidity risk
C) business risk
D) political risk
E) interest rate risk

Question 66

Which of the following statements about the various kinds of risks and their associated market reward is true?

A) Liquidity risk is a market risk, hence not rewarded by the market.
B) Default risk is a firm-specific risk, hence rewarded by the market.
C) Exchange rate risk is a diversifiable risk, hence not rewarded by the market.
D) Inflation risk is an unsystematic risk, hence not rewarded by the market.
E) Interest rate risk is a systematic risk, hence rewarded by the market.

Question 67

Which of the following pairs of risks have both the components referring to the same kind of risk?

A) Market risk and unsystematic risk
B) Market risk and relevant risk
C) Firm-specific risk and nondiversifiable risk
D) Firm-specific risk and systematic risk
E) Firm-specific risk and market risk

Question 68

The total risk associated with an investment can be divided into _____.

A) systematic and nondiversifiable risk
B) firm-specific and unsystematic risk
C) market and firm specific risk
D) market and nondiversifiable risk
E) firm-specific and diversifiable risk

Question 69

The next expected dividend for Stock P is $2.5, and the current price of the stock is $32.5. Its earnings, dividends, and price can be expected to grow at a constant rate of 4 percent per year. The risk free rate is 3%, the market risk premium is 5.5%, and the stock's beta is 1.2. Based on the given information, which of the following statements is correct?

A) An investor should buy this stock because its expected rate of return is 11.69%, and its required rate of return is 9.6%
B) An investor should not buy this stock because its expected rate of return is 9.6%, and its required rate of return is 11.69%
C) An investor should buy this stock because its expected rate of return is 12.54%, and its required rate of return is 8.28%,
D) An investor should not buy this stock because its expected rate of return is only 8.28%, and its required rate of return is 12.54%
E) An investor should be indifferent toward buying or selling the stock, because its required rate of return is equal to its expected rate of return.

Question 70

Which of the following statements about relevant and irrelevant risks is true?

A) Relevant risk includes inflation risk, but excludes political risk.
B) Relevant risk includes interest rate risk, but excludes default risk.
C) Relevant risk includes liquidity risk, but excludes exchange rate risk.
D) Relevant risk includes exchange rate risk, but excludes inflation risk.
E) Relevant risk includes default risk, but excludes political risk.

Question 71

Which of the following statements is correct about the risk-reward relationship of various types of risks?

A) Firm-specific risk is rewarded with additional returns.
B) Market risk is not rewarded with additional returns.
C) Systematic risk is rewarded with additional returns.
D) Unsystematic risk is rewarded with additional returns.
E) Diversifiable risk is not rewarded with additional returns.

Question 72

Which of the following statements about risk measures is correct?

A) Beta is the measure of total risk, whereas standard deviation is the measure of unsystematic risk.
B) Beta is the measure of unsystematic risk, whereas standard deviation is the measure of total risk.
C) Beta is the measure of total risk, whereas standard deviation is the measure of systematic risk.
D) Beta is the measure of systematic risk, whereas standard deviation is the measure of total risk.
E) Beta is the measure of total risk, whereas Standard deviation is the measure of systematic risk.

Question 73

Which of the following statements about the various kinds of risk is true?

A) Interest rate risk and inflation risk are diversifiable risks.
B) Liquidity risk and political risk are systematic risks.
C) Business risk and exchange rate risk are firm-specific risks.
D) Financial risk and maturity risk are market risks.
E) Default risk and inflation risk are relevant risks.

Question 74

According to the CAPM, _____.

A) investors should expect to be rewarded for the total risk associated with an individual investment, total risk being measured by the standard deviation of returns
B) investors should expect to be rewarded for only the unsystematic risk associated with an individual investment, unsystematic risk being measured by the standard deviation of returns
C) investors should expect to be rewarded only for the systematic risk associated with an individual investment, systematic risk being measured by the standard deviation of returns
D) investors should expect to be rewarded for only the unsystematic risk associated with an individual investment, unsystematic risk being measured by the beta coefficient
E) investors should expect to be rewarded for only the systematic risk associated with an individual investment, systematic risk being measured by the beta coefficient

Question 75

Which of the following statements about the various types of risks is true?

A) Default risk is a nondiversifiable risk.
B) Interest rate risk is an unsystematic risk.
C) Inflation risk is a systematic risk.
D) Maturity risk is a firm-specific risk.
E) Political risk is a diversifiable risk.

Question 76

Which of the following is a component of systematic risk?

A) Business risk
B) Financial risk
C) Default risk
D) Liquidity risk
E) Stand-alone risk