**8.1 Portfolio Returns and Portfolio Risk**

1) Which of the following portfolios is clearly preferred
to the others?

Expected Standard

Return Deviation

A 14% 12%

B 22% 20%

C 18% 16%

A) Investment A

B) Investment B

C) Investment C

D) Cannot be determined

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

A) Risk resulting from foreign expropriation of U.S. Steel
property

B) Risk resulting from oil exploration by Marathon Oil (a
U.S. Steel subsidy)

C) Risk resulting from a strike against U.S. Steel

D) None of the above

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

A) Risk resulting from a general decline in the stock
market

B) Risk resulting from a news release that several of
Continental's grain silos were tainted

C) Risk resulting from an explosion in a grain elevator
owned by Continental

D) Risk resulting from an impending lawsuit against
Continental

4) If there is a 20% chance we will get a 16% return, a 30%
chance of getting a 14% return, a 40% chance of getting a 12% return, and a 10%
chance of getting an 8% return, what is the expected rate of return?

A) 12%

B) 13%

C) 14%

D) 15%

5) If there is a 20% chance we will get a 16% return, a 30%
chance of getting a 14% return, a 40% chance of getting a 12% return, and a 10%
chance of getting an 8% return, what would be the standard deviation?

A) 2.24

B) 2.56

C) 2.83

D) 2.98

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

A) 12.50%

B) 13.20%

C) 11.80%

D) 10.00%

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

A) 20%

B) 16%

C) 18%

D) 25%

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

A) 21.45%

B) 25.00%

C) 4.60%

D) 15.00%

*Use the following information, which describes the possible outcomes from investing in a particular asset, to answer the following question(s).*

*State of the Economy Probability of the States Percentage Returns*

Economic recession 25% 5%

Moderate economic growth 55% 10%

Strong economic growth 20% 13%

9) The expected return from investing in the asset is

A) 9.00%.

B) 9.35%.

C) 10.00%.

D) 10.55%.

10) The standard deviation of returns is

A) 8.00%.

B) 7.63%.

C) 4.68%.

D) 2.76%.

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

A) 10.25%

B) 8.33%

C) 11.42%

D) 9.00%

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

A) $154.00

B) $142.80

C) $65.00

D) $15.12

*Use the following information, which describes the expected return and standard deviation for three different assets, to answer the following question(s).*

Portfolio
X Portfolio Y Portfolio Z

Expected return 9.5% 8.8% 9.5%

Standard deviation 4.9% 5.5% 5.5%

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

A) she will always choose Asset X over Asset Y.

B) she will always choose Asset Y over Asset X.

C) she will be indifferent between investing in Asset X and
Asset Y.

D) none of the above.

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

A) negatively correlated.

B) positively correlated.

C) uncorrelated.

D) perfectly, positively correlated.

15) A negative coefficient of correlation implies that

A) on average, returns to such assets are negative.

B) asset returns tend to move in opposite directions.

C) asset return tend to move in opposite directions.

D) None of the above because the coefficient of correlation
cannot be negative.

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

Answer: FALSE

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

Answer: TRUE

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

Answer: FALSE

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

Answer: TRUE

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

Answer: FALSE

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

Answer: TRUE

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

Answer: TRUE

23) Most financial assets have correlation coefficients
between 0 and 1.

Answer: TRUE

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

Answer: FALSE

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

Answer: FALSE

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

Answer: TRUE

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

Answer: TRUE

28) The greater the dispersion of possible returns, the
riskier is the investment.

Answer: TRUE

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

Answer: TRUE

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

Answer: TRUE

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

Answer: TRUE

32) You are considering
a portfolio consisting of equal investments in the stocks Northbank Inc. and
Tropical Escapes Inc. Returns on the 2
stocks under various conditions are shown below.

Scenario Return
(%) Return % Return %

Probability Northbank Tropical Portfolio

0.20 4% 16%

0.50 10% 10%

0.30 20% -10%

Calculate the expected rate of and
the standard deviation return of the portfolio.

Answer: In every scenario, the return on the
portfolio is 10% so the expected return must also be 10% and the standard
deviation is 0%.

**8.2 Systematic Risk and the Market Portfolio**

1) The capital asset pricing model

A) provides a risk-return trade-off in which risk is
measured in terms of the market returns.

B) provides a risk-return trade-off in which risk is
measured in terms of beta.

C) measures risk as the correlation coefficient between a
security and market rates of return.

D) depicts the total risk of a security.

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

A) the standard deviation of a firm's cash flows.

B) alpha.

C) beta.

D) probability of correlation.

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

A) Risk resulting from the possibility of a stock market
crash

B) Risk resulting from uncertainty regarding a possible
strike against Ford

C) Risk resulting from an expected recession

D) Risk resulting from interest rates decreasing

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

A) 1.2

B) 8.33%

C) 12%

D) Insufficient information is provided

5) Which of the following has a beta of zero?

A) A risk-free asset

B) The market

C) A high-risk asset

D) Both A and B

6) Beta is a statistical measure of

A) hyperbolic.

B) total risk.

C) the standard deviation.

D) the relationship between an investment's returns and the
market return.

7) A stock's beta is a measure of its

A) systematic risk.

B) unsystematic risk.

C) company-specific risk.

D) diversifiable risk.

8) If you hold a portfolio made up of the following stocks:

Investment Value Beta

Stock A $2,000 1.5

Stock B $5,000 1.2

Stock C $3,000 .8

What is the beta of the portfolio?

A) 1.17

B) 1.14

C) 1.32

D) Can't be determined from information given

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

A) Firm-specific risk

B) Market risk

C) Unsystematic risk

D) Diversifiable risk

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

A) more, more

B) more, less

C) less, more

D) less, less

11) You hold a portfolio with the following securities:

Percent

Security of
Portfolio Beta Return

X
Corporation 20% 1.35 14%

Y
Corporation 35% .95 10%

Z
Corporation 45% .75 8%

Compute the expected return and beta for the portfolio.

A) 10.67%, 1.02

B) 9.9%, 1.02

C) 34.4%, .94

D) 9.9%, .94

12) The beta of ABC Co. stock is the slope of

A) the security market line.

B) the characteristic line for a plot of returns on the
S&P 500 versus returns on short-term Treasury bills.

C) the arbitrage pricing line.

D) the line of best fit for a plot of ABC Co. returns
against the returns of the market portfolio for the same period.

13) You are thinking of adding one of two investments to an
already well diversified portfolio.

Security A Security
B

Expected return = 12% Expected
return = 12%

Standard deviation of returns =
20.9% Standard deviation of returns
= 10.1%

Beta = .8 Beta
= 2

If you are a risk-averse investor

A) security A is the better choice.

B) security B is the better choice.

C) either security would be acceptable.

D) cannot be determined with information given.

14) The market (systematic) risk associated with an
individual stock is most closely identified with the

A) variance of the returns of the stock.

B) variance of the returns of the market.

C) beta of the stock.

D) standard deviation of the stock.

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

A) Inflation

B) Recession

C) Management risk

D) Interest rate risk

16) What type of risk can investors reduce through
diversification?

A) All risk

B) Systematic risk only

C) Unsystematic risk only

D) Uncertainty

17) Which of the following statements is true?

A) A stock with a beta less than zero has no exposure to
systematic risk.

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

C) A stock with a beta less than 1.0 has lower
nondiversifiable risk than a stock with a beta of 1.0.

D) A stock with a beta less than 1.0 has higher
nondiversifiable risk than a stock with a beta of 1.0.

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

A) less than 1.0.

B) greater than 1.0.

C) equal to 1.0.

D) unknown based on the information provided.

19) Investment risk is

A) the probability of achieving a return that is greater
than what was expected.

B) the probability of achieving a beta coefficient that is
less than what was expected.

C) the probability of achieving a return that is less than
what was expected.

D) the probability of achieving a standard deviation that
is less than what was expected.

20) Which of the following statements is true?

A) Systematic, or market, risk can be reduced through
diversification.

B) Both systematic and unsystematic risk can be reduced
through diversification.

C) Unsystematic, or company, risk can be reduced through
diversification.

D) Neither systematic nor unsystematic risk can be reduced
through diversification.

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

A) The beta coefficient

B) The standard variation

C) The CPI

D) The S&P 500 Index

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

A) The Dow Jones Industrial Average

B) The Standard & Poors 500 Index

C) The Value Line Quantam Index

D) The Case Schiller Housing Index

23) Your broker mailed you your year-end statement. You
have $25,000 invested in Dow Chemical, $18,000 tied up in GM, $36,000 in
Microsoft stock, and $11,000 in Nike. The betas for each of your stocks are
1.55 for Dow, 1.12 for GM, 2.39 for Microsoft, and .76 for Nike. What is the
beta of your portfolio?

A) 1.46

B) 1.70

C) 2.60

D) 0.41

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

A) 1.24

B) 1.00

C) 1.28

D) 1.33

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

Answer: TRUE

26) Total risk equals unique security risk times systematic
risk.

Answer: FALSE

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

Answer: TRUE

28) It is impossible to eliminate all risk through
diversification.

Answer: TRUE

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

Answer: FALSE

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

Answer: FALSE

31) Unsystematic risk can be eliminated through
diversification.

Answer: TRUE

32) Increasing a portfolio from 2 stocks to 4 stocks will
reduce risk more than increasing a portfolio from 10 stocks to 12 stocks.

Answer: FALSE

33) The market rewards assuming additional unsystematic
risk with additional returns.

Answer: FALSE

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

Answer: TRUE

35) Betas for individual stocks tend to be stable.

Answer: FALSE

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

Answer: FALSE

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

Answer: Through
diversification, risk can be lowered without sacrificing returns. The market
rewards investors for the systematic risk that cannot be eliminated through
proper asset allocation in a diversified portfolio.

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

Answer: Beta is an
important measure that indicates the systematic risk of a given investment.
Since systematic risk cannot be diversified away, investors are compensated for
taking this risk. Beta compares the market risk of a particular investment with
the market risk of the market, and the risk premium necessary for a stock is
directly proportional to the risk premium for the market as a whole. When the
risk premium is added to the risk free rate, this results in the required
return for the stock.

**8.3 The Security Market Line and the CAPM**

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

A) the capital market line.

B) the New York Stock Exchange market line.

C) the security market line.

D) none of the above.

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

A) 7.8%

B) 13.4%

C) 14.4%

D) 8.4%

3) Huit Industries' common stock has an expected return of
11.4% and a beta of 1.2. If the expected risk-free return is 3%, what is the
expected return for the market (round your answer to the nearest .1%)?

A) 7.7%

B) 9.6%

C) 10.0%

D) 11.4%

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

A) 13.5%

B) 21.0%

C) 16.8%

D) 20.0%

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

A) 16.5%

B) 14.0%

C) 14.5%

D) 15.0%

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

A) The market risk premium would increase.

B) Beta would increase.

C) The slope of the SML would increase.

D) The SML line would shift up.

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

A) The market risk premium would increase.

B) Beta would increase.

C) The slope of the SML would increase.

D) The SML line would shift up.

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

A) 12.00%

B) 22.33%

C) 9.5%

D) 14.5%

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

A) 20.62%

B) 9.37%

C) 14.37%

D) 15.62%

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

A) 11.15%

B) 6.15%

C) 17.07%

D) 14.11%

11) You are going to invest all of your funds in one of
three projects with the following distribution of possible returns:

Project 1 Project
2

Standard Deviation
12% Standard
Deviation 19.5%

Probability Return Probability Return

50% Chance 20% 30% Chance 30%

50% Chance -4% 40% Chance 10%

30%
Chance -20%

Project 3

Standard Deviation
12%

Probability Return

10% Chance 30%

40% Chance 15%

40% Chance 10%

10% Chance -21%

If you are a risk-averse investor, which one should you
choose?

A) Project 1

B) Project 2

C) Project 3

12) The expected return on the market portfolio is
currently 11%. Battmobile Corporation stockholders require a rate of return of
23.0%, and the stock has a beta of 2.5. According to CAPM, determine the
risk-free rate.

A) 17.5%

B) 2.75%

C) 3.0%

D) 9.2%

13) Hefty stock has a beta of 1.2. If the risk-free rate is
7% and the market risk premium is 6.5%, what is the required rate of return on
Hefty?

A) 14.8%

B) 14.4%

C) 12.4%

D) 13.5%

14) The market risk premium is measured by

A) beta.

B) market return less risk-free rate.

C) T-bill rate.

D) standard deviation.

15) Marjen stock has a required return of 20%. The expected
market return is 15%, and the beta of Marjen's stock is 1.5. Calculate the
risk-free rate.

A) 4%

B) 5%

C) 6%

D) 7%

16) You are thinking
about purchasing 1,000 shares of stock in the following firms:

Number of
Shares Firm's Beta

Firm A 100 0.75

Firm B 200 1.47

Firm C 200 0.82

Firm D 600 1.60

If you purchase the number of shares specified, then the
beta of your portfolio will be:

A) 1.16.

B) 1.35.

C) 1.00.

D) Cannot be determined without knowing the stock prices.

*Use the following information to answer the following question(s).*

Beta

Market 1

Firm A 1.25

Firm B 0.6

Market Return 10% Risk
Free Rate 2%

17) The market risk premium is

A) 2%.

B) 4%.

C) 6%.

D) 8%.

18) Firm A's risk premium is

A) 4%.

B) 6%.

C) 8%.

D) 10%.

19) Firm B's risk premium is

A) 2.66%.

B) 4.8%.

C) 6.3%.

D) 8.1%.

20) The required rate of return for Firm A is

A) 8%.

B) 12%.

C) 16%.

D) Cannot be determined with information given.

21) U. S. Treasury bills can be used to approximate the
risk-free rate.

Answer: TRUE

22) Long-term bonds issued by large, established
corporations are commonly used to estimate the risk-free rate.

Answer: FALSE

23) The market beta changes frequently with economic
conditions.

Answer: FALSE

24) The S&P 500 Index is commonly used to estimate the
market rate of return.

Answer: TRUE

25) The security market line (SML) intercepts the Y axis at
the risk-free rate.

Answer: FALSE

26) The security market line can drawn by connecting the
risk-free rate and the expected return on the market portfolio.

Answer: TRUE

27) If investors expected inflation to increase in the
future, the SML would shift up, but the slope would remain the same.

Answer: TRUE

28) If investors became more risk averse The SML would
shift downward and the slope of the SML would fall.

Answer: FALSE

29) A security with a beta of zero has a required rate of
return equal to the overall market rate of return.

Answer: FALSE

30) The return for the market during the next period is
expected to be 11.5%; the risk-free rate is 2.5%. Calculate the required rate
of return for a stock with a beta of 1.5.

Answer:

K = 2.5% + 1.5(11.5% - 2.5%) = 16%

31) Asset A has a required return of 18% and a beta of 1.4.
The expected market return is 14%. What is the risk-free rate? Plot the
security market line.

Answer:

K = Krf + (Km - Krf)b

18% = X + (14% - X)1.4

18% - X =19.6% - 1.4X

.4X = 1.6%

X = 4% = Risk - free Rate = Krf

32) Security A has an expected rate of return of 22% and a
beta of 2.5. Security B has a beta of 1.20. If the Treasury bill rate is 2.0%,
what is the expected rate of return for security B?

Answer:

RA = RF + BA(Rm - Rf)

.22 = .02 + 2.5 (Rm - .02)

.20 = 2.5 (Rm - .02) =
2.5 Rm - .05

.25 = 2.5 Rm

.10 = Rm

RB = Rf + BB(Rm - Rf)

RB = .02 + 1.20(.10 - .02)

RB = .116 or 11.6%

33) AA & Co. has a beta of .656. If the expected market
return is 13.2% and the risk-free rate is 5.7%, what is the appropriate
required return of AA & Co. using the CAPM model?

Answer: Required
Rate of Return = Risk-Free Rate + (Market Return - Risk-Free Rate) × Beta =
5.7% + (13.2% - 5.7%) × 0.656 = 10.62%

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