Financial Management (Chapter 8: Risk and Return-Capital Market Theory)

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%