Deck 8: Risk and Return-Capital Market Theory

Question 1

The standard deviation of a portfolio is always just the weighted average of the standard deviations of assets in the portfolio.

Answer 1

False

Question 2

You are considering investing in U.S. Steel. Which of the following is an example of nondiversifiable risk?

A) Risk resulting from foreign expropriation of U.S. Steel property
B) Risk resulting from oil exploration by Marathon Oil (a U.S. Steel subsidy)
C) Risk resulting from a strike against U.S. Steel
D) None of the above

Answer 2

D

Question 3

A negative coefficient of correlation implies that

A) on average, returns to such assets are negative.
B) asset returns tend to move in opposite directions.
C) asset return tend to move in opposite directions.
D) None of the above because the coefficient of correlation cannot be negative.

Answer 3

B

Question 4

You are considering investing in a portfolio consisting of 40% Electric General and 60% Buckstar. If the expected rate of return on Electric General is 16% and the expected return on Buckstar is 9%, what is the expected return on the portfolio?

A) 12.50%
B) 13.20%
C) 11.80%
D) 10.00%

Question 5

You are considering buying some stock in Continental Grain. Which of the following is an example of nondiversifiable risk?

A) Risk resulting from a general decline in the stock market
B) Risk resulting from a news release that several of Continental's grain silos were tainted
C) Risk resulting from an explosion in a grain elevator owned by Continental
D) Risk resulting from an impending lawsuit against Continental

Question 6

If an investor must choose between investing in either portfolio X or portfolio Y, then

A) she will always choose portfolio X over portfolio Y.
B) she will always choose portfolio Y over portfolio X.
C) she will be indifferent between investing in portfolio X and portfolio Y.
D) none of the above.

Question 7

If your portfolio consists of 20% RJH (expected return 16% ) 30% PAV (expected return -2%), and 50% MB (expected return 8%), what is the expected rate of return on the portfolio?

A) 7.8%
B) 7.3%
C) 6.6%
D) 8.7%

Question 8

The expected return on VZ next year is 12% with a standard deviation of 20%. The expected return on ANT next year is 24% with a standard deviation of 30%. The correlation between the two stocks is .6. If Emily makes equal investments in VZ and ANT, what is the standard deviation of her portfolio?

A) 22.47%
B) 25.00%
C) 5.05%
D) 15.00%

Question 9

A portfolio will always have less risk than the riskiest asset in it if the correlation of assets is less than perfectly positive.

Question 10

A correlation coefficient of +1 indicates that returns on one asset can be exactly predicted from the returns on another asset.

Question 11

Your portfolio consists of $3,000 in ABC stock, $4,500 of DEF stock and $2,500 of GHI stock. Expected rates of return are ABC 5%, DEF 12%, and GHI 16%. What is the portfolio expected rate of return?

A) 10.9%
B) 12.0%
C) 11.4%
D) 16.0%

Question 12

When assets are positively correlated, they tend to rise or fall together.

Question 13

Adequate portfolio diversification can be achieved by investing in several companies in the same industry.

Question 14

The portfolio standard deviation will always be less than the standard deviation of any asset in the portfolio.

Question 15

The expected return on ZV next year is 12% with a standard deviation of 20%. The expected return on TNA next year is 24% with a standard deviation of 30%. The correlation between the two stocks is -.6. If Hannah makes equal investments in ZV and TNA, what is the standard deviation of her portfolio?

A) 22.47%.
B) 12.04%
C) 1.45%.
D) 16.00%.

Question 16

What is the expected rate of return on a portfolio 18% of which is invested in an S&P 500 Index fund, 65% in a technology fund, and 17% in Treasury Bills. The expected rate of return is 11% on the S&P Index fund, 14% on the technology fund and 2% on the Treasury Bills.

A) 10.25%
B) 8.33%
C) 11.42%
D) 9.00%

Question 17

The expected return on MSFT next year is 12% with a standard deviation of 20%. The expected return on AAPL next year is 24% with a standard deviation of 30%. If James makes equal investments in MSFT and AAPL, what is the expected return on his portfolio?

A) 20%
B) 16%
C) 18%%
D) 25%

Question 18

What is the expected dollar return on a portfolio which consists of $9,000 invested in an S&P 500 Index fund, $32,500 in a technology fund, and $8,500 in Treasury Bills. The expected rate of return is 11% on the S&P Index fund, 14% on the technology fund and 2% on the Treasury Bills.

A) $13,640
B) $571
C) $4,500
D) $5,710

Question 19

Which of the following portfolios is clearly preferred to the others? Expected Standard
Return Deviation
A 14% 12%
B 22% 20%
C 18% 16%

A) Investment A
B) Investment B
C) Investment C
D) Cannot be determined

Question 20

An investor will get maximum risk reduction by combining assets that are

A) negatively correlated.
B) positively correlated.
C) uncorrelated.
D) perfectly, positively correlated.

Question 21

Which of the following has a beta of zero?

A) A risk-free asset
B) The market
C) A high-risk asset
D) Both A and B

Question 22

You are considering investing in Ford Motor Company. Which of the following is an example of diversifiable risk?

A) Risk resulting from the possibility of a stock market crash
B) Risk resulting from uncertainty regarding a possible strike against Ford
C) Risk resulting from an expected recession
D) Risk resulting from interest rates decreasing

Question 23

A stock's beta is a measure of its

A) systematic risk.
B) unsystematic risk.
C) company-specific risk.
D) diversifiable risk.

Question 24

Which of the following has a beta of 1?

A) The 10 year T-Bond
B) The 1 year T-Bill
C) The Dow-Jones Industrial Average
D) The market

Question 25

The appropriate measure for risk according to the capital asset pricing model is

A) the standard deviation of a firm's cash flows.
B) alpha.
C) beta.
D) probability of correlation.

Question 26

Most financial assets have correlation coefficients between 0 and 1.

Question 27

The benefit from diversification is far greater when the diversification occurs across asset types.

Question 28

Changes in the general economy, such as changes in interest rates or tax laws, represent what type of risk?

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

Question 29

Portfolio returns can be calculated as the geometric mean of the returns on the individual assets in the portfolio.

Question 30

You are considering a portfolio consisting of equal investments in the stocks Northbank Inc. and Tropical Escapes Inc. Returns on the 2 stocks under various conditions are shown below.
Scenario Return (%) Return % Return %
Probability Northbank Tropical Portfolio
0.20 4% 16%
0.50 10% 10%
0.30 20% -10%
a. Calculate the expected rate of and the standard deviation return of the portfolio.

Question 31

Investing in foreign stocks is one way to improve diversification of a portfolio.

Question 32

On average, when the overall market changes by 10%, the stock of Veracity Communications changes 12%. Veracity's beta is

A) 1.2.
B) 8.33%.
C) 12%.
D) Insufficient information is provided

Question 33

Negatively correlated assets are quite hard to find.

Question 34

If you hold a portfolio made up of the following stocks: Investment Value Beta
Stock A $2,000 1.5
Stock B $5,000 1.2
Stock C $3,000 .8
What is the beta of the portfolio?

A) 1.17
B) 1.14
C) 1.32
D) Can't be determined from information given

Question 35

When constructing a portfolio, it is a good idea to put all your eggs in one basket, then watch the basket closely.

Question 36

The capital asset pricing model

A) provides a risk-return trade-off in which risk is measured in terms of the market returns.
B) provides a risk-return trade-off in which risk is measured in terms of beta.
C) measures risk as the correlation coefficient between a security and market rates of return.
D) depicts the total risk of a security.

Question 37

An asset with a large standard deviation of returns can lower portfolio risk if its returns are uncorrelated with the returns on the other assets in the portfolio.

Question 38

The standard deviation of returns on Warchester stock is 20% and on Shoesbury stock it is 16%. The coefficient of correlation between the stocks is .75. The standard deviation of any portfolio combining the two stocks will be less than 20%.

Question 39

For the most part, there has been a positive relation between risk and return historically.

Question 40

A portfolio containing a mix of stocks, bonds, and real estate is likely to be more diversified than a portfolio made up of only one asset class.

Question 41

What type of risk can investors reduce through diversification?

A) All risk
B) Systematic risk only
C) Unsystematic risk only
D) Uncertainty

Question 42

Currently, the expected return on the market is 12.5% and the required rate of return for Alpha, Inc. is 12.5%. Therefore, Alpha's beta must be

A) less than 1.0.
B) greater than 1.0.
C) equal to 1.0.
D) unknown based on the information provided.

Question 43

Investment risk is

A) the probability of achieving a return that is greater than what was expected.
B) the probability of achieving a beta coefficient that is less than what was expected.
C) the probability of achieving a return that is less than what was expected.
D) the probability of achieving a standard deviation that is less than what was expected.

Question 44

You are thinking of adding one of two investments to an already well diversified portfolio. Security A Security B
Expected return = 12% Expected return = 12%
Standard deviation of returns = 20.9% Standard deviation of returns = 10.1%
Beta = .8 Beta = 2
If you are a risk-averse investor

A) security A is the better choice.
B) security B is the better choice.
C) either security would be acceptable.
D) cannot be determined with information given.

Question 45

Which of the following is a good measure of the relationship between an investment's returns and the market's returns?

A) The beta coefficient
B) The standard variation
C) The CPI
D) The S&P 500 Index

Question 46

It is impossible to eliminate all risk through diversification.

Question 47

The beta of ABC Co. stock is the slope of

A) the security market line.
B) the characteristic line for a plot of returns on the S&P 500 versus returns on short-term Treasury bills.
C) the arbitrage pricing line.
D) the line of best fit for a plot of ABC Co. returns against the returns of the market portfolio for the same period.

Question 48

Stocks with higher betas are usually more stable than stocks with lower betas.

Question 49

Your broker mailed you your year-end statement. You have $25,000 invested in Amazon, $18,000 tied up in Boeing, $36,000 in Caterpillar stock, and $11,000 in DuPont. The betas for each of your stocks are 1.43 for Amazon, .79 for Boeing, 1.37 for Caterpillar, and 1.71 for DuPont. What is the beta of your portfolio?

A) 1.33
B) 1.31
C) 1.00
D) 5.30

Question 50

You are considering a portfolio of three stocks with 30% of your money invested in company X, 45% of your money invested in company Y, and 25% of your money invested in company Z. If the betas for each stock are 1.22 for company X, 1.46 for company Y, and 1.03 for company Z, what is the portfolio beta?

A) 1.24
B) 1.00
C) 1.28
D) 1.33

Question 51

A stock with a beta greater than 1.0 has returns that are ________ volatile than the market, and a stock with a beta of less than 1.0 exhibits returns which are ________ volatile than those of the market portfolio.

A) more, more
B) more, less
C) less, more
D) less, less

Question 52

Beta is a measurement of the relationship between a security's returns and the general market's returns.

Question 53

Beta is the slope of a straight line that best fits the returns on an asset plotted against the return on

A) inflation.
B) a portfolio of companies in the same industry.
C) a broad market index.
D) treasury bonds.

Question 54

Which of the following is generally used to measure the market when calculating betas?

A) The Dow Jones Industrial Average
B) The Standard & Poors 500 Index
C) The Value Line Quantam Index
D) The Case Schiller Housing Index

Question 55

Which of the following statements is true?

A) Systematic, or market, risk can be reduced through diversification.
B) Both systematic and unsystematic risk can be reduced through diversification.
C) Unsystematic, or company, risk can be reduced through diversification.
D) Neither systematic nor unsystematic risk can be reduced through diversification.

Question 56

You hold a portfolio with the following securities: Percent
Security of Portfolio Beta Return
X Corporation 20% 1.35 14%
Y Corporation 35% .95 10%
Z Corporation 45% .75 8%
Compute the expected return and beta for the portfolio.

A) 10.67%, 1.02
B) 9.9%, 1.02
C) 34.4%, .94
D) 9.9%, .94

Question 57

Which of the following statements is true?

A) A stock with a beta less than zero has no exposure to systematic risk.
B) A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.
C) A stock with a beta less than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.
D) A stock with a beta less than 1.0 has higher nondiversifiable risk than a stock with a beta of 1.0.

Question 58

Which of the following is NOT an example of systematic risk?

A) Inflation
B) Recession
C) Management risk
D) Interest rate risk

Question 59

Total risk equals unsystematic risk times systematic risk.

Question 60

The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in terms of beta.

Question 61

The market rewards assuming additional unsystematic risk with additional returns.

Question 62

Siebling Manufacturing Company's common stock has a beta of .8. If the expected risk-free return is 2% and the market offers a premium of 8% over the risk-free rate, what is the expected return on Siebling's common stock?

A) 7.8%
B) 13.4%
C) 14.4%
D) 8.4%

Question 63

The risk-return relationship for each financial asset is shown on

A) the capital market line.
B) the New York Stock Exchange market line.
C) the security market line.
D) none of the above.

Question 64

Bell Weather, Inc. has a beta of 1.25. The return on the market portfolio is 12.5%, and the risk-free rate is 5%. According to CAPM, what is the required return on this stock?

A) 20.62%
B) 9.37%
C) 14.38%
D) 15.62%

Question 65

The rate on six-month T-bills is currently 5%. Andvark Company stock has a beta of 1.69 and a required rate of return of 15.4%. According to CAPM, determine the return on the market portfolio.

A) 11.15%
B) 6.15%
C) 17.07%
D) 14.11%

Question 66

Briefly discuss why there is no reason to believe that the market will reward investors with additional returns for assuming unsystematic risk.

Question 67

On average, the market rewards assuming additional systematic risk with additional returns.

Question 68

Unsystematic risk can be eliminated through diversification.

Question 69

You are going to invest all of your funds in one of three projects with the following distribution of possible returns: Project 1 Project 2
Standard Deviation 12% Standard Deviation 19.5%
Probability Return Probability Return
50% Chance 20% 30% Chance 30%
50% Chance -4% 40% Chance 10%
30% Chance -20%
Project 3
Standard Deviation 12%
Probability Return
10% Chance 30%
40% Chance 15%
40% Chance 10%
10% Chance -21%
If you are a risk-averse investor, which one should you choose?

A) Project 1
B) Project 2
C) Project 3
D) None of the above

Question 70

Betas for individual stocks tend to be stable.

Question 71

In an efficient market there is no reward for accepting risk that can be eliminated through diversification.

Question 72

A stock with a beta of 1.0 would on average earn the risk-free rate.

Question 73

Treize Industries' common stock has an expected return of 13% and a beta of 1.3. If the expected risk-free return is 3%, what is the expected return for the market (round your answer to the nearest .1%)?

A) 7.7%
B) 9.6%
C) 10.0%
D) 10.7%

Question 74

The security market line (SML) relates risk to return, for a given set of market conditions. If risk aversion increases, which of the following would most likely occur?

A) The market risk premium would increase.
B) Beta would increase.
C) The slope of the SML would increase.
D) The SML line would shift up.

Question 75

Provide an intuitive discussion of beta and its importance for measuring risk.

Question 76

A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.

Question 77

Tanzlin Manufacturing's common stock has a beta of 1.5. If the expected risk-free return is 2% and the expected return on the market is 14%, what is the expected return on the stock?

A) 13.5%
B) 21.0%
C) 16.8%
D) 20.0%

Question 78

The security market line (SML) relates risk to return, for a given set of market conditions. If expected inflation increases, which of the following would most likely occur?

A) The market risk premium would increase.
B) Beta would increase.
C) The slope of the SML would increase.
D) The SML line would shift up.

Question 79

Given the capital asset pricing model, a security with a beta of 1.5 should return ________, if the risk-free rate is 3% and the market return is 11%.

A) 16.5%
B) 14.0%
C) 14.5%
D) 15.0%

Question 80

The Elvis Alive Corporation, makers of Elvis memorabilia, has a beta of 2.35. The return on the market portfolio is 12%, and the risk-free rate is 2.5%. According to CAPM, what is the risk premium on a stock with a beta of 1.0?

A) 12.00%
B) 22.33%
C) 9.5%
D) 14.5%