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Chapter 13 Return, Risk, and the Security Market Line 1. You believe that the possible returns on stock A will be either 25% or -15% over the coming year, depending on whether the economy does well or does poorly. Given some probabilities of the future state of the economy, you compute the standard deviation of the possible returns. To get the dispersion of the possible outcomes in the same units as the outcomes themselves (i.e., in percent), you must then compute the variance. Ans: False

Level: Basic

Subject: Variance

Type: Concepts

2. If the standard deviation of return on the stocks of the Dow Jones Industrial Average has been approximately 24% per year over the last decade, it must be true that half of the firms in the DJIA have a standard deviation of return below 24% over the same period. Ans: False

Level: Basic

Subject: Portfolio Variance

Type: Concepts

3. The realized return on an asset can be broken down into an expected component and a discounted component. Ans: False

Level: Basic

Subject: Realized Return

Type: Concepts

4. It is NOT possible to construct a portfolio with zero variance of expected returns from assets whose expected returns have positive variance individually. Ans: False

Level: Basic

Subject: Portfolio Risk

Type: Concepts

5. A market risk factor is a risk that influences only a small number of assets. Ans: False

Level: Basic

Subject: Systematic Risk

Type: Concepts

6. An example of systematic risk would be if the stock of the major airlines dropped after two airplanes crashed on the same day, making many passengers too nervous to fly. Ans: True

Level: Basic

Subject: Systematic Risk

Type: Concepts

7. Systematic risk is a type of risk that influences all assets to a greater or lesser degree. Ans: True

Level: Basic

Subject: Systematic Risk

Type: Concepts

8. Assume all of the stocks in a given industry fall as a result of an announcement about the general health of the economy. This is an example of systematic risk. Ans: True

Level: Basic

Subject: Systematic Risk

Type: Concepts

9. A unique risk is a risk that affects a relatively large number of the assets in the market. Ans: False

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

10. A firm in South Dakota announces a revolutionary way to make auto airbags in a way that decreases their risk to automobile occupants. This is a type of surprise that would be characterized as unsystematic risk. Ans: True

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

11. No matter how much total risk an asset has, only the unsystematic portion is relevant in determining the expected return on that asset. Ans: False

Level: Basic

Subject: Systematic Risk Principle

Type: Concepts

12. The projected risk premium is defined as the sum of the expected return on a risky investment and the return on a risk-free investment. Ans: False

Level: Basic

Subject: Risk Premiums

Type: Concepts

13. If world events cause investors to become more risk-averse, we would expect the market risk premium to increase. Ans: True

Level: Basic

Subject: Risk Premiums

Type: Concepts

14. If you invest in stocks with higher-than-average betas, you are certain to earn higher-than-average returns over the next year. Ans: False

Level: Basic

Subject: Systematic Risk

Type: Concepts

15. If the total risk of firm X is greater than that of firm Y, then the beta of firm X must be greater than that of firm Y. Ans: False

Level: Basic

Subject: Beta

Type: Concepts

16. A portfolio is _________________. A) a group of assets, such as stocks and bonds, held as a collective unit by an investor B) the expected return on a risky asset C) the expected return on a collection of risky assets D) the variance of returns for a risky asset E) the standard deviation of returns for a collection of risky assets Ans: A

Level: Basic

Subject: Portfolios

Type: Definitions

17. The percentage of a portfolio's total value invested in a particular asset is called that asset's: A) Portfolio return. B) Portfolio weight. C) Portfolio risk. D) Rate of return. E) Investment value. Ans: B

Level: Basic

Subject: Portfolio Weights

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

18. Risk that affects a large number of assets, each to a greater or lesser degree, is called: A) Idiosyncratic risk. B) Diversifiable risk. C) Systematic risk. D) Asset-specific risk. E) Total risk. Ans: C

Level: Basic

Subject: Systematic Risk

Type: Definitions

19. Risk that affects at most a small number of assets is called: A) Portfolio risk. B) Undiversifiable risk. C) Market risk. D) Unsystematic risk. E) Total risk. Ans: D

Level: Basic

Subject: Unsystematic Risk

Type: Definitions

20. The principle of diversification tells us that: A) Concentrating an investment in two or three large stocks will eliminate all of your risk. B) Concentrating an investment in two or three large stocks will reduce your overall risk. C) Spreading an investment across many diverse assets cannot (in an efficient market) eliminate any risk. D) Spreading an investment across many diverse assets will eliminate all of the risk. E) Spreading an investment across many diverse assets will eliminate some of the risk. Ans: E

Level: Basic

Subject: Principle Of Diversification

Type: Definitions

21. The __________________ tells us that the expected return on a risky asset depends only on that asset's systematic risk. A) Efficient Markets Hypothesis (EMH) B) systematic risk principle C) Open Markets Theorem D) Law of One Price E) principle of diversification Ans: B

Level: Basic

Subject: Systematic Risk Principle

Type: Definitions

22. The amount of systematic risk present in a particular risky asset, relative to the systematic risk present in an average risky asset, is called the particular asset's: A) Beta coefficient. B) Reward to risk ratio. C) Law of One Price. D) Diversifiable risk. E) Treynor index. Ans: A

Level: Basic

Subject: Beta Coefficient

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

23. A particular risky asset's risk premium, measured relative to its beta coefficient, is its: A) Diversifiable risk. B) Systematic risk. C) Reward to risk ratio. D) Security market line. E) Market risk premium. Ans: C

Level: Basic

Subject: Reward To Risk Ratio

Type: Definitions

24. The linear relation between an asset's expected return and its beta coefficient is the: A) Reward to risk ratio. B) Portfolio weight. C) Portfolio risk. D) Security market line. E) Market risk premium. Ans: D

Level: Basic

Subject: Security Market Line

Type: Definitions

25. The slope of an asset's security market line is the ________________. A) reward to risk ratio B) portfolio weight C) beta coefficient D) risk-free interest rate E) market risk premium Ans: E

Level: Basic

Subject: Market Risk Premium

Type: Definitions

26. Unsystematic risk is defined as the risk that: A) Affects almost every financial asset that is sold in the marketplace. B) Relates to the overall economy, such as inflation and GDP growth. C) Serves as the basis for determining the amount of the risk premium. D) Is derived from an event that affects a single firm or a limited number of assets. E) Is generated by expected news. Ans: D

Level: Basic

Subject: Unsystematic Risk

Type: Definitions

27. The risk-free rate of return subtracted from the expected market rate of return is called the: A) Expected rate of return. B) Real rate of expected return. C) Risk premium. D) Unexpected rate of return. E) Unsystematic rate of risk. Ans: C

Level: Basic

Subject: Risk Premium

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

28. The news that influences the unanticipated rate of return on a stock is called the: A) Surprise. B) Expected rate of return. C) Beta. D) Systematic risk. E) Asset-specific risk. Ans: A

Level: Basic

Subject: Surprise

Type: Definitions

29. The process of eliminating systematic risk through the purchase of a number of assets is called: A) Portfolio reduction. B) The systematic risk principle. C) The beta principle. D) The risk-reward slope. E) Portfolio diversification. Ans: E

Level: Basic

Subject: Diversification

Type: Definitions

30. The reward-to-risk ratio can be defined as the: A) Risk premium minus the risk-free rate of return. B) Market risk premium divided by the beta of a risky stock. C) Slope of the security market line. D) Beta of a risky stock. E) Market risk premium minus the risk free rate of return divided by a stock's beta. Ans: C

Level: Basic

Subject: Reward To Risk Ratio

Type: Definitions

31. Beta is defined as the: A) Slope of the security market line. B) Amount of systematic risk in a risky asset relative to that in an average asset. C) Ratio of unsystematic risk in a risky asset relative to the systematic risk in the overall market. D) Ratio of the total risk in a risky asset relative to the systematic risk in the overall market. E) Amount of systematic risk in a risky asset relative to that of a risk-free asset. Ans: B

Level: Basic

Subject: Beta

Type: Definitions

32. A portfolio beta can be defined as the: A) Weighted average of the betas of the individual securities within the portfolio. B) Total of the betas of the individual securities within the portfolio. C) Amount of unsystematic risk remaining after the portfolio is diversified. D) Measure of the unsystematic risk of the portfolio relative to the level of market risk. E) Measure of the total risk of the portfolio in excess of the level of market risk. Ans: A

Level: Basic

Subject: Portfolio Beta

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

33. The market risk premium can be defined as the: A) Return on the market plus the risk-free rate of return. B) Amount of return received for accepting unsystematic risk. C) Beta multiplied by the risk-free rate of return. D) Slope of the market portfolio's security market line. E) Intercept point of the security market line. Ans: D

Level: Basic

Subject: Market Risk Premium

Type: Definitions

34. The security market line can be defined as: A) Rm + (Rm - Rf). B) Rm + (Rf - Rm). C) Rf + (Rf - Rm). D) Rf + (Rm + Rf). E) Rf + (Rm - Rf). Ans: E

Level: Basic

Subject: Security Market Line

Type: Definitions

35. The pure time value of money is called the: A) Market rate of return. B) Risk-free rate of return. C) Beta adjusted market rate of return. D) Beta adjusted market risk premium. E) Beta adjusted risk-free rate of return. Ans: B

Level: Basic

Subject: Risk-Free Rate Of Return

Type: Definitions

36. Which of the following is a true statement? A) To calculate the expected risk premium one needs the expected return on the risky asset and the return on a risk-free asset. B) The risk premium is the difference between the return on a risky asset and the return on the market portfolio. C) The expected return on an asset is equal to the sum of the possible returns divided by their probabilities. D) Comparison of two different risky assets cannot be simplified by calculating the expected return for each. E) Expected returns depend on the states of the economy but not the associated probabilities. Ans: A

Level: Basic

Subject: Risk Premiums

Type: Concepts

37. When computing the expected return on a share of common stock (or other asset) where you have projected returns for each state of the economy along with associated probabilities of occurrence, A) the expected return is equal to the sum of the returns projected for each state of the economy B) the probabilities for the states must sum to 1 C) it is safe to ignore any states in which the return is negative D) if all of the state-returns and probabilities are positive, the total expected return must be higher than the highest state return E) the lowest projected state-return is guaranteed to be your largest loss if you buy the investment Ans: B

Level: Basic

Subject: Expected Returns

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

38. Which of the following statements is/are true about the variance of the possible future returns on a financial asset where you have multiple possible states of the economy along with associated probabilities of the states occurring? I. The variance is a simple average of the squared deviations of the actual returns from the expected returns II. The greater the dispersion in the possible returns on the firm's stock, the lower the variance of the possible returns, all else equal III. The variance of the possible returns on a risk-free asset is zero A) I only B) II only C) III only D) II and III only E) I, II, and III Ans: C

Level: Basic

Subject: Variance

Type: Concepts

39. Which of the following statements is/are true about the variance of the possible future returns on a financial asset? A) The standard deviation of the possible returns on an asset is equal to the square root of the variance of the possible returns B) Low-variance securities are high-standard deviation securities C) The variance and the standard deviation of the possible returns on a risk-free asset are negative D) Standard deviation of returns can be computed without considering probabilities, but variance cannot E) All else equal, assets with high average returns will also have high standard deviations relative to those with lower returns Ans: A

Level: Basic

Subject: Variance

Type: Concepts

40. Which of the following is true about calculating expected portfolio returns and variances? A) You need to calculate the weight of each asset relative to the total portfolio to calculate the portfolio return, but not to calculate the portfolio variance. B) Portfolio return can be calculated using the expected return and portfolio weight for each asset. C) The portfolio return is not needed to calculate the portfolio variance. D) The portfolio return and variance are independent of the possible states of nature. E) The portfolio variance is generally a weighted average of the variances of the individual assets in the portfolio. Ans: B

Level: Intermediate

Subject: Portfolio Return & Variance

Type: Concepts

41. If portfolio weights are positive: 1) Can the return on a portfolio ever be less than the smallest return on an individual security in the portfolio? 2) Can the variance of a portfolio ever be less than the smallest variance of an individual security in the portfolio? A) 1) yes; 2) yes B) 1) yes; 2) no C) 1) no; 2) yes D) 1) no; 2) no E) 1) maybe; 2) no Ans: C

Level: Intermediate

Subject: Portfolio Return & Variance

Copyright © 2005 McGraw-Hill Ryerson Limited.

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

42. You have a portfolio consisting of equal amounts of IBM stock and Treasury bills. If you replace half of the Treasury bills with more IBM stock, the portfolio expected return will likely ___________ , all else the same. A) increase B) decrease C) remain unchanged D) either increase or decrease E) decrease if IBM is considered a small-cap stock Ans: A

Level: Basic

Subject: Portfolio Return

Type: Concepts

43. Which of the following does NOT correctly complete this sentence: In general, the link between an information announcement and the stock price is that ____________________. A) the expected stock return will change if the announcement contains a surprise component B) the stock price will not change if the announcement provided only anticipated information C) only announcements that have already been discounted will affect the stock price D) in order for the price of the stock to change, the announcement must be relevant to that particular stock and must be unanticipated E) if markets are efficient in the semi-strong form, then the market will react rapidly to the new information Ans: C

Level: Basic

Subject: Efficient Markets

Type: Concepts

44. The return anticipated on a risky asset in the future is the ____________ return. A) unexpected B) expected C) actual D) unsystematic E) systematic Ans: B

Level: Basic

Subject: Expected Returns

Type: Concepts

45. The ____________ return is that portion of total return attributable to information surprises. A) unexpected B) expected C) actual D) systematic E) non-diversifiable Ans: A

Level: Basic

Subject: Unexpected Returns

Type: Concepts

46. The ____________ portion of the total return contains news that has been "discounted" by the market. A) unexpected B) expected C) actual D) unsystematic E) surprise Ans: B

Level: Basic

Subject: Expected Returns

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

47. You own a security with a return that rises as interest rates increase. If interest rates rise at a rate generally expected in the market, which of the following will likely occur? A) The security's return on investment will likely increase. B) The security's return on investment will likely remain unchanged. C) The security's return on investment will likely decrease. D) The market risk premium will likely increase. E) The security's market price will likely remain unchanged. Ans: B

Level: Basic

Subject: New Information

Type: Concepts

48. If the actual return on an investment is different from the expected return, then it is likely that A) when investors estimated the expected return they correctly weighed all of information that they believed would bear on the investment B) interest rates remained unchanged after the expected return was computed C) even though the expected return was incorrect, the normal return was estimated accurately D) some unanticipated information about the investment was revealed after the expected return was computed E) investors didn't use all relevant information that was available when computing the expected return. Ans: D

Level: Basic

Subject: Expected Returns

Type: Concepts

49. Brady Lady Cosmetics just announced that earnings for the first quarter of the current year grew at an annualized rate of 3%, well above the rate for the same quarter the previous year. Upon the announcement, the stock price did not change. (The market in general was unchanged also. ) Which of the following is most likely correct? A) Brady's price didn't change since the market was surprised by the announcement. B) Interest rates in the economy must have increased. C) Brady's price didn't change because investors likely anticipated the news release. D) Brady's price didn't change because the market in general was unchanged. E) Brady must have a beta coefficient equal to 1. Ans: C

Level: Basic

Subject: Expected Returns

Type: Concepts

50. The true risk of any investment is the __________________________. A) magnitude of the investment's return B) part of the return resulting from surprises C) expected part of any announcement D) impact of unsystematic risk E) risk premium of the investment Ans: B

Level: Basic

Subject: Relevant Risk

Type: Concepts

51. Unsystematic risk is also known as _____________________. A) total risk B) market risk C) asset-specific risk D) non-diversifiable risk E) specific risk Ans: C

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

52. Which of the following would be considered an example of unsystematic risk? I. Higher quarterly loss than expected for Procter and Gamble II. Lower consumer spending than expected III. Latest unemployment figures increased, as expected A) I only B) II only C) III only D) II and III only E) I and III only Ans: A

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

53. The stock price of a gold-mining firm drops when it is discovered the firm's chairman has overstated minable gold reserves. This is an example of a(n) ______________ risk factor. A) systematic B) non-diversifiable C) unsystematic D) market E) anticipated Ans: C

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

54. Which of the following would be considered an example of systematic risk? I. Lower trade deficit than expected II. Quarterly profit for GM equals expectations III. Lower quarterly sales for IBM than expected A) I only B) II only C) III only D) I and II only E) I, II, and III Ans: A

Level: Basic

Subject: Systematic Risk

Type: Concepts

55. Which (one or more) of the following would be considered an example of systematic risk? I. Higher quarterly loss than expected for Procter and Gamble II. Lower consumer spending than expected III. Higher unemployment, and therefore interest rates, than expected A) I only B) II only C) III only D) II and III only E) I and III only Ans: D

Level: Basic

Subject: Systematic Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

56. All else the same, actions or events that cause firm returns to be less correlated with changes in the economy will _______ the firm's systematic risk. A) increase B) decrease C) not affect D) affect (direction not determinable) E) increase the firm's unsystematic risk but not affect Ans: B

Level: Basic

Subject: Systematic Risk

Type: Concepts

57. Which of the following is a correct statement about diversification? A) Most diversification benefits are realized with just 10 stocks. B) Diversification is the process of reducing the riskiness associated with individual assets by spreading an investment across numerous assets. C) Diversifiable risk is the only risk that matters to a rational investor. D) When a stock is combined into a portfolio, the standard deviation of that portfolio remains unchanged. E) There is no limit to the amount of risk that can be eliminated through diversification. Ans: B

Level: Basic

Subject: Diversification

Type: Concepts

58. Diversification works because: I. Unsystematic risk exists. II. Forming stocks into portfolios reduces the standard deviation of returns for each stock. III. Firm-specific risk can be dramatically reduced if not eliminated. A) I only B) III only C) I and II only D) I and III only E) I, II, and III Ans: D

Level: Basic

Subject: Diversification

Type: Concepts

59. Which of the following is true concerning diversification? Assume that the securities being considered for selection into a portfolio are not perfectly correlated. A) The risk of the portfolio is certain to be increased as securities are added. B) As more securities are added to the portfolio, the market risk of the portfolio declines. C) After about 10 securities are added to the portfolio, additional securities have essentially no impact on reducing risk. D) As more and more securities are added to the portfolio, the level of risk approaches the level of systematic risk in the market. E) If you hold more than 100 securities, then the portfolio is risk-free. Ans: D

Level: Basic

Subject: Diversification

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

60. Systematic risk is considered important because ________________________. A) it is needed in order to measure the total risk of an asset B) the risk premium depends only on this type of risk C) the market does not provide a reward for this type of risk D) the risk premium depends on both systematic and unsystematic risk E) investors are willing to pay more for stocks with high systematic risk components Ans: B

Level: Basic

Subject: Systematic Risk

Type: Concepts

61. Which of the following does NOT describe the risk that exists in a well-diversified portfolio? A) Market risk B) Asset-specific risk C) Non-diversifiable risk D) Systematic risk Ans: B

Level: Basic

Subject: Systematic Risk

Type: Concepts

62. Which of the following would have the lowest amount of systematic risk? A) A portfolio of the common stocks of 100 different companies. B) The market portfolio. C) A portfolio half invested in the market portfolio and half invested in Treasury bills. D) A portfolio half invested in the market portfolio and half invested in stocks with betas = 1. 50. E) A portfolio made up entirely of Treasury bills. Ans: E

Level: Basic

Subject: Portfolio Systematic Risk

Type: Concepts

63. Which of the following would increase a portfolio's systematic risk? I. Common stock is sold and replaced with Treasury bills. II. Stocks with a beta equal to the market beta are added to a portfolio of Treasury bills. III. Low-beta stocks are sold and replaced with high-beta stocks. A) I only B) II only C) III only D) I and II only E) II and III only Ans: E

Level: Basic

Subject: Portfolio Systematic Risk

Type: Concepts

64. You sell some of your IBM common stock (which tends to move up and down with the economy as a whole) and replace it with the common stock of Fort Knox Gold Mining, Inc. (whose shares tend to rise when the economy falls, and vice versa). Your portfolio's beta should _______________. A) increase B) decrease C) remain unchanged D) either increase or decrease E) definitely exceed the beta of the market when all is said and done Ans: B

Level: Basic

Subject: Portfolio Systematic Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

65. Total risk equals _________________. A) market risk plus firm-specific risk B) firm-specific risk plus diversifiable risk C) systematic risk minus unsystematic risk D) diversifiable risk plus unsystematic risk E) market risk plus non-diversifiable risk Ans: A

Level: Basic

Subject: Total Risk

Type: Concepts

66. Which of the following statements is false? A) Total risk = market risk + unique risk. B) Total risk = systematic risk + unsystematic risk. C) Market risk = non-diversifiable risk + asset-specific risk. D) Announcement = expected part + surprise. E) Total return = expected return + unexpected return. Ans: C

Level: Basic

Subject: Total Risk

Type: Concepts

67. Aziz Equipment Co. invests in a group of risky projects, which increases the unsystematic risk of the firm, but does not change the systematic risk of the firm. All else the same, the expected risk premium on its common stock is most likely to: A) Increase, because the difference between the expected return on the firm's stock and the risk-free rate will widen. B) Decrease, because the difference between the expected return on the firm's stock and the risk-free rate will narrow. C) Remain unchanged, because the level of systematic risk is unchanged. D) Increase or decrease, depending on the internal rate of return of the new projects. E) None of the above Ans: C

Level: Basic

Subject: Expected Risk Premium

Type: Concepts

68. Which of the following is true regarding the beta coefficient? A) It is a measure of unsystematic risk. B) A beta greater than one represents lower systematic risk than the market. C) Generally speaking, the higher the beta the higher the expected return. D) A beta of one indicates an asset is totally risk-free. E) The risk premium of an asset will increase if the beta of that asset decreases. Ans: C

Level: Basic

Subject: Beta

Type: Concepts

69. You are looking at two different stocks. IBX has a beta of 1.25 and Microsquish has a beta of 1.95. Which statement is true about these investments? A) IBX is always a better addition to your portfolio. B) Microsquish is always a better addition to your portfolio. C) The expected return on IBX will be the higher of the two. D) You cannot tell which of the two will have the higher expected return without further information. E) The stock in IBX has the same reward to risk ratio as does Microsquish. Ans: E

Level: Basic

Subject: Beta Coefficients

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

70. An asset's undiversifiable risk is measured by its ______________. A) total return B) expected return C) variance of returns D) unexpected component of returns E) beta coefficient Ans: E

Level: Basic

Subject: Beta

Type: Concepts

71. Which of the following is/are true for a stock with beta equal to 1.5? I. The stock has a 50% higher expected return than the average stock. II. Given a market risk premium of 10%, the expected return on the stock would be 15%. III. The stock has 50% more systematic risk than the average stock. A) I only B) II only C) III only D) I and III only E) I, II, and III Ans: C

Level: Basic

Subject: Beta & Systematic Risk

Type: Concepts

72. If investors can freely trade assets in financial markets, then the impact of trading activity on expected returns insures that ________________________. A) all assets will have the same degree of systematic risk B) each firm's reward to risk ratio will be based on a different risk-free rate of return C) systematic risk can be diversified away D) assets will have the same reward to risk ratio E) all assets will have the same risk premium Ans: D

Level: Basic

Subject: Reward To Risk Ratio

Type: Concepts

73. Which of the following describes a portfolio that plots below the security market line? A) The security is undervalued. B) The security is providing a return that is greater than expected. C) The security's reward to risk ratio is too low. D) The security's beta is too low. E) The security provides a return that exceeds the average return on the market. Ans: C

Level: Basic

Subject: Security Market Line

Type: Concepts

74. Which of the following is true about the market portfolio? A) The expected return of the market portfolio determines the slope of the security market line. B) It plots below the security market line. C) It has a beta equal to zero. D) It consists of all the stocks on the TSX. E) It has a different reward to risk ratio than the individual assets in the market. Ans: A

Level: Basic

Subject: Market Portfolio

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

75. The CAPM shows that the expected return for a particular asset depends on: I. The amount of unsystematic risk. II. The reward for bearing systematic risk. III. The pure time value of money. A) I only B) I and II only C) III only D) II and III only E) I, II, and III Ans: D

Level: Basic

Subject: CAPM

Type: Concepts

76. Which of the following is correct regarding the CAPM? A) The expected return for a particular asset depends on the pure time value of money as measured by beta B) The expected return for a particular asset depends on the amount of systematic risk as measured by the risk free rate C) The standard deviation for a particular asset depends on the reward for bearing risk as measured by beta D) Implicit in the CAPM is that all risky assets have the same reward to risk ratio E) The SML and CAPM illustrate that the higher the beta, the lower the expected return Ans: D

Level: Basic

Subject: CAPM

Type: Concepts

77. The appropriate discount rate for a new investment project is: I. The minimum expected rate of return the investment must earn to be attractive to investors. II. The rate of return investments of similar risk earn in the market. III. The internal rate of return (IRR) for the project. A) I only B) II only C) II and III only D) I and II only E) I, II, and III Ans: D

Level: Basic

Subject: Discount Rate

Type: Concepts

78. The expected return on an individual asset depends only on that asset's ____ risk. A) Total B) Incremental C) Systematic D) Unsystematic E) Portfolio Ans: C

Level: Basic

Subject: Systematic Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

79. The principle of diversification states that spreading an investment over a number of assets will eliminate: A) All of the risk. B) All of the systematic risk and part of the unsystematic risk. C) All of the unsystematic risk and part of the systematic risk. D) Most of the systematic risk. E) Most of the unsystematic risk. Ans: E

Level: Intermediate

Subject: Diversification

Type: Concepts

80. Which one of the following stocks will have the highest risk premium? Stock Standard deviation Beta A) B) C) D) E)

A 4.00% 0.8

B 9.00% 1.1

C 11.00% 1.4

D 13.00% 1.3

E 7.00% 0.9

Stock A Stock B Stock C Stock D Stock E

Ans: C

Level: Basic

Subject: Beta

Type: Concepts

81. In a competitive market the reward to risk ratio can be expressed as: A) [E(Ra) - Rf] / ßa > [E(Rb) - Rf] / ßb B) [E(Ra) - Rf] / ßa = [E(Rb) - Rf] / ßb C) [E(Ra) - Rf] = ßa D) E(Ra) = E(Rb) E) E(Ra) - E(Rb) = Rf Ans: B

Level: Basic

Subject: Reward To Risk Ratio

Type: Concepts

82. Standard deviation measures the ____ risk and beta measures the ____ risk of a portfolio. A) Unsystematic; systematic B) Systematic; unsystematic C) Unsystematic; total D) Total; unsystematic E) Total; systematic Ans: E

Level: Basic

Subject: Standard Deviation And Beta

Type: Concepts

83. Investors are rewarded for the ____ risk they assume. A) Total B) Marginal C) Unsystematic D) Systematic E) Inflation adjusted Ans: D

Level: Basic

Subject: Systematic Risk

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

84. Systematic risks are _____ events and unsystematic risks are _____ events. A) Anticipated; anticipated B) Anticipated; unanticipated C) Unanticipated, anticipated D) Unanticipated; unanticipated Ans: D

Level: Intermediate

Subject: Unanticipated Events

Type: Concepts

85. Which of the following relationships are correct? I. Risk premium = Expected return - Risk-free rate II. Announcement = Expected part - Surprise III. Total risk - Systematic risk = Unsystematic risk IV. Slope of the SML = [E(RA) + Rf] / ßA A) I and II only B) III and IV only C) I and IV only D) II and III only E) I and III only Ans: E

Level: Intermediate

Subject: Formulas

Type: Concepts

86. Which of the following are examples of systematic risk? I. An increase in the rate of GDP growth II. An increase in the productivity of ABC Co. workers III. A decrease in the rate of inflation IV. A decrease in a firm's cost of borrowing A) I and II only B) I and III only C) II and IV only D) II and III only E) I, III, and IV only Ans: B

Level: Intermediate

Subject: Systematic Risk

Type: Concepts

87. Which one of the following is an example of diversifiable risk? A) A decrease in the average cost of living B) An increase in the federal funds rate C) An increase in the minimum hourly wage D) A new government regulation on aircraft engines E) A decrease in federal income taxes on business incomes Ans: D

Level: Intermediate

Subject: Diversifiable Risk

Type: Concepts

88. The steeper the slope of the security market line, the A) Higher the risk-free rate of return. B) Lower the risk-free rate of return. C) Higher the market beta. D) Higher the risk premium E) Lower the risk premium. Ans: D

Level: Intermediate

Subject: SML

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

89. The inclusion of thirty highly diverse securities in a portfolio eliminates the bulk of the ___ risk. A) Market B) Unique C) Unexpected D) Expected E) Inflation Ans: B

Level: Intermediate

Subject: Unique Risk

Type: Concepts

90. In a highly diversified portfolio, the standard deviation of the portfolio will be equal to: A) Zero. B) One. C) The portfolio beta. D) The systematic risk. E) The risk premium of the portfolio. Ans: D

Level: Intermediate

Subject: Standard Deviation

Type: Concepts

91. Which one of the following statements is correct about a portfolio that is invested 30% in stock A, 40% in stock B, and 30% in stock C? A) The expected return on the portfolio is equal to the summation of the returns on the individual securities within the portfolio divided by three. B) The standard deviation of the portfolio is equal to the summation of the weights of each security multiplied by the standard deviation of each respective security. C) The expected return on the portfolio is equal to the portfolio beta times the weighted average of the expected returns of each of the individual securities in the portfolio. D) The standard deviation of the portfolio is equal to the square root of the summation of the individual security variances. E) The expected return of the portfolio is equal to the risk free rate of return plus a risk premium based on a weighted average of the betas of the individual securities and the market risk premium. Ans: E

Level: Challenge

Subject: Portfolio Return And Standard Deviation

Type: Concepts

92. Suppose the Bank of Canada increased the rate on T-bills. As a result of this action, the security market line of a risky individual security would: A) Remain constant. B) Have an increased slope. C) Have a decreased slope. D) Increase in a parallel manner. E) Decrease in a parallel manner. Ans: D

Level: Intermediate

Subject: SML

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

93. Which one of the following statements concerning beta is correct? A) The beta of a portfolio must be greater than or equal to zero but less than or equal to one. B) The beta of a portfolio can be greater than the highest beta of an individual security within the portfolio. C) If the weights of the individual securities within a portfolio are changed, the beta of the portfolio will remain constant. D) The beta of a portfolio measures the systematic risk of the portfolio and has a value that can not exceed the value of the highest beta of any individual security in the portfolio. E) The beta of a portfolio measures the unsystematic risk of the portfolio and has a value that must be greater than or equal to zero. Ans: D

Level: Intermediate

Subject: Beta Coefficient

Type: Concepts

94. Theoretically, a risk-free portfolio could be created by combining risky securities in a manner that caused the: A) Portfolio standard deviation to equal one. B) Expected return of the portfolio to equal the market expected return. C) Portfolio beta to equal zero. D) Risk premium to equal one. E) Nondiversifiable risk to be eliminated. Ans: C

Level: Intermediate

Subject: Beta

Type: Concepts

95. Which one of the following will decrease the risk of a portfolio that consists of stocks, Canadian Treasury bills, and gold? A) Decreasing the number of securities in the portfolio B) Selling stocks and replacing them with Canadian Treasury bills C) Selling a .90 beta stock and buying a 1.1 beta stock D) Selling the gold and buying more diversified stocks E) Selling the large-company stocks and buying small-company stocks Ans: B

Level: Intermediate

Subject: Portfolio Risk

Type: Concepts

96. An asset that has an expected rate of return above the security market line: A) Is overpriced. B) Is underpriced. C) Is less risky than the market. D) Has a beta greater than 1. E) Has a standard deviation equal to 0. Ans: B

Level: Intermediate

Subject: SML

Type: Concepts

97. In a highly competitive market, all stocks should: A) Produce the same rate of return. B) Plot on the same security market line. C) Have the same beta. D) Have the same standard deviation. E) Plot at the intercept point. Ans: B

Level: Intermediate

Subject: SML

Type: Concepts

98. What is the expected return for the following stock? State Probability

Return

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line Average Recession Depression A) B) C) D) E)

.55 .20 .25

.20 .10 -.20

0.055 0.080 0.095 0.105 0.110

Ans: B

Level: Basic

Subject: Expected Return

Type: Problems

99. Which of the following stocks has the greatest expected return and by how much? State Probability Return on A Return on B Boom .1 .6 .4 Good .8 .3 .3 Recession .1 0 -.1 A) B) C) D) E)

A by 6% B by 6% A by 3% B by 3% A and B have the same expected return.

Ans: C

Level: Basic

Subject: Expected Return

Type: Problems

100. What is the risk premium for the following returns if the risk-free rate is 5%? State Probability Return Boom .15 .60 Good .50 .20 Recession .25 -.10 Depression .10 -.30 A) B) C) D) E)

0.085 0.100 0.125 0.135 0.175

Ans: A

Level: Basic

Subject: Risk Premiums

101. What is the variance of the following returns? State Probability Boom .15 Good .50 Recession .25 Depression .10

Type: Problems

Return .60 .20 -.10 -.30

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Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

0.0523 0.0673 0.0835 0.1324 0.4156

Ans: B

Level: Basic

Subject: Variance

Type: Problems

102. Ed Lawrence has $100,000 invested. Of that, $30,000 is invested in IBM stock, $25,000 is invested in Tbills, and the remainder is invested in corporate bonds. Which of the following is NOT correct regarding his portfolio weights? (All values are current market values. ) A) Ed has 30% of his portfolio invested in stocks. B) Ed has 45% of his portfolio invested in corporate bonds. C) Ed has 70% of his portfolio invested in assets other than stocks. D) Ed has 70% of his portfolio invested in risk-free assets. E) If Ed sells his corporate bonds and buys GM stock with the proceeds, he will end up with 75% of his portfolio invested in stocks. Ans: D

Level: Basic

Subject: Portfolio Weights

Type: Problems

103. You own 40 shares of stock A, which has a price of $15 per share, and 200 shares of stock B, which has a price of $2 per share. What is the portfolio weight for stock A in your portfolio? A) 18% B) 25% C) 40% D) 60% E) 75% Ans: D

Level: Basic

Subject: Portfolio Weights

Type: Problems

104. What is the expected portfolio return given the following information: Asset Portfolio Return weight A .25 15% B .25 20% C .30 10% D .20 35% A) B) C) D) E)

7.71% 9.23% 18.75% 19.25% 21.15%

Ans: C

Level: Basic

Subject: Portfolio Expected Return

105. What is the expected return for the following portfolio? Asset Investment A $200 B $300 C $500

Type: Problems

Return 0.15 0.10 0.25

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Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

0.1000 0.1150 0.1225 0.1550 0.1850

Ans: E

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

106. Given the following information, what is the portfolio standard deviation? State Probability Return Boom .2 .30 Good .6 .21 Recession .2 .08 A) B) C) D) E)

0.0128 0.0527 0.0638 0.0703 0.1159

Ans: D

Level: Basic

Subject: Portfolio Standard Deviation

Type: Problems

107. What is the portfolio beta if 75% of your money is invested in the market portfolio, and the remainder is invested in a risk-free asset? A) 0.50 B) 0.25 C) 1.25 D) 1.00 E) 0.75 Ans: E

Level: Basic

Subject: Portfolio Beta

Type: Problems

108. What is the portfolio beta with 125% of your funds invested in the market portfolio via borrowing 25% of the funds at the risk-free interest rate? A) 0.25 B) 0.50 C) 0.75 D) 1.00 E) 1.25 Ans: E

Level: Basic

Subject: Portfolio Beta

Type: Problems

109. What is the portfolio beta if 25% of your funds are invested in the market portfolio, 25% in an asset with twice as much risk as the market portfolio, and the remainder in a risk-free asset? A) 0.25 B) 0.50 C) 0.75 D) 1.00 E) 1.25 Ans: C

Level: Basic

Subject: Portfolio Beta

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

110. What is the beta for a portfolio equally weighted in four assets: A, the market portfolio; B, which has half the risk of A; C, which has twice the risk of A; and D, which is risk-free? A) 0.500 B) 0.750 C) 0.875 D) 1.250 E) 1.375 Ans: C

Level: Basic

Subject: Portfolio Beta

Type: Problems

111. You hold three stocks in your portfolio: A, B, and C. The portfolio beta is 1.50. Stock A comprises 20% of the dollar value of your holdings and has a beta of 1.0. If you sell all of your investment in A and invest the proceeds in the risk-free asset, your new portfolio beta will be: A) 0.850 B) 1.025 C) 1.200 D) 1.300 E) 1.625 Ans: D

Level: Basic

Subject: Portfolio Beta

Type: Problems

112. Port Company is financed entirely by equity and has three divisions. Division A is the stable products division, and has a beta of 0.8. Division B takes only projects with the same risk as the market portfolio. Division C is the research and development division, where the average beta of projects taken is 1.6. The firm's assets are divided equally (both in terms of market value and book value) among the three divisions. What is the beta of the firm? A) 0.80 B) 1.00 C) 1.03 D) 1.13 E) 1.33 Ans: D

Level: Basic

Subject: Portfolio Beta

Type: Problems

113. You own two risky assets, both of which plot on the security market line. Asset A has an expected return of 12% and a beta of 0.8. Asset B has an expected return of 18% and a beta of 1.4. If your portfolio beta is the same as the market portfolio, what proportion of your funds are invested in asset A? A) 0.33 B) 0.50 C) 0.67 D) 1.33 E) 1.67 Ans: C

Level: Basic

Subject: Portfolio Betas and Weights

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

114. You hold four stocks in your portfolio: A, B, C, and D. The portfolio beta is 1.20. Stock C comprises 40% of the dollar value of your holdings and has a beta of 1.60. If you sell all of your holdings in stock C, and replace it with an equal investment in stock E (which has a beta of 1.25), what will be your new portfolio beta? A) 1.00 B) 1.06 C) 1.12 D) 1.25 E) 1.32 Ans: B

Level: Basic

Subject: Portfolio Beta

115. What is the beta for the following portfolio? Stock A Investment ($) 15,000 Beta 0.6 A) B) C) D) E)

Type: Problems

B 10,000 0.9

C 25,000 1.6

D 12,500 1.1

E 17,500 0.0

0.80 0.88 0.90 0.93 0.98

Ans: C

Level: Basic

Subject: Portfolio Beta

Type: Problems

116. What is the beta of a portfolio made up of two risky assets and a risk-free asset? You invest 40% in asset A with a beta of 1.25 and 40% in asset B with a beta of 1.15. A) 0.84 B) 0.96 C) 1.03 D) 1.12 E) 1.20 Ans: B

Level: Basic

Subject: Portfolio Beta

Type: Problems

117. You form a portfolio by investing equally in A (beta=0.8), B (beta=1.2), the risk-free asset, and the market portfolio. What is your portfolio beta? A) 0.67 B) 0.75 C) 0.95 D) 1.12 E) 1.15 Ans: B

Level: Basic

Subject: Portfolio Beta

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

118. Given the following information: The risk-free rate is 7%, the beta of stock A is 1.2, the beta of stock B is 0.8, the expected return on stock A is 13.5%, and the expected return on stock B is 11.0%. Further, we know that stock A is fairly priced and that the betas of stocks A and B are correct. Which of the following regarding stock B must be true? A) Stock B is also fairly priced. B) The expected return on stock B is too high. C) The expected return on stock A is too high. D) The price of stock B is too high. E) The price of stock A is too high. Ans: D

Level: Basic

Subject: Reward To Risk Ratio

Type: Problems

119. Asset A has a reward to risk ratio of .075 and a beta of 1.5. The risk-free rate is 5%. What is the expected return on A? A) 11.25% B) 12.25% C) 13.50% D) 14.25% E) 16.25% Ans: E

Level: Basic

Subject: Reward To Risk Ratio

Type: Problems

120. Asset A, which has an expected return of 12% and a beta of 0.8, plots on the security market line. Which of the following is false about Asset B, another risky asset with a beta of 1.4? A) If the market is in equilibrium, Asset B also plots on the SML. B) If Asset B plots on the SML, then Asset B and Asset A have the same reward to risk ratio. C) Asset B has more systematic risk than both Asset A and the market portfolio. D) If Asset B plots on the SML with an expected return = 18%, then the risk-free rate must be 4%. E) If Asset B plots on the SML with an expected return = 18%, the expected return on the market must be 15%. Ans: E

Level: Basic

Subject: Security Market Line

Type: Problems

121. What is the expected return on asset A if it has a beta of 0.3, the expected market return is 14%, and the risk-free rate is 5%? A) 6.0% B) 9.2% C) 7.2% D) 7.7% E) 4.5% Ans: D

Level: Basic

Subject: CAPM

Type: Problems

122. What is the expected market return if the expected return on asset A is 16% and the risk-free rate is 7%? Asset A has a beta of 1.2. A) 9.5% B) 14.5% C) 16.5% D) 17.5% E) 20.5% Ans: B

Level: Basic

Subject: CAPM

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

123. Asset A has an expected return of 15%. The expected market return is 14% and the risk-free rate is 4%. What is asset A's beta? A) 0.80 B) 1.10 C) 1.40 D) 1.80 E) 2.00 Ans: B

Level: Basic

Subject: CAPM

Type: Problems

124. Asset A has an expected return of 22% and a beta of 1.8. The expected market return is 14%. What is the risk-free rate? A) 0.6% B) 1.2% C) 3.0% D) 4.0% E) 6.0% Ans: D

Level: Basic

Subject: CAPM

Type: Problems

125. Asset A has an expected return of 12% and a beta of 1.05. The risk-free rate is 4%. What is the market risk premium? A) 7.6% B) 8.2% C) 9.6% D) 10.2% E) 11.6% Ans: A

Level: Basic

Subject: CAPM

Type: Problems

Use the following to answer questions 126-128: Standard Deviation Security X Security Y Security Z

0.35 0.28 0.44

Beta 1.45 1.06 1.22

126. Which security has the greatest expected return? A) Y because it has the largest standard deviation. B) X because it has the largest beta coefficient. C) Z because it has the highest ratio of standard deviation to beta. D) Y because it has the lowest beta coefficient, and therefore the lowest risk. E) It is not possible to tell given the information above. Ans: B

Level: Basic

Subject: Expected Return

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

127. Which security has the greatest systematic risk? A) Z because it has the largest standard deviation. B) X because it has the largest beta coefficient. C) Z because it has a high beta and the largest standard deviation. D) Y because it has the greatest diversifiable risk. E) It is not possible to tell given the information above. Ans: B

Level: Basic

Subject: Systematic Risk

Type: Problems

128. Which of the following is correct? A) Security Z has the greatest total risk because it has the largest standard deviation. B) Security X has the greatest total risk because it has the largest beta. C) Security X has the greatest diversifiable risk because it has the largest beta. D) Security Y has the lowest total risk because it has the lowest beta. E) An equally-weighted portfolio of XYZ will have the same systematic risk as the market portfolio. Ans: A

Level: Basic

Subject: Total Risk

Type: Problems

Use the following to answer questions 129-132: State Boom Bust

Probability .6 .4

Return on A 0.15 0.05

Return on B 0.08 0.20

129. What is the expected return on security B? A) 0.080 B) 0.100 C) 0.110 D) 0.128 E) 0.138 Ans: D

Level: Basic

Subject: Expected Return

Type: Problems

130. What is the standard deviation of security A? A) 0.0002 B) 0.0006 C) 0.0490 D) 0.0545 E) 0.0600 Ans: C

Level: Basic

Subject: Standard Deviation

Type: Problems

131. What is the expected return on a portfolio that is 40% invested in A and 60% invested in B? A) 0.100 B) 0.110 C) 0.121 D) 0.128 E) 0.138 Ans: C

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

132. What is the expected return on a portfolio that is equally-weighted amongst A, B, and the risk-free asset? The expected return on the risk-free asset is 4%. A) 0.089 B) 0.093 C) 0.101 D) 0.118 E) 0.138 Ans: B

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

133. What is the standard deviation of a portfolio with one-quarter of the funds in A? A) 0.0008 B) 0.0065 C) 0.0089 D) 0.0103 E) 0.0320 Ans: E

Level: Intermediate

Subject: Portfolio Standard Deviation

Type: Problems

Use the following to answer questions 134-137: Security A B Risk-free asset

Return 15% 12% 5%

Standard Deviation 8% 14% ???

Beta 1.2 0.9 ???

134. Which of A and B has the least total risk? The least systematic risk? A) A; A B) A; B C) B D) B; B E) Cannot be determined without more information. Ans: B

Level: Intermediate

Subject: Total vs. Systematic Risk

Type: Problems

135. What is the value of systematic risk for a portfolio with 75% of the funds invested in A and 25% of the funds invested in B? A) 0.98 B) 1.13 C) 1.28 D) 1.40 E) 1.60 Ans: B

Level: Intermediate

Subject: Portfolio Beta

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

136. What is the portfolio expected return and the portfolio beta if you invest 30% in A, 30% in B and 40% in the risk-free asset? A) 9.6%; 1.32 B) 9.6%; 1.00 C) 10.1%; 0.95 D) 10.1%; 0.72 E) 10.1%; 0.63 Ans: E

Level: Intermediate

Subject: Portfolio Return & Beta

Type: Problems

137. What is the portfolio expected return with 125% invested in A and the remainder in the risk-free asset via borrowing at the risk-free interest rate? A) 9.8% B) 11.3% C) 16.8% D) 17.5% E) 20.1% Ans: D

Level: Intermediate

Subject: Portfolio Return With Short Position

Use the following to answer questions 138-142: State Boom Normal Bust

Probability .3 .6 .1

Return on A 12% 8% 4%

Return on B -2% 2% 6%

138. What is the expected return for asset A? A) 1.2% B) 4.0% C) 8.0% D) 8.8% E) 9.3% Ans: D

Level: Intermediate

Subject: Expected Return

Type: Problems

139. What is the standard deviation of returns for asset A? A) 1.3% B) 1.9% C) 2.5% D) 2.4% E) 6.4% Ans: D

Level: Basic

Subject: Standard Deviation

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Type: Problems

Chapter 13 Return, Risk, and the Security Market Line

140. What is the standard deviation of returns for asset B? A) 1.3% B) 1.9% C) 2.5% D) 2.4% E) 6.4% Ans: D

Level: Basic

Subject: Standard Deviation

Type: Problems

141. What is the expected return on a portfolio with weights of 60% in asset A and 40% in asset B? A) 2.2% B) 4.4% C) 5.8% D) 8.8% E) 9.9% Ans: C

Level: Basic

Subject: Portfolio Return

Type: Problems

142. What is the standard deviation of a portfolio with weights of 60% in security A and the remainder in security B? A) 0.5% B) 0.9% C) 1.5% D) 2.3% E) 6.4% Ans: A

Level: Basic

Subject: Portfolio Standard Deviation

Type: Problems

143. What is the portfolio weight of stock B given the following information? Stock A B C A) B) C) D) E)

Number of shares owned 150 100 200

Value per share $15.00 $25.00 $12.00

31% 33% 34% 35% 36%

Ans: D

Level: Basic

Subject: Portfolio Weights

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

144. You are planning on investing $5,000 in stock A. You currently own 500 shares of stock B with a market value of $25 a share and 300 shares of stock C with a market value of $18 a share. What percent of your portfolio will stock A assume once you complete your planned purchase? A) 22% B) 23% C) 24% D) 25% E) 27% Ans: A

Level: Basic

Subject: Portfolio Weights

Type: Problems

145. What is the expected return on the following stock? Economic State Probability of State Boom 15% Normal 65% Recession 20% A) B) C) D) E)

Return on Stock 28% 12% -30%

6% 9% 12% 15% 18%

Ans: A

Level: Basic

Subject: Expected Return

Type: Problems

146. You have 20% of your portfolio invested in stock A, 40% in stock B, and the balance in stock C. The expected returns on these three stocks are 14%, 3%, and 8%, respectively. What is the expected return on the portfolio? A) 6.40% B) 6.88% C) 7.20% D) 8.00% E) 8.88% Ans: C

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

147. You have 15% of your portfolio invested in stock A, 25% in stock B, 40% in stock C, and 20% in stock D. The expected returns on these four stocks are 18%, 3%, 9%, and -12%, respectively. What is the expected return on the portfolio? A) 4.65% B) 5.25% C) 5.60% D) 7.55% E) 9.45% Ans: A

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

148. What is the expected return on a portfolio that is invested 40% in stock A and 60% in stock B, given the following information? Economic State Normal Recession

Probability of State 70% 30%

Return on Stock A 12% -10%

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Return on Stock B 5% 8%

Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

5.40% 5.70% 6.40% 7.80% 8.10%

Ans: B

Level: Intermediate

Subject: Portfolio Expected Return

Type: Problems

149. What is the expected return on a portfolio that is invested 30% in stock A and 70% in stock B, given the following information? Economic State Normal Boom A) B) C) D) E)

Probability of State 80% 20%

Return on Stock A 8% 15%

Return on Stock B 6% 7%

5.28% 6.60% 7.16% 7.43% 7.90%

Ans: C

Level: Intermediate

Subject: Portfolio Expected Return

Type: Problems

150. What is the standard deviation of a portfolio that is invested 60% in stock A and 40% in stock B, given the following information? Economic State Normal Recession A) B) C) D) E)

Probability of State 30% 70%

Return on Stock A 13% -8%

Return on Stock B 3% 8%

1.58% 2.36% 4.06% 4.86% 5.51%

Ans: D

Level: Intermediate

Subject: Standard Deviation

Type: Problems

151. What is the standard deviation of a portfolio that is invested 40% in stock A and 60% in stock B, given the following information? Economic State Normal Boom

Probability of State 70% 30%

Return on Stock A 9% 14%

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Return on Stock B 12% 18%

Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

2.18% 2.57% 2.69% 2.84% 3.13%

Ans: B

Level: Intermediate

Subject: Standard Deviation

Type: Problems

152. You own a stock portfolio that is invested 10% in stock A, 30% in stock B, 40% in stock C, and 20% in stock D. These stocks have betas of 1.2, .8, 1.1, and 1.5, respectively. What is the beta of the portfolio? A) 1.04 B) 1.07 C) 1.10 D) 1.13 E) 1.14 Ans: C

Level: Intermediate

Subject: Portfolio Beta

Type: Problems

153. What is the beta of the following portfolio? Stock Amount Invested Stock Beta A) B) C) D) E)

A $5,000 1.20

B $10,000 1.80

C $15,000 0.70

.98 1.15 1.19 1.21 1.23

Ans: B

Level: Intermediate

Subject: Portfolio Beta

Type: Problems

154. A stock has a beta of 1.4. The expected return on the market is 8% and the T-bill is yielding 2%. What is the expected return on the stock? A) 8.40% B) 9.65% C) 10.40% D) 11.65% E) 13.20% Ans: C

Level: Intermediate

Subject: CAPM

Type: Problems

155. A stock has a beta of .8 and an expected return of 6%. The risk-free rate is 3%. What is the expected return on the market? A) 3.50% B) 3.75 C) 4.50% D) 5.25% E) 6.75% Ans: E

Level: Intermediate

Subject: CAPM

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

156. A stock has a beta of 1.2 and an expected return of 12%. The market is expected to yield 11%. What is the security market line intercept point? A) 0% B) 1.20% C) 3.5% D) 5.00% E) 6.00% Ans: E

Level: Intermediate

Subject: SML

Type: Problems

157. A stock has a beta of 1.4 and an expected return of 16%. The risk-free rate is 5%. What is the slope of the Security Market Line? A) 7.86% B) 7.98% C) 8.23% D) 8.67% E) 8.98% Ans: A

Level: Intermediate

Subject: Reward To Risk Ratio

Type: Problems

158. Which of the following stocks is (are) incorrectly priced if the risk-free rate is 4% and the market risk premium is 6%? Stock Beta Expected Return A) B) C) D) E)

A 1.25 12.60%

B 0.80 8.80%

C 1.06 11.20%

A only B only C only A and C only A, B, and C

Ans: D

Level: Intermediate

Subject: SML

Type: Problems

159. An investor has a portfolio comprised of stock A, which has a beta of 1.4 and an expected return of 10%, and Treasury bills, which have an expected return of 4%. The portfolio has an expected return of 7.30%. What is the portfolio weight of stock A? A) 40% B) 45% C) 50% D) 55% E) 60% Ans: D

Level: Intermediate

Subject: CAPM

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

160. An investor has a portfolio with an expected return of 11.19%. The portfolio is evenly invested in a stock and a risk-free asset. The market has an expected return of 17% and the risk-free asset has an expected return of 3%. What is the beta of the stock? A) .98 B) 1.17 C) 1.43 D) 1.62 E) 1.94 Ans: B

Level: Intermediate

Subject: CAPM

Type: Problems

161. You own a portfolio that is invested 50% in a risk-free asset and 50% in a stock that is equally as risky as the market. The risk-free asset has an expected return of 5%. Your portfolio has an expected return of 8.80%. What is the expected return on the market? A) 11.60% B) 11.75% C) 12.30% D) 12.35% E) 12.60% Ans: E

Level: Intermediate

Subject: CAPM

Type: Problems

162. A portfolio has an expected return of 13.12%. The portfolio is comprised of 60% stock A and 40% stock B. The risk-free rate of return is 4% and the market risk premium is 8%. The beta of stock B is .87. What is the reward-to-risk ratio of stock A? A) 1.28 B) 1.32 C) 1.36 D) 1.41 E) 1.46 Ans: B

Level: Challenge

Subject: Reward To Risk Ratio

Type: Problems

163. A portfolio has an expected return of 11.57%. The portfolio consists of stock A with an expected return of 8.6% and stock B with a beta of 1.28. The risk-free rate of return is 3% and the market risk premium is 8%. What is the portfolio weight of Stock A? A) 31% B) 32% C) 34% D) 36% E) 37% Ans: D

Level: Challenge

Subject: Portfolio Weight

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

164. Consider a day on which the Dow Jones Industrial Average, an average of 30 large stocks, rose 59 points. On that same day, IBM, which is one of the 30 stocks in the DJIA, announced some unexpectedly bad news. The price of IBM declined $10 on that same day. Using this example, discuss systematic risk, portfolio diversification, and asset specific risk. Ans: Asset specific risk is obviously the negative announcement coming from IBM, resulting in a decline in the stock's price. The principle of systematic risk is evident in that the market in general was advancing. Finally, the deeper part of this question is that students should recognize that any investor who held IBM alone on this particular day lost money. However, anyone who owned IBM in a well diversified portfolio, such as the DJIA, made money in spite of IBM's decline within the portfolio. This clearly demonstrates the value of portfolio diversification. Level: Challenge

Subject: Portfolio Diversification

Type: Essays

165. Why are some risks diversifiable and some nondiversifiable? Give an example of each. Ans: A reasonable answer would, at a minimum, explain that some risks (diversifiable) affect only a specific security, and when put into a portfolio, losses as a result of these firm-specific events will tend to be offset by price gains amongst other securities. Nondiversifiable risk, however, is unavoidable because such risks affect all or almost all securities in the market and can't be eliminated by forming portfolios. In the second part of the question, the students get a chance to use a minor amount of imagination. A strong answer would note the dependence of diversification effects on the degree of correlation between the assets used to form portfolios. Level: Intermediate

Subject: Diversifiable Risk

Type: Essays

166. We routinely assume that investors are risk-averse return-seekers; i.e., they like returns and dislike risk. If so, why do we contend that only systematic risk is important? (Alternatively, why is total risk not important to investors, in and of itself?) Ans: This question, of course, gets to the point of the chapter: That rational investors will diversify away as much risk as possible. From the discussion in the text, most students will also have picked up that it is quite easy to eliminate diversifiable risk in practice, either by holding portfolios with 15 to 25 assets, or by holding shares in a diversified mutual fund. And, as noted in the text, there will be no return for bearing diversifiable risk, thus, total risk is not particularly important to a diversified investor. Level: Intermediate

Subject: Risk

Type: Essays

167. Explain in words what beta is and why it is important. Ans: This is a concept check question that requires students to put into words that beta is a measure of systematic risk, the only risk an investor can expect to earn compensation for bearing. Beta specifically measures the amount of systematic risk an asset has relative to an average asset. Level: Basic

Subject: Beta

Type: Essays

168. Is it possible for an asset to have a negative beta? (Hint: yes. ) What would the expected return on such an asset be? Why? Ans: While it is unlikely to observe a negative beta asset, it would have less systematic risk than the riskfree asset and would be expected to provide an even lower return. One possibility often cited is that of gold. The return would be less than the risk-free rate because, while the risk-free rate is determined by changes in inflation and the business cycle for the economy at large, gold, as an ultimate store of value, is not affected by these factors (at least to the same degree) . Level: Intermediate

Subject: Negative Beta

Type: Essays

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

169. Explain what we mean when we say all assets have the same reward to risk ratio. What does this mean for investors? Ans: A constant reward to risk ratio means that the reward for bearing risk, measured as the risk premium, increases as the amount of risk, measured by beta, also increases. Investors who are risk averse will not consider taking additional risk if they expect to receive no additional compensation for doing so. This is an equilibrium concept which essentially restates the axiom that prices observed in efficient markets are considered fair. Level: Intermediate

Subject: Reward To Risk Ratio

Type: Essays

170. Draw the SML and plot asset C such that it has less risk than the market but plots above the SML, and asset D such that it has more risk than the market and plots below the SML. (Be sure to indicate where the market portfolio is on your graph. ) Explain how assets like C or D can plot as they do and explain why such pricing cannot persist in a market that is in equilibrium. Ans: The student should draw a picture similar to Figure 13.9, adding a point where the market portfolio exists. In this case, asset C is underpriced and asset D is overpriced. This condition cannot persist in equilibrium because investors will buy C with its high expected return and sell D with its low expected return. The resultant buy and sell activity will force the prices back to a level that eventually causes both C and D to plot on the SML. Level: Challenge

Subject: Security Market Line

Type: Essays

171. According to the CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return. Ans: The CAPM suggests that expected return is a function of (1) the pure time value of money, (2) the reward for bearing systematic risk, and (3) the amount of systematic risk present in a particular asset. Better students 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. Level: Challenge

Subject: CAPM

Type: Essays

172. Write out the equation for the CAPM. Using the symbols in the model, identify the expected return on each of three assets: Asset A has a beta of one, Asset B has a beta of zero, and Asset C has a beta of negative one. In each case, interpret your result. Ans: This is a relatively straightforward application of the CAPM, but it does require students to fully understand the implications of the model. Clearly, Asset A is expected to earn the market return while Asset B is expected to earn the risk free rate. Asset C is a little tougher to explain. Students would likely expect that since it has a beta of negative one, it should have an expected return equal to the negative of the market return. However, it is expected to earn 2Rf - E(Rm). Level: Challenge

Subject: CAPM

Type: Essays

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

173. In the first chapter, it was stated that financial managers should act to maximize shareholder wealth. Why are the efficient markets hypothesis (EMH), the CAPM, and the SML so important in the accomplishment of this objective? Ans: In simple terms, one could say that maximizing shareholder wealth by maximizing the current share price (Chapter 1) is a reasonable objective if and only if we have some assurance that observed prices are meaningful; i.e., that they reflect the value of the firm. This is a major implication of the EMH. Further, if we are to be able to assess the wealth effects of future decisions on security and firm values, we must have a valuation model whose parameters can be shown to be affected by those decisions (Chapters 7 & 8). Finally, any valuation model we employ will require us to quantify return and risk (Chapters 12 and 13). Level: Challenge

Subject: EMH, CAPM, & The Market Value Rule

Type: Essays

174. In the previous chapter, we dealt with historical returns and variances. In this chapter, we focused on expected returns. Why did we need to make the switch from historical to expected? Why not use historical returns for both chapters or else use expected returns for both chapters? Ans: In general, the historical data is useful for illustrating the relationship between risk and return and for demonstrating the two lessons from capital market history. However, to completely understand risk as it relates to the future we need to deal with expected returns. Most importantly, by using expected returns we can discuss surprises, with the end result of presenting the SML and CAPM. Level: Challenge

Subject: Expected vs. Historical Returns

Type: Essays

175. Explain why in a highly competitive market all stocks should plot on the same security market line. Ans: The security market line for all stocks will have the same intercept point, which is the risk-free rate of return as represented by the Treasury bill rate. In a highly competitive market, all stocks should be priced correctly so that the risk-reward ratio is constant. A constant risk-reward ratio would cause all stocks to plot on the same security market line due to the fact that the risk-reward ratio is the slope of that line. Level: Intermediate

Subject: Competitive Markets And The SML

Type: Essays

176. Give some examples to explain how diversification actually works to reduce portfolio risk. Ans: Student answers will vary. All stocks possess risk due to unexpected events. By owning stocks in different industries, the odds are increased that a negative event in one industry will be offset by a positive event in another industry. These offsetting events can then help reduce the unsystematic risk. Level: Intermediate

Subject: Diversification

Type: Essays

Copyright © 2005 McGraw-Hill Ryerson Limited.

Page 38

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Level: Basic

Subject: Variance

Type: Concepts

2. If the standard deviation of return on the stocks of the Dow Jones Industrial Average has been approximately 24% per year over the last decade, it must be true that half of the firms in the DJIA have a standard deviation of return below 24% over the same period. Ans: False

Level: Basic

Subject: Portfolio Variance

Type: Concepts

3. The realized return on an asset can be broken down into an expected component and a discounted component. Ans: False

Level: Basic

Subject: Realized Return

Type: Concepts

4. It is NOT possible to construct a portfolio with zero variance of expected returns from assets whose expected returns have positive variance individually. Ans: False

Level: Basic

Subject: Portfolio Risk

Type: Concepts

5. A market risk factor is a risk that influences only a small number of assets. Ans: False

Level: Basic

Subject: Systematic Risk

Type: Concepts

6. An example of systematic risk would be if the stock of the major airlines dropped after two airplanes crashed on the same day, making many passengers too nervous to fly. Ans: True

Level: Basic

Subject: Systematic Risk

Type: Concepts

7. Systematic risk is a type of risk that influences all assets to a greater or lesser degree. Ans: True

Level: Basic

Subject: Systematic Risk

Type: Concepts

8. Assume all of the stocks in a given industry fall as a result of an announcement about the general health of the economy. This is an example of systematic risk. Ans: True

Level: Basic

Subject: Systematic Risk

Type: Concepts

9. A unique risk is a risk that affects a relatively large number of the assets in the market. Ans: False

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

10. A firm in South Dakota announces a revolutionary way to make auto airbags in a way that decreases their risk to automobile occupants. This is a type of surprise that would be characterized as unsystematic risk. Ans: True

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

Page 1

Chapter 13 Return, Risk, and the Security Market Line

11. No matter how much total risk an asset has, only the unsystematic portion is relevant in determining the expected return on that asset. Ans: False

Level: Basic

Subject: Systematic Risk Principle

Type: Concepts

12. The projected risk premium is defined as the sum of the expected return on a risky investment and the return on a risk-free investment. Ans: False

Level: Basic

Subject: Risk Premiums

Type: Concepts

13. If world events cause investors to become more risk-averse, we would expect the market risk premium to increase. Ans: True

Level: Basic

Subject: Risk Premiums

Type: Concepts

14. If you invest in stocks with higher-than-average betas, you are certain to earn higher-than-average returns over the next year. Ans: False

Level: Basic

Subject: Systematic Risk

Type: Concepts

15. If the total risk of firm X is greater than that of firm Y, then the beta of firm X must be greater than that of firm Y. Ans: False

Level: Basic

Subject: Beta

Type: Concepts

16. A portfolio is _________________. A) a group of assets, such as stocks and bonds, held as a collective unit by an investor B) the expected return on a risky asset C) the expected return on a collection of risky assets D) the variance of returns for a risky asset E) the standard deviation of returns for a collection of risky assets Ans: A

Level: Basic

Subject: Portfolios

Type: Definitions

17. The percentage of a portfolio's total value invested in a particular asset is called that asset's: A) Portfolio return. B) Portfolio weight. C) Portfolio risk. D) Rate of return. E) Investment value. Ans: B

Level: Basic

Subject: Portfolio Weights

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

Page 2

Chapter 13 Return, Risk, and the Security Market Line

18. Risk that affects a large number of assets, each to a greater or lesser degree, is called: A) Idiosyncratic risk. B) Diversifiable risk. C) Systematic risk. D) Asset-specific risk. E) Total risk. Ans: C

Level: Basic

Subject: Systematic Risk

Type: Definitions

19. Risk that affects at most a small number of assets is called: A) Portfolio risk. B) Undiversifiable risk. C) Market risk. D) Unsystematic risk. E) Total risk. Ans: D

Level: Basic

Subject: Unsystematic Risk

Type: Definitions

20. The principle of diversification tells us that: A) Concentrating an investment in two or three large stocks will eliminate all of your risk. B) Concentrating an investment in two or three large stocks will reduce your overall risk. C) Spreading an investment across many diverse assets cannot (in an efficient market) eliminate any risk. D) Spreading an investment across many diverse assets will eliminate all of the risk. E) Spreading an investment across many diverse assets will eliminate some of the risk. Ans: E

Level: Basic

Subject: Principle Of Diversification

Type: Definitions

21. The __________________ tells us that the expected return on a risky asset depends only on that asset's systematic risk. A) Efficient Markets Hypothesis (EMH) B) systematic risk principle C) Open Markets Theorem D) Law of One Price E) principle of diversification Ans: B

Level: Basic

Subject: Systematic Risk Principle

Type: Definitions

22. The amount of systematic risk present in a particular risky asset, relative to the systematic risk present in an average risky asset, is called the particular asset's: A) Beta coefficient. B) Reward to risk ratio. C) Law of One Price. D) Diversifiable risk. E) Treynor index. Ans: A

Level: Basic

Subject: Beta Coefficient

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

Page 3

Chapter 13 Return, Risk, and the Security Market Line

23. A particular risky asset's risk premium, measured relative to its beta coefficient, is its: A) Diversifiable risk. B) Systematic risk. C) Reward to risk ratio. D) Security market line. E) Market risk premium. Ans: C

Level: Basic

Subject: Reward To Risk Ratio

Type: Definitions

24. The linear relation between an asset's expected return and its beta coefficient is the: A) Reward to risk ratio. B) Portfolio weight. C) Portfolio risk. D) Security market line. E) Market risk premium. Ans: D

Level: Basic

Subject: Security Market Line

Type: Definitions

25. The slope of an asset's security market line is the ________________. A) reward to risk ratio B) portfolio weight C) beta coefficient D) risk-free interest rate E) market risk premium Ans: E

Level: Basic

Subject: Market Risk Premium

Type: Definitions

26. Unsystematic risk is defined as the risk that: A) Affects almost every financial asset that is sold in the marketplace. B) Relates to the overall economy, such as inflation and GDP growth. C) Serves as the basis for determining the amount of the risk premium. D) Is derived from an event that affects a single firm or a limited number of assets. E) Is generated by expected news. Ans: D

Level: Basic

Subject: Unsystematic Risk

Type: Definitions

27. The risk-free rate of return subtracted from the expected market rate of return is called the: A) Expected rate of return. B) Real rate of expected return. C) Risk premium. D) Unexpected rate of return. E) Unsystematic rate of risk. Ans: C

Level: Basic

Subject: Risk Premium

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

Page 4

Chapter 13 Return, Risk, and the Security Market Line

28. The news that influences the unanticipated rate of return on a stock is called the: A) Surprise. B) Expected rate of return. C) Beta. D) Systematic risk. E) Asset-specific risk. Ans: A

Level: Basic

Subject: Surprise

Type: Definitions

29. The process of eliminating systematic risk through the purchase of a number of assets is called: A) Portfolio reduction. B) The systematic risk principle. C) The beta principle. D) The risk-reward slope. E) Portfolio diversification. Ans: E

Level: Basic

Subject: Diversification

Type: Definitions

30. The reward-to-risk ratio can be defined as the: A) Risk premium minus the risk-free rate of return. B) Market risk premium divided by the beta of a risky stock. C) Slope of the security market line. D) Beta of a risky stock. E) Market risk premium minus the risk free rate of return divided by a stock's beta. Ans: C

Level: Basic

Subject: Reward To Risk Ratio

Type: Definitions

31. Beta is defined as the: A) Slope of the security market line. B) Amount of systematic risk in a risky asset relative to that in an average asset. C) Ratio of unsystematic risk in a risky asset relative to the systematic risk in the overall market. D) Ratio of the total risk in a risky asset relative to the systematic risk in the overall market. E) Amount of systematic risk in a risky asset relative to that of a risk-free asset. Ans: B

Level: Basic

Subject: Beta

Type: Definitions

32. A portfolio beta can be defined as the: A) Weighted average of the betas of the individual securities within the portfolio. B) Total of the betas of the individual securities within the portfolio. C) Amount of unsystematic risk remaining after the portfolio is diversified. D) Measure of the unsystematic risk of the portfolio relative to the level of market risk. E) Measure of the total risk of the portfolio in excess of the level of market risk. Ans: A

Level: Basic

Subject: Portfolio Beta

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited.

Page 5

Chapter 13 Return, Risk, and the Security Market Line

33. The market risk premium can be defined as the: A) Return on the market plus the risk-free rate of return. B) Amount of return received for accepting unsystematic risk. C) Beta multiplied by the risk-free rate of return. D) Slope of the market portfolio's security market line. E) Intercept point of the security market line. Ans: D

Level: Basic

Subject: Market Risk Premium

Type: Definitions

34. The security market line can be defined as: A) Rm + (Rm - Rf). B) Rm + (Rf - Rm). C) Rf + (Rf - Rm). D) Rf + (Rm + Rf). E) Rf + (Rm - Rf). Ans: E

Level: Basic

Subject: Security Market Line

Type: Definitions

35. The pure time value of money is called the: A) Market rate of return. B) Risk-free rate of return. C) Beta adjusted market rate of return. D) Beta adjusted market risk premium. E) Beta adjusted risk-free rate of return. Ans: B

Level: Basic

Subject: Risk-Free Rate Of Return

Type: Definitions

36. Which of the following is a true statement? A) To calculate the expected risk premium one needs the expected return on the risky asset and the return on a risk-free asset. B) The risk premium is the difference between the return on a risky asset and the return on the market portfolio. C) The expected return on an asset is equal to the sum of the possible returns divided by their probabilities. D) Comparison of two different risky assets cannot be simplified by calculating the expected return for each. E) Expected returns depend on the states of the economy but not the associated probabilities. Ans: A

Level: Basic

Subject: Risk Premiums

Type: Concepts

37. When computing the expected return on a share of common stock (or other asset) where you have projected returns for each state of the economy along with associated probabilities of occurrence, A) the expected return is equal to the sum of the returns projected for each state of the economy B) the probabilities for the states must sum to 1 C) it is safe to ignore any states in which the return is negative D) if all of the state-returns and probabilities are positive, the total expected return must be higher than the highest state return E) the lowest projected state-return is guaranteed to be your largest loss if you buy the investment Ans: B

Level: Basic

Subject: Expected Returns

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

38. Which of the following statements is/are true about the variance of the possible future returns on a financial asset where you have multiple possible states of the economy along with associated probabilities of the states occurring? I. The variance is a simple average of the squared deviations of the actual returns from the expected returns II. The greater the dispersion in the possible returns on the firm's stock, the lower the variance of the possible returns, all else equal III. The variance of the possible returns on a risk-free asset is zero A) I only B) II only C) III only D) II and III only E) I, II, and III Ans: C

Level: Basic

Subject: Variance

Type: Concepts

39. Which of the following statements is/are true about the variance of the possible future returns on a financial asset? A) The standard deviation of the possible returns on an asset is equal to the square root of the variance of the possible returns B) Low-variance securities are high-standard deviation securities C) The variance and the standard deviation of the possible returns on a risk-free asset are negative D) Standard deviation of returns can be computed without considering probabilities, but variance cannot E) All else equal, assets with high average returns will also have high standard deviations relative to those with lower returns Ans: A

Level: Basic

Subject: Variance

Type: Concepts

40. Which of the following is true about calculating expected portfolio returns and variances? A) You need to calculate the weight of each asset relative to the total portfolio to calculate the portfolio return, but not to calculate the portfolio variance. B) Portfolio return can be calculated using the expected return and portfolio weight for each asset. C) The portfolio return is not needed to calculate the portfolio variance. D) The portfolio return and variance are independent of the possible states of nature. E) The portfolio variance is generally a weighted average of the variances of the individual assets in the portfolio. Ans: B

Level: Intermediate

Subject: Portfolio Return & Variance

Type: Concepts

41. If portfolio weights are positive: 1) Can the return on a portfolio ever be less than the smallest return on an individual security in the portfolio? 2) Can the variance of a portfolio ever be less than the smallest variance of an individual security in the portfolio? A) 1) yes; 2) yes B) 1) yes; 2) no C) 1) no; 2) yes D) 1) no; 2) no E) 1) maybe; 2) no Ans: C

Level: Intermediate

Subject: Portfolio Return & Variance

Copyright © 2005 McGraw-Hill Ryerson Limited.

Type: Concepts

Page 7

Chapter 13 Return, Risk, and the Security Market Line

42. You have a portfolio consisting of equal amounts of IBM stock and Treasury bills. If you replace half of the Treasury bills with more IBM stock, the portfolio expected return will likely ___________ , all else the same. A) increase B) decrease C) remain unchanged D) either increase or decrease E) decrease if IBM is considered a small-cap stock Ans: A

Level: Basic

Subject: Portfolio Return

Type: Concepts

43. Which of the following does NOT correctly complete this sentence: In general, the link between an information announcement and the stock price is that ____________________. A) the expected stock return will change if the announcement contains a surprise component B) the stock price will not change if the announcement provided only anticipated information C) only announcements that have already been discounted will affect the stock price D) in order for the price of the stock to change, the announcement must be relevant to that particular stock and must be unanticipated E) if markets are efficient in the semi-strong form, then the market will react rapidly to the new information Ans: C

Level: Basic

Subject: Efficient Markets

Type: Concepts

44. The return anticipated on a risky asset in the future is the ____________ return. A) unexpected B) expected C) actual D) unsystematic E) systematic Ans: B

Level: Basic

Subject: Expected Returns

Type: Concepts

45. The ____________ return is that portion of total return attributable to information surprises. A) unexpected B) expected C) actual D) systematic E) non-diversifiable Ans: A

Level: Basic

Subject: Unexpected Returns

Type: Concepts

46. The ____________ portion of the total return contains news that has been "discounted" by the market. A) unexpected B) expected C) actual D) unsystematic E) surprise Ans: B

Level: Basic

Subject: Expected Returns

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

47. You own a security with a return that rises as interest rates increase. If interest rates rise at a rate generally expected in the market, which of the following will likely occur? A) The security's return on investment will likely increase. B) The security's return on investment will likely remain unchanged. C) The security's return on investment will likely decrease. D) The market risk premium will likely increase. E) The security's market price will likely remain unchanged. Ans: B

Level: Basic

Subject: New Information

Type: Concepts

48. If the actual return on an investment is different from the expected return, then it is likely that A) when investors estimated the expected return they correctly weighed all of information that they believed would bear on the investment B) interest rates remained unchanged after the expected return was computed C) even though the expected return was incorrect, the normal return was estimated accurately D) some unanticipated information about the investment was revealed after the expected return was computed E) investors didn't use all relevant information that was available when computing the expected return. Ans: D

Level: Basic

Subject: Expected Returns

Type: Concepts

49. Brady Lady Cosmetics just announced that earnings for the first quarter of the current year grew at an annualized rate of 3%, well above the rate for the same quarter the previous year. Upon the announcement, the stock price did not change. (The market in general was unchanged also. ) Which of the following is most likely correct? A) Brady's price didn't change since the market was surprised by the announcement. B) Interest rates in the economy must have increased. C) Brady's price didn't change because investors likely anticipated the news release. D) Brady's price didn't change because the market in general was unchanged. E) Brady must have a beta coefficient equal to 1. Ans: C

Level: Basic

Subject: Expected Returns

Type: Concepts

50. The true risk of any investment is the __________________________. A) magnitude of the investment's return B) part of the return resulting from surprises C) expected part of any announcement D) impact of unsystematic risk E) risk premium of the investment Ans: B

Level: Basic

Subject: Relevant Risk

Type: Concepts

51. Unsystematic risk is also known as _____________________. A) total risk B) market risk C) asset-specific risk D) non-diversifiable risk E) specific risk Ans: C

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

52. Which of the following would be considered an example of unsystematic risk? I. Higher quarterly loss than expected for Procter and Gamble II. Lower consumer spending than expected III. Latest unemployment figures increased, as expected A) I only B) II only C) III only D) II and III only E) I and III only Ans: A

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

53. The stock price of a gold-mining firm drops when it is discovered the firm's chairman has overstated minable gold reserves. This is an example of a(n) ______________ risk factor. A) systematic B) non-diversifiable C) unsystematic D) market E) anticipated Ans: C

Level: Basic

Subject: Unsystematic Risk

Type: Concepts

54. Which of the following would be considered an example of systematic risk? I. Lower trade deficit than expected II. Quarterly profit for GM equals expectations III. Lower quarterly sales for IBM than expected A) I only B) II only C) III only D) I and II only E) I, II, and III Ans: A

Level: Basic

Subject: Systematic Risk

Type: Concepts

55. Which (one or more) of the following would be considered an example of systematic risk? I. Higher quarterly loss than expected for Procter and Gamble II. Lower consumer spending than expected III. Higher unemployment, and therefore interest rates, than expected A) I only B) II only C) III only D) II and III only E) I and III only Ans: D

Level: Basic

Subject: Systematic Risk

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

56. All else the same, actions or events that cause firm returns to be less correlated with changes in the economy will _______ the firm's systematic risk. A) increase B) decrease C) not affect D) affect (direction not determinable) E) increase the firm's unsystematic risk but not affect Ans: B

Level: Basic

Subject: Systematic Risk

Type: Concepts

57. Which of the following is a correct statement about diversification? A) Most diversification benefits are realized with just 10 stocks. B) Diversification is the process of reducing the riskiness associated with individual assets by spreading an investment across numerous assets. C) Diversifiable risk is the only risk that matters to a rational investor. D) When a stock is combined into a portfolio, the standard deviation of that portfolio remains unchanged. E) There is no limit to the amount of risk that can be eliminated through diversification. Ans: B

Level: Basic

Subject: Diversification

Type: Concepts

58. Diversification works because: I. Unsystematic risk exists. II. Forming stocks into portfolios reduces the standard deviation of returns for each stock. III. Firm-specific risk can be dramatically reduced if not eliminated. A) I only B) III only C) I and II only D) I and III only E) I, II, and III Ans: D

Level: Basic

Subject: Diversification

Type: Concepts

59. Which of the following is true concerning diversification? Assume that the securities being considered for selection into a portfolio are not perfectly correlated. A) The risk of the portfolio is certain to be increased as securities are added. B) As more securities are added to the portfolio, the market risk of the portfolio declines. C) After about 10 securities are added to the portfolio, additional securities have essentially no impact on reducing risk. D) As more and more securities are added to the portfolio, the level of risk approaches the level of systematic risk in the market. E) If you hold more than 100 securities, then the portfolio is risk-free. Ans: D

Level: Basic

Subject: Diversification

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

60. Systematic risk is considered important because ________________________. A) it is needed in order to measure the total risk of an asset B) the risk premium depends only on this type of risk C) the market does not provide a reward for this type of risk D) the risk premium depends on both systematic and unsystematic risk E) investors are willing to pay more for stocks with high systematic risk components Ans: B

Level: Basic

Subject: Systematic Risk

Type: Concepts

61. Which of the following does NOT describe the risk that exists in a well-diversified portfolio? A) Market risk B) Asset-specific risk C) Non-diversifiable risk D) Systematic risk Ans: B

Level: Basic

Subject: Systematic Risk

Type: Concepts

62. Which of the following would have the lowest amount of systematic risk? A) A portfolio of the common stocks of 100 different companies. B) The market portfolio. C) A portfolio half invested in the market portfolio and half invested in Treasury bills. D) A portfolio half invested in the market portfolio and half invested in stocks with betas = 1. 50. E) A portfolio made up entirely of Treasury bills. Ans: E

Level: Basic

Subject: Portfolio Systematic Risk

Type: Concepts

63. Which of the following would increase a portfolio's systematic risk? I. Common stock is sold and replaced with Treasury bills. II. Stocks with a beta equal to the market beta are added to a portfolio of Treasury bills. III. Low-beta stocks are sold and replaced with high-beta stocks. A) I only B) II only C) III only D) I and II only E) II and III only Ans: E

Level: Basic

Subject: Portfolio Systematic Risk

Type: Concepts

64. You sell some of your IBM common stock (which tends to move up and down with the economy as a whole) and replace it with the common stock of Fort Knox Gold Mining, Inc. (whose shares tend to rise when the economy falls, and vice versa). Your portfolio's beta should _______________. A) increase B) decrease C) remain unchanged D) either increase or decrease E) definitely exceed the beta of the market when all is said and done Ans: B

Level: Basic

Subject: Portfolio Systematic Risk

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

65. Total risk equals _________________. A) market risk plus firm-specific risk B) firm-specific risk plus diversifiable risk C) systematic risk minus unsystematic risk D) diversifiable risk plus unsystematic risk E) market risk plus non-diversifiable risk Ans: A

Level: Basic

Subject: Total Risk

Type: Concepts

66. Which of the following statements is false? A) Total risk = market risk + unique risk. B) Total risk = systematic risk + unsystematic risk. C) Market risk = non-diversifiable risk + asset-specific risk. D) Announcement = expected part + surprise. E) Total return = expected return + unexpected return. Ans: C

Level: Basic

Subject: Total Risk

Type: Concepts

67. Aziz Equipment Co. invests in a group of risky projects, which increases the unsystematic risk of the firm, but does not change the systematic risk of the firm. All else the same, the expected risk premium on its common stock is most likely to: A) Increase, because the difference between the expected return on the firm's stock and the risk-free rate will widen. B) Decrease, because the difference between the expected return on the firm's stock and the risk-free rate will narrow. C) Remain unchanged, because the level of systematic risk is unchanged. D) Increase or decrease, depending on the internal rate of return of the new projects. E) None of the above Ans: C

Level: Basic

Subject: Expected Risk Premium

Type: Concepts

68. Which of the following is true regarding the beta coefficient? A) It is a measure of unsystematic risk. B) A beta greater than one represents lower systematic risk than the market. C) Generally speaking, the higher the beta the higher the expected return. D) A beta of one indicates an asset is totally risk-free. E) The risk premium of an asset will increase if the beta of that asset decreases. Ans: C

Level: Basic

Subject: Beta

Type: Concepts

69. You are looking at two different stocks. IBX has a beta of 1.25 and Microsquish has a beta of 1.95. Which statement is true about these investments? A) IBX is always a better addition to your portfolio. B) Microsquish is always a better addition to your portfolio. C) The expected return on IBX will be the higher of the two. D) You cannot tell which of the two will have the higher expected return without further information. E) The stock in IBX has the same reward to risk ratio as does Microsquish. Ans: E

Level: Basic

Subject: Beta Coefficients

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

70. An asset's undiversifiable risk is measured by its ______________. A) total return B) expected return C) variance of returns D) unexpected component of returns E) beta coefficient Ans: E

Level: Basic

Subject: Beta

Type: Concepts

71. Which of the following is/are true for a stock with beta equal to 1.5? I. The stock has a 50% higher expected return than the average stock. II. Given a market risk premium of 10%, the expected return on the stock would be 15%. III. The stock has 50% more systematic risk than the average stock. A) I only B) II only C) III only D) I and III only E) I, II, and III Ans: C

Level: Basic

Subject: Beta & Systematic Risk

Type: Concepts

72. If investors can freely trade assets in financial markets, then the impact of trading activity on expected returns insures that ________________________. A) all assets will have the same degree of systematic risk B) each firm's reward to risk ratio will be based on a different risk-free rate of return C) systematic risk can be diversified away D) assets will have the same reward to risk ratio E) all assets will have the same risk premium Ans: D

Level: Basic

Subject: Reward To Risk Ratio

Type: Concepts

73. Which of the following describes a portfolio that plots below the security market line? A) The security is undervalued. B) The security is providing a return that is greater than expected. C) The security's reward to risk ratio is too low. D) The security's beta is too low. E) The security provides a return that exceeds the average return on the market. Ans: C

Level: Basic

Subject: Security Market Line

Type: Concepts

74. Which of the following is true about the market portfolio? A) The expected return of the market portfolio determines the slope of the security market line. B) It plots below the security market line. C) It has a beta equal to zero. D) It consists of all the stocks on the TSX. E) It has a different reward to risk ratio than the individual assets in the market. Ans: A

Level: Basic

Subject: Market Portfolio

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

75. The CAPM shows that the expected return for a particular asset depends on: I. The amount of unsystematic risk. II. The reward for bearing systematic risk. III. The pure time value of money. A) I only B) I and II only C) III only D) II and III only E) I, II, and III Ans: D

Level: Basic

Subject: CAPM

Type: Concepts

76. Which of the following is correct regarding the CAPM? A) The expected return for a particular asset depends on the pure time value of money as measured by beta B) The expected return for a particular asset depends on the amount of systematic risk as measured by the risk free rate C) The standard deviation for a particular asset depends on the reward for bearing risk as measured by beta D) Implicit in the CAPM is that all risky assets have the same reward to risk ratio E) The SML and CAPM illustrate that the higher the beta, the lower the expected return Ans: D

Level: Basic

Subject: CAPM

Type: Concepts

77. The appropriate discount rate for a new investment project is: I. The minimum expected rate of return the investment must earn to be attractive to investors. II. The rate of return investments of similar risk earn in the market. III. The internal rate of return (IRR) for the project. A) I only B) II only C) II and III only D) I and II only E) I, II, and III Ans: D

Level: Basic

Subject: Discount Rate

Type: Concepts

78. The expected return on an individual asset depends only on that asset's ____ risk. A) Total B) Incremental C) Systematic D) Unsystematic E) Portfolio Ans: C

Level: Basic

Subject: Systematic Risk

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

79. The principle of diversification states that spreading an investment over a number of assets will eliminate: A) All of the risk. B) All of the systematic risk and part of the unsystematic risk. C) All of the unsystematic risk and part of the systematic risk. D) Most of the systematic risk. E) Most of the unsystematic risk. Ans: E

Level: Intermediate

Subject: Diversification

Type: Concepts

80. Which one of the following stocks will have the highest risk premium? Stock Standard deviation Beta A) B) C) D) E)

A 4.00% 0.8

B 9.00% 1.1

C 11.00% 1.4

D 13.00% 1.3

E 7.00% 0.9

Stock A Stock B Stock C Stock D Stock E

Ans: C

Level: Basic

Subject: Beta

Type: Concepts

81. In a competitive market the reward to risk ratio can be expressed as: A) [E(Ra) - Rf] / ßa > [E(Rb) - Rf] / ßb B) [E(Ra) - Rf] / ßa = [E(Rb) - Rf] / ßb C) [E(Ra) - Rf] = ßa D) E(Ra) = E(Rb) E) E(Ra) - E(Rb) = Rf Ans: B

Level: Basic

Subject: Reward To Risk Ratio

Type: Concepts

82. Standard deviation measures the ____ risk and beta measures the ____ risk of a portfolio. A) Unsystematic; systematic B) Systematic; unsystematic C) Unsystematic; total D) Total; unsystematic E) Total; systematic Ans: E

Level: Basic

Subject: Standard Deviation And Beta

Type: Concepts

83. Investors are rewarded for the ____ risk they assume. A) Total B) Marginal C) Unsystematic D) Systematic E) Inflation adjusted Ans: D

Level: Basic

Subject: Systematic Risk

Type: Concepts

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Chapter 13 Return, Risk, and the Security Market Line

84. Systematic risks are _____ events and unsystematic risks are _____ events. A) Anticipated; anticipated B) Anticipated; unanticipated C) Unanticipated, anticipated D) Unanticipated; unanticipated Ans: D

Level: Intermediate

Subject: Unanticipated Events

Type: Concepts

85. Which of the following relationships are correct? I. Risk premium = Expected return - Risk-free rate II. Announcement = Expected part - Surprise III. Total risk - Systematic risk = Unsystematic risk IV. Slope of the SML = [E(RA) + Rf] / ßA A) I and II only B) III and IV only C) I and IV only D) II and III only E) I and III only Ans: E

Level: Intermediate

Subject: Formulas

Type: Concepts

86. Which of the following are examples of systematic risk? I. An increase in the rate of GDP growth II. An increase in the productivity of ABC Co. workers III. A decrease in the rate of inflation IV. A decrease in a firm's cost of borrowing A) I and II only B) I and III only C) II and IV only D) II and III only E) I, III, and IV only Ans: B

Level: Intermediate

Subject: Systematic Risk

Type: Concepts

87. Which one of the following is an example of diversifiable risk? A) A decrease in the average cost of living B) An increase in the federal funds rate C) An increase in the minimum hourly wage D) A new government regulation on aircraft engines E) A decrease in federal income taxes on business incomes Ans: D

Level: Intermediate

Subject: Diversifiable Risk

Type: Concepts

88. The steeper the slope of the security market line, the A) Higher the risk-free rate of return. B) Lower the risk-free rate of return. C) Higher the market beta. D) Higher the risk premium E) Lower the risk premium. Ans: D

Level: Intermediate

Subject: SML

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

89. The inclusion of thirty highly diverse securities in a portfolio eliminates the bulk of the ___ risk. A) Market B) Unique C) Unexpected D) Expected E) Inflation Ans: B

Level: Intermediate

Subject: Unique Risk

Type: Concepts

90. In a highly diversified portfolio, the standard deviation of the portfolio will be equal to: A) Zero. B) One. C) The portfolio beta. D) The systematic risk. E) The risk premium of the portfolio. Ans: D

Level: Intermediate

Subject: Standard Deviation

Type: Concepts

91. Which one of the following statements is correct about a portfolio that is invested 30% in stock A, 40% in stock B, and 30% in stock C? A) The expected return on the portfolio is equal to the summation of the returns on the individual securities within the portfolio divided by three. B) The standard deviation of the portfolio is equal to the summation of the weights of each security multiplied by the standard deviation of each respective security. C) The expected return on the portfolio is equal to the portfolio beta times the weighted average of the expected returns of each of the individual securities in the portfolio. D) The standard deviation of the portfolio is equal to the square root of the summation of the individual security variances. E) The expected return of the portfolio is equal to the risk free rate of return plus a risk premium based on a weighted average of the betas of the individual securities and the market risk premium. Ans: E

Level: Challenge

Subject: Portfolio Return And Standard Deviation

Type: Concepts

92. Suppose the Bank of Canada increased the rate on T-bills. As a result of this action, the security market line of a risky individual security would: A) Remain constant. B) Have an increased slope. C) Have a decreased slope. D) Increase in a parallel manner. E) Decrease in a parallel manner. Ans: D

Level: Intermediate

Subject: SML

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

93. Which one of the following statements concerning beta is correct? A) The beta of a portfolio must be greater than or equal to zero but less than or equal to one. B) The beta of a portfolio can be greater than the highest beta of an individual security within the portfolio. C) If the weights of the individual securities within a portfolio are changed, the beta of the portfolio will remain constant. D) The beta of a portfolio measures the systematic risk of the portfolio and has a value that can not exceed the value of the highest beta of any individual security in the portfolio. E) The beta of a portfolio measures the unsystematic risk of the portfolio and has a value that must be greater than or equal to zero. Ans: D

Level: Intermediate

Subject: Beta Coefficient

Type: Concepts

94. Theoretically, a risk-free portfolio could be created by combining risky securities in a manner that caused the: A) Portfolio standard deviation to equal one. B) Expected return of the portfolio to equal the market expected return. C) Portfolio beta to equal zero. D) Risk premium to equal one. E) Nondiversifiable risk to be eliminated. Ans: C

Level: Intermediate

Subject: Beta

Type: Concepts

95. Which one of the following will decrease the risk of a portfolio that consists of stocks, Canadian Treasury bills, and gold? A) Decreasing the number of securities in the portfolio B) Selling stocks and replacing them with Canadian Treasury bills C) Selling a .90 beta stock and buying a 1.1 beta stock D) Selling the gold and buying more diversified stocks E) Selling the large-company stocks and buying small-company stocks Ans: B

Level: Intermediate

Subject: Portfolio Risk

Type: Concepts

96. An asset that has an expected rate of return above the security market line: A) Is overpriced. B) Is underpriced. C) Is less risky than the market. D) Has a beta greater than 1. E) Has a standard deviation equal to 0. Ans: B

Level: Intermediate

Subject: SML

Type: Concepts

97. In a highly competitive market, all stocks should: A) Produce the same rate of return. B) Plot on the same security market line. C) Have the same beta. D) Have the same standard deviation. E) Plot at the intercept point. Ans: B

Level: Intermediate

Subject: SML

Type: Concepts

98. What is the expected return for the following stock? State Probability

Return

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line Average Recession Depression A) B) C) D) E)

.55 .20 .25

.20 .10 -.20

0.055 0.080 0.095 0.105 0.110

Ans: B

Level: Basic

Subject: Expected Return

Type: Problems

99. Which of the following stocks has the greatest expected return and by how much? State Probability Return on A Return on B Boom .1 .6 .4 Good .8 .3 .3 Recession .1 0 -.1 A) B) C) D) E)

A by 6% B by 6% A by 3% B by 3% A and B have the same expected return.

Ans: C

Level: Basic

Subject: Expected Return

Type: Problems

100. What is the risk premium for the following returns if the risk-free rate is 5%? State Probability Return Boom .15 .60 Good .50 .20 Recession .25 -.10 Depression .10 -.30 A) B) C) D) E)

0.085 0.100 0.125 0.135 0.175

Ans: A

Level: Basic

Subject: Risk Premiums

101. What is the variance of the following returns? State Probability Boom .15 Good .50 Recession .25 Depression .10

Type: Problems

Return .60 .20 -.10 -.30

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Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

0.0523 0.0673 0.0835 0.1324 0.4156

Ans: B

Level: Basic

Subject: Variance

Type: Problems

102. Ed Lawrence has $100,000 invested. Of that, $30,000 is invested in IBM stock, $25,000 is invested in Tbills, and the remainder is invested in corporate bonds. Which of the following is NOT correct regarding his portfolio weights? (All values are current market values. ) A) Ed has 30% of his portfolio invested in stocks. B) Ed has 45% of his portfolio invested in corporate bonds. C) Ed has 70% of his portfolio invested in assets other than stocks. D) Ed has 70% of his portfolio invested in risk-free assets. E) If Ed sells his corporate bonds and buys GM stock with the proceeds, he will end up with 75% of his portfolio invested in stocks. Ans: D

Level: Basic

Subject: Portfolio Weights

Type: Problems

103. You own 40 shares of stock A, which has a price of $15 per share, and 200 shares of stock B, which has a price of $2 per share. What is the portfolio weight for stock A in your portfolio? A) 18% B) 25% C) 40% D) 60% E) 75% Ans: D

Level: Basic

Subject: Portfolio Weights

Type: Problems

104. What is the expected portfolio return given the following information: Asset Portfolio Return weight A .25 15% B .25 20% C .30 10% D .20 35% A) B) C) D) E)

7.71% 9.23% 18.75% 19.25% 21.15%

Ans: C

Level: Basic

Subject: Portfolio Expected Return

105. What is the expected return for the following portfolio? Asset Investment A $200 B $300 C $500

Type: Problems

Return 0.15 0.10 0.25

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Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

0.1000 0.1150 0.1225 0.1550 0.1850

Ans: E

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

106. Given the following information, what is the portfolio standard deviation? State Probability Return Boom .2 .30 Good .6 .21 Recession .2 .08 A) B) C) D) E)

0.0128 0.0527 0.0638 0.0703 0.1159

Ans: D

Level: Basic

Subject: Portfolio Standard Deviation

Type: Problems

107. What is the portfolio beta if 75% of your money is invested in the market portfolio, and the remainder is invested in a risk-free asset? A) 0.50 B) 0.25 C) 1.25 D) 1.00 E) 0.75 Ans: E

Level: Basic

Subject: Portfolio Beta

Type: Problems

108. What is the portfolio beta with 125% of your funds invested in the market portfolio via borrowing 25% of the funds at the risk-free interest rate? A) 0.25 B) 0.50 C) 0.75 D) 1.00 E) 1.25 Ans: E

Level: Basic

Subject: Portfolio Beta

Type: Problems

109. What is the portfolio beta if 25% of your funds are invested in the market portfolio, 25% in an asset with twice as much risk as the market portfolio, and the remainder in a risk-free asset? A) 0.25 B) 0.50 C) 0.75 D) 1.00 E) 1.25 Ans: C

Level: Basic

Subject: Portfolio Beta

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

110. What is the beta for a portfolio equally weighted in four assets: A, the market portfolio; B, which has half the risk of A; C, which has twice the risk of A; and D, which is risk-free? A) 0.500 B) 0.750 C) 0.875 D) 1.250 E) 1.375 Ans: C

Level: Basic

Subject: Portfolio Beta

Type: Problems

111. You hold three stocks in your portfolio: A, B, and C. The portfolio beta is 1.50. Stock A comprises 20% of the dollar value of your holdings and has a beta of 1.0. If you sell all of your investment in A and invest the proceeds in the risk-free asset, your new portfolio beta will be: A) 0.850 B) 1.025 C) 1.200 D) 1.300 E) 1.625 Ans: D

Level: Basic

Subject: Portfolio Beta

Type: Problems

112. Port Company is financed entirely by equity and has three divisions. Division A is the stable products division, and has a beta of 0.8. Division B takes only projects with the same risk as the market portfolio. Division C is the research and development division, where the average beta of projects taken is 1.6. The firm's assets are divided equally (both in terms of market value and book value) among the three divisions. What is the beta of the firm? A) 0.80 B) 1.00 C) 1.03 D) 1.13 E) 1.33 Ans: D

Level: Basic

Subject: Portfolio Beta

Type: Problems

113. You own two risky assets, both of which plot on the security market line. Asset A has an expected return of 12% and a beta of 0.8. Asset B has an expected return of 18% and a beta of 1.4. If your portfolio beta is the same as the market portfolio, what proportion of your funds are invested in asset A? A) 0.33 B) 0.50 C) 0.67 D) 1.33 E) 1.67 Ans: C

Level: Basic

Subject: Portfolio Betas and Weights

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

114. You hold four stocks in your portfolio: A, B, C, and D. The portfolio beta is 1.20. Stock C comprises 40% of the dollar value of your holdings and has a beta of 1.60. If you sell all of your holdings in stock C, and replace it with an equal investment in stock E (which has a beta of 1.25), what will be your new portfolio beta? A) 1.00 B) 1.06 C) 1.12 D) 1.25 E) 1.32 Ans: B

Level: Basic

Subject: Portfolio Beta

115. What is the beta for the following portfolio? Stock A Investment ($) 15,000 Beta 0.6 A) B) C) D) E)

Type: Problems

B 10,000 0.9

C 25,000 1.6

D 12,500 1.1

E 17,500 0.0

0.80 0.88 0.90 0.93 0.98

Ans: C

Level: Basic

Subject: Portfolio Beta

Type: Problems

116. What is the beta of a portfolio made up of two risky assets and a risk-free asset? You invest 40% in asset A with a beta of 1.25 and 40% in asset B with a beta of 1.15. A) 0.84 B) 0.96 C) 1.03 D) 1.12 E) 1.20 Ans: B

Level: Basic

Subject: Portfolio Beta

Type: Problems

117. You form a portfolio by investing equally in A (beta=0.8), B (beta=1.2), the risk-free asset, and the market portfolio. What is your portfolio beta? A) 0.67 B) 0.75 C) 0.95 D) 1.12 E) 1.15 Ans: B

Level: Basic

Subject: Portfolio Beta

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

118. Given the following information: The risk-free rate is 7%, the beta of stock A is 1.2, the beta of stock B is 0.8, the expected return on stock A is 13.5%, and the expected return on stock B is 11.0%. Further, we know that stock A is fairly priced and that the betas of stocks A and B are correct. Which of the following regarding stock B must be true? A) Stock B is also fairly priced. B) The expected return on stock B is too high. C) The expected return on stock A is too high. D) The price of stock B is too high. E) The price of stock A is too high. Ans: D

Level: Basic

Subject: Reward To Risk Ratio

Type: Problems

119. Asset A has a reward to risk ratio of .075 and a beta of 1.5. The risk-free rate is 5%. What is the expected return on A? A) 11.25% B) 12.25% C) 13.50% D) 14.25% E) 16.25% Ans: E

Level: Basic

Subject: Reward To Risk Ratio

Type: Problems

120. Asset A, which has an expected return of 12% and a beta of 0.8, plots on the security market line. Which of the following is false about Asset B, another risky asset with a beta of 1.4? A) If the market is in equilibrium, Asset B also plots on the SML. B) If Asset B plots on the SML, then Asset B and Asset A have the same reward to risk ratio. C) Asset B has more systematic risk than both Asset A and the market portfolio. D) If Asset B plots on the SML with an expected return = 18%, then the risk-free rate must be 4%. E) If Asset B plots on the SML with an expected return = 18%, the expected return on the market must be 15%. Ans: E

Level: Basic

Subject: Security Market Line

Type: Problems

121. What is the expected return on asset A if it has a beta of 0.3, the expected market return is 14%, and the risk-free rate is 5%? A) 6.0% B) 9.2% C) 7.2% D) 7.7% E) 4.5% Ans: D

Level: Basic

Subject: CAPM

Type: Problems

122. What is the expected market return if the expected return on asset A is 16% and the risk-free rate is 7%? Asset A has a beta of 1.2. A) 9.5% B) 14.5% C) 16.5% D) 17.5% E) 20.5% Ans: B

Level: Basic

Subject: CAPM

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

123. Asset A has an expected return of 15%. The expected market return is 14% and the risk-free rate is 4%. What is asset A's beta? A) 0.80 B) 1.10 C) 1.40 D) 1.80 E) 2.00 Ans: B

Level: Basic

Subject: CAPM

Type: Problems

124. Asset A has an expected return of 22% and a beta of 1.8. The expected market return is 14%. What is the risk-free rate? A) 0.6% B) 1.2% C) 3.0% D) 4.0% E) 6.0% Ans: D

Level: Basic

Subject: CAPM

Type: Problems

125. Asset A has an expected return of 12% and a beta of 1.05. The risk-free rate is 4%. What is the market risk premium? A) 7.6% B) 8.2% C) 9.6% D) 10.2% E) 11.6% Ans: A

Level: Basic

Subject: CAPM

Type: Problems

Use the following to answer questions 126-128: Standard Deviation Security X Security Y Security Z

0.35 0.28 0.44

Beta 1.45 1.06 1.22

126. Which security has the greatest expected return? A) Y because it has the largest standard deviation. B) X because it has the largest beta coefficient. C) Z because it has the highest ratio of standard deviation to beta. D) Y because it has the lowest beta coefficient, and therefore the lowest risk. E) It is not possible to tell given the information above. Ans: B

Level: Basic

Subject: Expected Return

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

127. Which security has the greatest systematic risk? A) Z because it has the largest standard deviation. B) X because it has the largest beta coefficient. C) Z because it has a high beta and the largest standard deviation. D) Y because it has the greatest diversifiable risk. E) It is not possible to tell given the information above. Ans: B

Level: Basic

Subject: Systematic Risk

Type: Problems

128. Which of the following is correct? A) Security Z has the greatest total risk because it has the largest standard deviation. B) Security X has the greatest total risk because it has the largest beta. C) Security X has the greatest diversifiable risk because it has the largest beta. D) Security Y has the lowest total risk because it has the lowest beta. E) An equally-weighted portfolio of XYZ will have the same systematic risk as the market portfolio. Ans: A

Level: Basic

Subject: Total Risk

Type: Problems

Use the following to answer questions 129-132: State Boom Bust

Probability .6 .4

Return on A 0.15 0.05

Return on B 0.08 0.20

129. What is the expected return on security B? A) 0.080 B) 0.100 C) 0.110 D) 0.128 E) 0.138 Ans: D

Level: Basic

Subject: Expected Return

Type: Problems

130. What is the standard deviation of security A? A) 0.0002 B) 0.0006 C) 0.0490 D) 0.0545 E) 0.0600 Ans: C

Level: Basic

Subject: Standard Deviation

Type: Problems

131. What is the expected return on a portfolio that is 40% invested in A and 60% invested in B? A) 0.100 B) 0.110 C) 0.121 D) 0.128 E) 0.138 Ans: C

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

132. What is the expected return on a portfolio that is equally-weighted amongst A, B, and the risk-free asset? The expected return on the risk-free asset is 4%. A) 0.089 B) 0.093 C) 0.101 D) 0.118 E) 0.138 Ans: B

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

133. What is the standard deviation of a portfolio with one-quarter of the funds in A? A) 0.0008 B) 0.0065 C) 0.0089 D) 0.0103 E) 0.0320 Ans: E

Level: Intermediate

Subject: Portfolio Standard Deviation

Type: Problems

Use the following to answer questions 134-137: Security A B Risk-free asset

Return 15% 12% 5%

Standard Deviation 8% 14% ???

Beta 1.2 0.9 ???

134. Which of A and B has the least total risk? The least systematic risk? A) A; A B) A; B C) B D) B; B E) Cannot be determined without more information. Ans: B

Level: Intermediate

Subject: Total vs. Systematic Risk

Type: Problems

135. What is the value of systematic risk for a portfolio with 75% of the funds invested in A and 25% of the funds invested in B? A) 0.98 B) 1.13 C) 1.28 D) 1.40 E) 1.60 Ans: B

Level: Intermediate

Subject: Portfolio Beta

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

136. What is the portfolio expected return and the portfolio beta if you invest 30% in A, 30% in B and 40% in the risk-free asset? A) 9.6%; 1.32 B) 9.6%; 1.00 C) 10.1%; 0.95 D) 10.1%; 0.72 E) 10.1%; 0.63 Ans: E

Level: Intermediate

Subject: Portfolio Return & Beta

Type: Problems

137. What is the portfolio expected return with 125% invested in A and the remainder in the risk-free asset via borrowing at the risk-free interest rate? A) 9.8% B) 11.3% C) 16.8% D) 17.5% E) 20.1% Ans: D

Level: Intermediate

Subject: Portfolio Return With Short Position

Use the following to answer questions 138-142: State Boom Normal Bust

Probability .3 .6 .1

Return on A 12% 8% 4%

Return on B -2% 2% 6%

138. What is the expected return for asset A? A) 1.2% B) 4.0% C) 8.0% D) 8.8% E) 9.3% Ans: D

Level: Intermediate

Subject: Expected Return

Type: Problems

139. What is the standard deviation of returns for asset A? A) 1.3% B) 1.9% C) 2.5% D) 2.4% E) 6.4% Ans: D

Level: Basic

Subject: Standard Deviation

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Type: Problems

Chapter 13 Return, Risk, and the Security Market Line

140. What is the standard deviation of returns for asset B? A) 1.3% B) 1.9% C) 2.5% D) 2.4% E) 6.4% Ans: D

Level: Basic

Subject: Standard Deviation

Type: Problems

141. What is the expected return on a portfolio with weights of 60% in asset A and 40% in asset B? A) 2.2% B) 4.4% C) 5.8% D) 8.8% E) 9.9% Ans: C

Level: Basic

Subject: Portfolio Return

Type: Problems

142. What is the standard deviation of a portfolio with weights of 60% in security A and the remainder in security B? A) 0.5% B) 0.9% C) 1.5% D) 2.3% E) 6.4% Ans: A

Level: Basic

Subject: Portfolio Standard Deviation

Type: Problems

143. What is the portfolio weight of stock B given the following information? Stock A B C A) B) C) D) E)

Number of shares owned 150 100 200

Value per share $15.00 $25.00 $12.00

31% 33% 34% 35% 36%

Ans: D

Level: Basic

Subject: Portfolio Weights

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

144. You are planning on investing $5,000 in stock A. You currently own 500 shares of stock B with a market value of $25 a share and 300 shares of stock C with a market value of $18 a share. What percent of your portfolio will stock A assume once you complete your planned purchase? A) 22% B) 23% C) 24% D) 25% E) 27% Ans: A

Level: Basic

Subject: Portfolio Weights

Type: Problems

145. What is the expected return on the following stock? Economic State Probability of State Boom 15% Normal 65% Recession 20% A) B) C) D) E)

Return on Stock 28% 12% -30%

6% 9% 12% 15% 18%

Ans: A

Level: Basic

Subject: Expected Return

Type: Problems

146. You have 20% of your portfolio invested in stock A, 40% in stock B, and the balance in stock C. The expected returns on these three stocks are 14%, 3%, and 8%, respectively. What is the expected return on the portfolio? A) 6.40% B) 6.88% C) 7.20% D) 8.00% E) 8.88% Ans: C

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

147. You have 15% of your portfolio invested in stock A, 25% in stock B, 40% in stock C, and 20% in stock D. The expected returns on these four stocks are 18%, 3%, 9%, and -12%, respectively. What is the expected return on the portfolio? A) 4.65% B) 5.25% C) 5.60% D) 7.55% E) 9.45% Ans: A

Level: Basic

Subject: Portfolio Expected Return

Type: Problems

148. What is the expected return on a portfolio that is invested 40% in stock A and 60% in stock B, given the following information? Economic State Normal Recession

Probability of State 70% 30%

Return on Stock A 12% -10%

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Return on Stock B 5% 8%

Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

5.40% 5.70% 6.40% 7.80% 8.10%

Ans: B

Level: Intermediate

Subject: Portfolio Expected Return

Type: Problems

149. What is the expected return on a portfolio that is invested 30% in stock A and 70% in stock B, given the following information? Economic State Normal Boom A) B) C) D) E)

Probability of State 80% 20%

Return on Stock A 8% 15%

Return on Stock B 6% 7%

5.28% 6.60% 7.16% 7.43% 7.90%

Ans: C

Level: Intermediate

Subject: Portfolio Expected Return

Type: Problems

150. What is the standard deviation of a portfolio that is invested 60% in stock A and 40% in stock B, given the following information? Economic State Normal Recession A) B) C) D) E)

Probability of State 30% 70%

Return on Stock A 13% -8%

Return on Stock B 3% 8%

1.58% 2.36% 4.06% 4.86% 5.51%

Ans: D

Level: Intermediate

Subject: Standard Deviation

Type: Problems

151. What is the standard deviation of a portfolio that is invested 40% in stock A and 60% in stock B, given the following information? Economic State Normal Boom

Probability of State 70% 30%

Return on Stock A 9% 14%

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Return on Stock B 12% 18%

Chapter 13 Return, Risk, and the Security Market Line

A) B) C) D) E)

2.18% 2.57% 2.69% 2.84% 3.13%

Ans: B

Level: Intermediate

Subject: Standard Deviation

Type: Problems

152. You own a stock portfolio that is invested 10% in stock A, 30% in stock B, 40% in stock C, and 20% in stock D. These stocks have betas of 1.2, .8, 1.1, and 1.5, respectively. What is the beta of the portfolio? A) 1.04 B) 1.07 C) 1.10 D) 1.13 E) 1.14 Ans: C

Level: Intermediate

Subject: Portfolio Beta

Type: Problems

153. What is the beta of the following portfolio? Stock Amount Invested Stock Beta A) B) C) D) E)

A $5,000 1.20

B $10,000 1.80

C $15,000 0.70

.98 1.15 1.19 1.21 1.23

Ans: B

Level: Intermediate

Subject: Portfolio Beta

Type: Problems

154. A stock has a beta of 1.4. The expected return on the market is 8% and the T-bill is yielding 2%. What is the expected return on the stock? A) 8.40% B) 9.65% C) 10.40% D) 11.65% E) 13.20% Ans: C

Level: Intermediate

Subject: CAPM

Type: Problems

155. A stock has a beta of .8 and an expected return of 6%. The risk-free rate is 3%. What is the expected return on the market? A) 3.50% B) 3.75 C) 4.50% D) 5.25% E) 6.75% Ans: E

Level: Intermediate

Subject: CAPM

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

156. A stock has a beta of 1.2 and an expected return of 12%. The market is expected to yield 11%. What is the security market line intercept point? A) 0% B) 1.20% C) 3.5% D) 5.00% E) 6.00% Ans: E

Level: Intermediate

Subject: SML

Type: Problems

157. A stock has a beta of 1.4 and an expected return of 16%. The risk-free rate is 5%. What is the slope of the Security Market Line? A) 7.86% B) 7.98% C) 8.23% D) 8.67% E) 8.98% Ans: A

Level: Intermediate

Subject: Reward To Risk Ratio

Type: Problems

158. Which of the following stocks is (are) incorrectly priced if the risk-free rate is 4% and the market risk premium is 6%? Stock Beta Expected Return A) B) C) D) E)

A 1.25 12.60%

B 0.80 8.80%

C 1.06 11.20%

A only B only C only A and C only A, B, and C

Ans: D

Level: Intermediate

Subject: SML

Type: Problems

159. An investor has a portfolio comprised of stock A, which has a beta of 1.4 and an expected return of 10%, and Treasury bills, which have an expected return of 4%. The portfolio has an expected return of 7.30%. What is the portfolio weight of stock A? A) 40% B) 45% C) 50% D) 55% E) 60% Ans: D

Level: Intermediate

Subject: CAPM

Type: Problems

Copyright © 2005 McGraw-Hill Ryerson Limited.

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Chapter 13 Return, Risk, and the Security Market Line

160. An investor has a portfolio with an expected return of 11.19%. The portfolio is evenly invested in a stock and a risk-free asset. The market has an expected return of 17% and the risk-free asset has an expected return of 3%. What is the beta of the stock? A) .98 B) 1.17 C) 1.43 D) 1.62 E) 1.94 Ans: B

Level: Intermediate

Subject: CAPM

Type: Problems

161. You own a portfolio that is invested 50% in a risk-free asset and 50% in a stock that is equally as risky as the market. The risk-free asset has an expected return of 5%. Your portfolio has an expected return of 8.80%. What is the expected return on the market? A) 11.60% B) 11.75% C) 12.30% D) 12.35% E) 12.60% Ans: E

Level: Intermediate

Subject: CAPM

Type: Problems

162. A portfolio has an expected return of 13.12%. The portfolio is comprised of 60% stock A and 40% stock B. The risk-free rate of return is 4% and the market risk premium is 8%. The beta of stock B is .87. What is the reward-to-risk ratio of stock A? A) 1.28 B) 1.32 C) 1.36 D) 1.41 E) 1.46 Ans: B

Level: Challenge

Subject: Reward To Risk Ratio

Type: Problems

163. A portfolio has an expected return of 11.57%. The portfolio consists of stock A with an expected return of 8.6% and stock B with a beta of 1.28. The risk-free rate of return is 3% and the market risk premium is 8%. What is the portfolio weight of Stock A? A) 31% B) 32% C) 34% D) 36% E) 37% Ans: D

Level: Challenge

Subject: Portfolio Weight

Type: Problems

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Chapter 13 Return, Risk, and the Security Market Line

164. Consider a day on which the Dow Jones Industrial Average, an average of 30 large stocks, rose 59 points. On that same day, IBM, which is one of the 30 stocks in the DJIA, announced some unexpectedly bad news. The price of IBM declined $10 on that same day. Using this example, discuss systematic risk, portfolio diversification, and asset specific risk. Ans: Asset specific risk is obviously the negative announcement coming from IBM, resulting in a decline in the stock's price. The principle of systematic risk is evident in that the market in general was advancing. Finally, the deeper part of this question is that students should recognize that any investor who held IBM alone on this particular day lost money. However, anyone who owned IBM in a well diversified portfolio, such as the DJIA, made money in spite of IBM's decline within the portfolio. This clearly demonstrates the value of portfolio diversification. Level: Challenge

Subject: Portfolio Diversification

Type: Essays

165. Why are some risks diversifiable and some nondiversifiable? Give an example of each. Ans: A reasonable answer would, at a minimum, explain that some risks (diversifiable) affect only a specific security, and when put into a portfolio, losses as a result of these firm-specific events will tend to be offset by price gains amongst other securities. Nondiversifiable risk, however, is unavoidable because such risks affect all or almost all securities in the market and can't be eliminated by forming portfolios. In the second part of the question, the students get a chance to use a minor amount of imagination. A strong answer would note the dependence of diversification effects on the degree of correlation between the assets used to form portfolios. Level: Intermediate

Subject: Diversifiable Risk

Type: Essays

166. We routinely assume that investors are risk-averse return-seekers; i.e., they like returns and dislike risk. If so, why do we contend that only systematic risk is important? (Alternatively, why is total risk not important to investors, in and of itself?) Ans: This question, of course, gets to the point of the chapter: That rational investors will diversify away as much risk as possible. From the discussion in the text, most students will also have picked up that it is quite easy to eliminate diversifiable risk in practice, either by holding portfolios with 15 to 25 assets, or by holding shares in a diversified mutual fund. And, as noted in the text, there will be no return for bearing diversifiable risk, thus, total risk is not particularly important to a diversified investor. Level: Intermediate

Subject: Risk

Type: Essays

167. Explain in words what beta is and why it is important. Ans: This is a concept check question that requires students to put into words that beta is a measure of systematic risk, the only risk an investor can expect to earn compensation for bearing. Beta specifically measures the amount of systematic risk an asset has relative to an average asset. Level: Basic

Subject: Beta

Type: Essays

168. Is it possible for an asset to have a negative beta? (Hint: yes. ) What would the expected return on such an asset be? Why? Ans: While it is unlikely to observe a negative beta asset, it would have less systematic risk than the riskfree asset and would be expected to provide an even lower return. One possibility often cited is that of gold. The return would be less than the risk-free rate because, while the risk-free rate is determined by changes in inflation and the business cycle for the economy at large, gold, as an ultimate store of value, is not affected by these factors (at least to the same degree) . Level: Intermediate

Subject: Negative Beta

Type: Essays

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Chapter 13 Return, Risk, and the Security Market Line

169. Explain what we mean when we say all assets have the same reward to risk ratio. What does this mean for investors? Ans: A constant reward to risk ratio means that the reward for bearing risk, measured as the risk premium, increases as the amount of risk, measured by beta, also increases. Investors who are risk averse will not consider taking additional risk if they expect to receive no additional compensation for doing so. This is an equilibrium concept which essentially restates the axiom that prices observed in efficient markets are considered fair. Level: Intermediate

Subject: Reward To Risk Ratio

Type: Essays

170. Draw the SML and plot asset C such that it has less risk than the market but plots above the SML, and asset D such that it has more risk than the market and plots below the SML. (Be sure to indicate where the market portfolio is on your graph. ) Explain how assets like C or D can plot as they do and explain why such pricing cannot persist in a market that is in equilibrium. Ans: The student should draw a picture similar to Figure 13.9, adding a point where the market portfolio exists. In this case, asset C is underpriced and asset D is overpriced. This condition cannot persist in equilibrium because investors will buy C with its high expected return and sell D with its low expected return. The resultant buy and sell activity will force the prices back to a level that eventually causes both C and D to plot on the SML. Level: Challenge

Subject: Security Market Line

Type: Essays

171. According to the CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return. Ans: The CAPM suggests that expected return is a function of (1) the pure time value of money, (2) the reward for bearing systematic risk, and (3) the amount of systematic risk present in a particular asset. Better students 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. Level: Challenge

Subject: CAPM

Type: Essays

172. Write out the equation for the CAPM. Using the symbols in the model, identify the expected return on each of three assets: Asset A has a beta of one, Asset B has a beta of zero, and Asset C has a beta of negative one. In each case, interpret your result. Ans: This is a relatively straightforward application of the CAPM, but it does require students to fully understand the implications of the model. Clearly, Asset A is expected to earn the market return while Asset B is expected to earn the risk free rate. Asset C is a little tougher to explain. Students would likely expect that since it has a beta of negative one, it should have an expected return equal to the negative of the market return. However, it is expected to earn 2Rf - E(Rm). Level: Challenge

Subject: CAPM

Type: Essays

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Chapter 13 Return, Risk, and the Security Market Line

173. In the first chapter, it was stated that financial managers should act to maximize shareholder wealth. Why are the efficient markets hypothesis (EMH), the CAPM, and the SML so important in the accomplishment of this objective? Ans: In simple terms, one could say that maximizing shareholder wealth by maximizing the current share price (Chapter 1) is a reasonable objective if and only if we have some assurance that observed prices are meaningful; i.e., that they reflect the value of the firm. This is a major implication of the EMH. Further, if we are to be able to assess the wealth effects of future decisions on security and firm values, we must have a valuation model whose parameters can be shown to be affected by those decisions (Chapters 7 & 8). Finally, any valuation model we employ will require us to quantify return and risk (Chapters 12 and 13). Level: Challenge

Subject: EMH, CAPM, & The Market Value Rule

Type: Essays

174. In the previous chapter, we dealt with historical returns and variances. In this chapter, we focused on expected returns. Why did we need to make the switch from historical to expected? Why not use historical returns for both chapters or else use expected returns for both chapters? Ans: In general, the historical data is useful for illustrating the relationship between risk and return and for demonstrating the two lessons from capital market history. However, to completely understand risk as it relates to the future we need to deal with expected returns. Most importantly, by using expected returns we can discuss surprises, with the end result of presenting the SML and CAPM. Level: Challenge

Subject: Expected vs. Historical Returns

Type: Essays

175. Explain why in a highly competitive market all stocks should plot on the same security market line. Ans: The security market line for all stocks will have the same intercept point, which is the risk-free rate of return as represented by the Treasury bill rate. In a highly competitive market, all stocks should be priced correctly so that the risk-reward ratio is constant. A constant risk-reward ratio would cause all stocks to plot on the same security market line due to the fact that the risk-reward ratio is the slope of that line. Level: Intermediate

Subject: Competitive Markets And The SML

Type: Essays

176. Give some examples to explain how diversification actually works to reduce portfolio risk. Ans: Student answers will vary. All stocks possess risk due to unexpected events. By owning stocks in different industries, the odds are increased that a negative event in one industry will be offset by a positive event in another industry. These offsetting events can then help reduce the unsystematic risk. Level: Intermediate

Subject: Diversification

Type: Essays

Copyright © 2005 McGraw-Hill Ryerson Limited.

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