You own a stock that you think will produce a return of 11 percent in a good economy and 3 percent in a poor economy. Given the probabilities of each state of the economy occurring, you anticipate that your stock will earn 6.5 percent next year. Which one of the following terms applies to this 6.5 percent?
answer
expected return
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Suzie owns five different bonds valued at $36,000 and twelve different stocks valued at $82,500 total. Which one of the following terms most applies to Suzie's investments?
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portfolio
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Steve has invested in twelve different stocks that have a combined value today of $121,300. Fifteen percent of that total is invested in Wise Man Foods. The 15 percent is a measure of which one of the following?
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portfolio weight
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Which one of the following is a risk that applies to most securities?
answer
systematic
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A news flash just appeared that caused about a dozen stocks to suddenly drop in value by about 20 percent. What type of risk does this news flash represent?
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unsystematic
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The principle of diversification tells us that:
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spreading an investment across many diverse assets will eliminate some of the total risk.
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The _____ tells us that the expected return on a risky asset depends only on that asset's nondiversifiable risk.
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systematic risk principle
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Which one of the following measures the amount of systematic risk present in a particular risky asset relative to the systematic risk present in an average risky asset?
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beta
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Which one of the following is a positively sloped linear function that is created when expected returns are graphed against security betas?
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security market line
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Which one of the following is represented by the slope of the security market line?
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market risk premium
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Which one of the following is the formula that explains the relationship between the expected return on a security and the level of that security's systematic risk?
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capital asset pricing model
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Treynor Industries is investing in a new project. The minimum rate of return the firm requires on this project is referred to as the:
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cost of capital.
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The expected return on a stock given various states of the economy is equal to the:
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weighted average of the returns for each economic state.
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The expected return on a stock computed using economic probabilities is:
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a mathematical expectation based on a weighted average and not an actual anticipated outcome.
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The expected risk premium on a stock is equal to the expected return on the stock minus the:
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risk-free rate.
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Standard deviation measures which type of risk?
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total
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The expected rate of return on a stock portfolio is a weighted average where the weights are based on the:
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market value of the investment in each stock.
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The expected return on a portfolio considers which of the following factors?
I. percentage of the portfolio invested in each individual security
II. projected states of the economy
III. the performance of each security given various economic states
IV. probability of occurrence for each state of the economy
answer
I, II, III, and IV
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The expected return on a portfolio:
I. can never exceed the expected return of the best performing security in the portfolio.
II. must be equal to or greater than the expected return of the worst performing security in the portfolio.
III. is independent of the unsystematic risks of the individual securities held in the portfolio.
IV. is independent of the allocation of the portfolio amongst individual securities.
answer
I, II, and III only
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If a stock portfolio is well diversified, then the portfolio variance:
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may be less than the variance of the least risky stock in the portfolio.
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The standard deviation of a portfolio:
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can be less than the standard deviation of the least risky security in the portfolio.
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The standard deviation of a portfolio:
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can be less than the weighted average of the standard deviations of the individual securities held in that portfolio.
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Which one of the following statements is correct concerning a portfolio of 20 securities with multiple states of the economy when both the securities and the economic states have unequal weights?
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Given both the unequal weights of the securities and the economic states, an investor might be able to create a portfolio that has an expected standard deviation of zero.
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Which one of the following events would be included in the expected return on Sussex stock?
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This morning, Sussex confirmed that its CEO is retiring at the end of the year as was anticipated.
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Which one of the following statements is correct?
A. The unexpected return is always negative.
B. The expected return minus the unexpected return is equal to the total return.
C. Over time, the average return is equal to the unexpected return.
D. The expected return includes the surprise portion of news announcements.
E. Over time, the average unexpected return will be zero.
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E. Over time, the average unexpected return will be zero.
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Which one of the following statements related to unexpected returns is correct?
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Unexpected returns can be either positive or negative in the short term but tend to be zero over the long-term.
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Which one of the following is an example of systematic risk?
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investors panic causing security prices around the globe to fall precipitously
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Unsystematic risk:
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can be effectively eliminated by portfolio diversification.
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Which one of the following is an example of unsystematic risk?
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consumer spending on entertainment decreased nationally
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Which one of the following is least apt to reduce the unsystematic risk of a portfolio?
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reducing the number of stocks held in the portfolio
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Which one of the following statements is correct concerning unsystematic risk?
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Eliminating unsystematic risk is the responsibility of the individual investor.
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Which one of the following statements related to risk is correct?
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The systematic risk of a portfolio can be effectively lowered by adding T-bills to the portfolio.
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Which one of the following risks is irrelevant to a well-diversified investor?
answer
unsystematic risk
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Which of the following are examples of diversifiable risk?
I. earthquake damages an entire town
II. federal government imposes a $100 fee on all business entities
III. employment taxes increase nationally
IV. toymakers are required to improve their safety standards
answer
I and IV only
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Which of the following statements are correct concerning diversifiable risks?
I. Diversifiable risks can be essentially eliminated by investing in thirty unrelated securities.
II. There is no reward for accepting diversifiable risks.
III. Diversifiable risks are generally associated with an individual firm or industry.
IV. Beta measures diversifiable risk.
answer
I, II and III only
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Which one of the following is the best example of a diversifiable risk?
A. interest rates increase
B. energy costs increase
C. core inflation increases
D. a firm's sales decrease
E. taxes decrease
answer
D. a firm's sales decrease
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Which of the following statements concerning risk are correct?
I. Nondiversifiable risk is measured by beta.
II. The risk premium increases as diversifiable risk increases.
III. Systematic risk is another name for nondiversifiable risk.
IV. Diversifiable risks are market risks you cannot avoid.
answer
I and III only
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The primary purpose of portfolio diversification is to:
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eliminate asset-specific risk.
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Which one of the following indicates a portfolio is being effectively diversified?
answer
a decrease in the portfolio standard deviation
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How many diverse securities are required to eliminate the majority of the diversifiable risk from a portfolio?
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10
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Systematic risk is measured by:
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beta
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Which one of the following is most directly affected by the level of systematic risk in a security?
answer
expected rate of return
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Which one of the following statements is correct concerning a portfolio beta?
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A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio.
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The systematic risk of the market is measured by:
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a beta of 1.0.
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At a minimum, which of the following would you need to know to estimate the amount of additional reward you will receive for purchasing a risky asset instead of a risk-free asset?
I. asset's standard deviation
II. asset's beta
III. risk-free rate of return
IV. market risk premium
answer
II and IV only
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Total risk is measured by _____ and systematic risk is measured by _____.
answer
standard deviation; beta
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The intercept point of the security market line is the rate of return which corresponds to:
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the risk-free rate.
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A stock with an actual return that lies above the security market line has:
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a higher return than expected for the level of risk assumed.
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The market rate of return is 11 percent and the risk-free rate of return is 3 percent. Lexant stock has 3 percent less systematic risk than the market and has an actual return of 12 percent. This stock:
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is underpriced.
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Which one of the following will be constant for all securities if the market is efficient and securities are priced fairly?
answer
reward-to-risk ratio
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The reward-to-risk ratio for stock A is less than the reward-to-risk ratio of stock B. Stock A has a beta of 0.82 and stock B has a beta of 1.29. This information implies that:
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either stock A is overpriced or stock B is underpriced or both.
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The market risk premium is computed by:
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subtracting the risk-free rate of return from the market rate of return.
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The excess return earned by an asset that has a beta of 1.34 over that earned by a risk-free asset is referred to as the:
answer
risk premium.
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The _____ of a security divided by the beta of that security is equal to the slope of the security market line if the security is priced fairly.
answer
risk premium
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The capital asset pricing model (CAPM) assumes which of the following?
I. a risk-free asset has no systematic risk.
II. beta is a reliable estimate of total risk.
III. the reward-to-risk ratio is constant.
IV. the market rate of return can be approximated.
answer
I, III, and IV only
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According to CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends upon the:
answer
market risk premium and the amount of systematic risk inherent in the security.
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Which one of the following should earn the most risk premium based on CAPM?
answer
stock with a beta of 1.38
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According to CAPM, the expected return on a risky asset depends on three components. Describe each component and explain its role in determining expected return.
answer
CAPM suggests the expected return is a function of (1) the risk-free rate of return, which is the pure time value of money, (2) the market risk premium, which is the reward for bearing systematic risk, and (3) beta, which is the amount of systematic risk present in a particular asset. Better answers will point out that both the pure time value of money and the reward for bearing systematic risk are exogenously determined and can change on a daily basis, while the amount of systematic risk for a particular asset is determined by the firm's decision-makers.
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Explain how the slope of the security market line is determined and why every stock that is correctly priced, according to CAPM, will lie on this line.
answer
The market risk premium is the slope of the security market line. Slope is the rise over the run, which in this case is the difference between the market return and the risk-free rate divided by a beta of 1.0 minus a beta of zero. If a stock is correctly priced the reward-to-risk ratio will be constant and equal to the slope of the security market line. Thus, every stock that is correctly priced will lie on the security market line.
question
Explain how the beta of a portfolio can equal the market beta if 50 percent of the portfolio is invested in a security that has twice the amount of systematic risk as an average risky security.
answer
An average risky security has a beta of 1.0, which is the market beta. Risk-free securities, i.e., U.S. Treasury bills, have a beta of zero. A portfolio that is invested 50 percent in a security that has a beta of 2.0 (twice the systematic risk as an average risky security) and 50 percent in risk-free securities (U.S. Treasury bills) will have a beta of 1.0 (which is the market beta).
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Explain the difference between systematic and unsystematic risk. Also explain why one of these types of risks is rewarded with a risk premium while the other type is not.
answer
Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated by investing in securities from various industries and geographic regions. Unsystematic risk is not rewarded since it can be eliminated by investors.
Systematic risk is risk which affects most, or all, securities and cannot be diversified away. Since systematic risk must be accepted by investors it is rewarded with a risk premium and is measured by beta.
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A portfolio beta is a weighted average of the betas of the individual securities which comprise the portfolio. However, the standard deviation is not a weighted average of the standard deviations of the individual securities which comprise the portfolio. Explain why this difference exists.
answer
Standard deviation measures total risk. The unsystematic portion of the total risk can be eliminated by diversification. Therefore, the total risk of a diversified portfolio is less than the total risk of the component parts. Beta, on the other hand, measures systematic risk, which cannot be eliminated by diversification. Thus, the systematic risk of a portfolio is the summation of the systematic risk of the component parts.
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