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CHAPTER 11

Risk and Return

I. DEFINITIONS

Topic: PORTFOLIOS
1. 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
Answer: A

Topic: PORTFOLIO WEIGHTS


2. 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.
Answer: B

Topic: SYSTEMATIC RISK


3. 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.
Answer: C

Topic: UNSYSTEMATIC RISK


4. 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.
Answer: D
Topic: PRINCIPLE OF DIVERSIFICATION
5. 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.
Answer: E

Topic: SYSTEMATIC RISK PRINCIPLE


6. 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
Answer: B

Topic: BETA COEFFICIENT


7. 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.
Answer: A

Topic: REWARD TO RISK RATIO


8. 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.
Answer: C

Topic: SECURITY MARKET LINE


9. 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.
Answer: D
Topic: MARKET RISK PREMIUM
10. 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
Answer: E

II CONCEPTS

Topic: RISK PREMIUMS


11. Which of the following is a true statement regarding risky assets?
A) The risk premium is the difference between the return on a risky asset and the
return on the market portfolio.
B) The expected return on an asset is equal to the sum of the possible returns
divided by their probabilities.
C) The risk premium is the expected return on a risky asset less the return on a risk-
free asset.
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.
Answer: C

Topic: RISK AND RETURN


12. The stock in Scoundrel, Inc. shows a historical return of 13.5% with a standard
deviation of 20%. The projected return on Scoundrel, based on 5 possible states of the economy,
is 15.5% with a standard deviation of 22%. Which of the following is true about the stock?
A) The projected returns of Scoundrel must be positive in all possible states of the
economy.
B) Projected returns vary less widely from the expected return than historical returns
did from the historical average return.
C) Investors who prefer assets with high returns and relatively low risk will likely
now be more interested in the stock than in the past.
D) The risk premium for the stock has likely increased.
E) Investors who choose this stock should expect, on average, to lose money.
Answer: D

Topic: PORTFOLIO RETURN AND VARIANCE


13. Which of the following is FALSE 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 and the portfolio variance.
B) Portfolio return can be calculated using the expected return and portfolio weight
for each asset.
C) The portfolio return is needed to calculate the portfolio variance.
D) The portfolio return and variance are dependent on the possible states of nature.
E) The portfolio variance is a weighted average of the variances of the individual
assets in the portfolio.
Answer: E
Topic: EFFICIENT MARKETS
14. 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
Answer: C

Topic: RELEVANT RISK


15. The relevant risk for the fair market pricing of financial securities is the
________________.
A) standard deviation of the investment's return
B) expected part of any announcement
C) part of the return resulting from surprises
D) impact of unsystematic risk
E) risk premium of the investment
Answer: C

Topic: DIVERSIFICATION
16. Regarding diversification, ______________________.
A) most of the benefits are realized with just 20 stocks.
B) it is the process of increasing the riskiness associated with individual assets by
spreading an investment across numerous assets.
C) it is the only type of risk that matters to a rational investor.
D) the portfolio returns are reduced, and the standard deviation of that portfolio
remains unchanged.
E) there is no limit to the amount of risk that can be eliminated through this process.
Answer: A

Topic: DIVERSIFICATION
17. Diversification works because:
A) Unsystematic risk exists.
B) Forming stocks into portfolios reduces the standard deviation of returns for each
stock.
C) Firm-specific risk can be never be reduced.
D) Stocks earn higher returns than bonds.
E) Portfolios have higher returns than individual assets.
Answer: A
Topic: DIVERSIFIABLE RISK
18. Asset-specific risk is also known as _________ risk.
A) total
B) market
C) systematic
D) diversifiable
E) beta
Answer: D

Topic: SYSTEMATIC RISK


19. The risk premium depends only on ______________ risk.
A) total
B) systematic
C) diversifiable
D) asset-specific and market-based
E) identifiable
Answer: B

Topic: BETA
20. The ________ the beta coefficient the _________ the expected return, on
average.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower or higher (depending on the level of the risk-free rate)
E) lower; more risky
Answer: A
Topic: REWARD TO RISK RATIO
21. In market equilibrium:
A) All assets will have the same degree of systematic risk.
B) Assets will have the same reward to risk ratio.
C) Each firm's reward to risk ratio will be based on a different risk-free rate of
return.
D) Systematic risk can be diversified away.
E) All assets will have the same risk premium.
Answer: B

Topic: CAPM
22. The CAPM implies that the expected return for a particular asset does NOT
depend on:
A) The amount of unsystematic risk.
B) The reward for bearing systematic risk.
C) The pure time value of money.
D) The reward to risk ratio.
E) The risk-free interest rate.
Answer: A
Topic: MARKET PORTFOLIO
23. Which of the following is FALSE regarding the market portfolio?
A) The market risk premium determines the slope of the security market line.
B) It plots on the security market line.
C) It has a beta equal to one.
D) It consists of all the stocks on the NYSE and NASDAQ combined.
E) It has the same reward to risk ratio as every individual asset in the market.
Answer: D

Topic: DISCOUNT RATE


24. 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.
IV. The risk-free rate.

A) I only
B) I and II only
C) III only
D) III and IV only
E) II and IV only
Answer: B

Topic: BETA COEFFICIENTS


25. Stock A has a beta coefficient of 0.9, and stock B has a beta coefficient of 1.2.
Which of the following statements is FALSE regarding these two stocks?
A) Stock A is less risky from the market's perspective than a typical stock, and stock
B is more risky than a typical stock.
B) Stock B, if purchased, will increase the market risk of a portfolio more than stock
A would (if purchased).
C) Stock A necessarily must have a lower standard deviation of returns than stock B.
D) Stock B must have a higher expected return than stock A if markets are efficient.
E) Stock A has the same reward to risk ratio as stock B.
Answer: C

Topic: SYSTEMATIC RISK


26. Which of the following risks is irrelevant to a well-diversified investor?
A) Asset-specific risk
B) Market risk
C) Non-diversifiable risk
D) Systematic risk
E) All risks are always relevant
Answer: A
Topic: NEW INFORMATION
27. A security has an unexpected negative news announcement specific to that
security. Most likely, the ______________________________.
A) security's required return on investment will increase.
B) security's required return on investment will remain unchanged.
C) security's required return on investment will decrease.
D) market risk premium will increase.
E) security's market price will remain unchanged.
Answer: A

Topic: SECURITY MARKET LINE


28. Which of the following describes a portfolio that plots above the security market
line?
A) The security is overvalued.
B) The security's reward to risk ratio is too high.
C) The security is providing a return that is less than expected.
D) The security's beta is too high.
E) The security provides a return that is less than the average return on the market.
Answer: B

Topic: DIVERSIFICATION
29. Which of the following is FALSE concerning diversification? Assume that the
securities being considered for selection into a portfolio are not perfectly correlated.
A) As more securities are added to the portfolio, the unsystematic risk of the
portfolio declines.
B) As more securities are added to the portfolio, the total risk of the portfolio
declines.
C) As more securities are added to the portfolio, the systematic risk of the portfolio
declines.
D) As more securities are added to the portfolio, the portfolio risk eventually
approaches the level of systematic risk in the market.
E) If you hold more than 100 securities, then there is little benefit to be gained by
adding a 101st security to the portfolio.
Answer: C

Topic: PORTFOLIO RETURN AND VARIANCE


30. If portfolio weights are positive: 1) Can the return on a portfolio ever be greater
than the largest return on an individual security in the portfolio? 2) Can the variance of a portfolio
ever be greater than the largest 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
Answer: D
Topic: SYSTEMATIC RISK
31. Which of the following would be considered an example of systematic risk?
A) Intel reports record sales.
B) Quarterly profit for GM equals expectations.
C) Lower quarterly sales for IBM than expected.
D) Greater new jobless claims than expected.
E) Fed leaves interest rates unchanged, as expected.
Answer: D

Topic: SYSTEMATIC RISK


32. 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
Answer: B

Topic: TOTAL RISK


33. Portfolio risk is comprised of _________ risk ____________ risk.
A) firm-specific; plus diversifiable
B) systematic; minus unsystematic
C) diversifiable; plus unsystematic
D) market; plus firm-specific
E) market; plus non-diversifiable
Answer: D
Topic: PORTFOLIO SYSTEMATIC RISK
34. Which of the following would likely have the greatest amount of systematic risk?
A) A portfolio of the common stocks of 100 randomly-selected 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.
Answer: D

Topic: PORTFOLIO RETURN


35. In terms of minimizing portfolio riskand assuming you only buy securities and
do not short sell themwhich of the following assets is the most desirable?
A) A zero beta asset like Treasury bills
B) A negative beta asset like gold
C) A small, positive beta asset like an electric utility stock
D) A typical, average asset with beta equal to one
E) A large, positive beta asset like a start-up technology stock
Answer: B
Topic: UNSYSTEMATIC RISK
36. Which of the following would be considered an example of unsystematic risk?
A) Higher quarterly loss than expected for Microsoft.
B) Lower consumer spending than expected.
C) Latest unemployment figures increased as expected.
D) The CEO of AT&T retired as he had promised he would last month.
E) The Fed unexpectedly increases interest rates.
Answer: A

Topic: PORTFOLIO SYSTEMATIC RISK


37. Which of the following would decrease a portfolio's systematic risk?
A) Common stock is sold and replaced with Treasury bills.
B) Stocks with a beta equal to the market beta are added to a portfolio of Treasury
bills.
C) Low-beta stocks are sold and replaced with high-beta stocks.
D) A stock is sold in favor of a different stock with the same beta.
E) The portfolio beta is less than one and the risk-free rate declines.
Answer: A

Topic: SECURITY MARKET LINE


38. The linear nature of the security market line suggests that the beta coefficient for
a security can be estimated via _______________ .
A) scenario analysis
B) NPV analysis
C) means analysis
D) regression analysis
E) IRR analysis
Answer: D
Topic: SYSTEMATIC RISK
39. Which of the following is true regarding a stock with beta equal to 1.5?
A) The stock has a 50% higher expected return than the average stock.
B) Given a market risk premium of 10%, the expected return on the stock would be
15%.
C) The stock has 50% more systematic risk than the average stock.
D) If the risk-free rate is 5%, the expected return on the stock would be 7.5%.
E) The standard deviation of the stock is 50% greater than the market portfolio.
Answer: C
Topic: EXPECTED RISK PREMIUM
40. Your firm invests in a set of risky projects that increase the diversifiable risk of
the firm without changing its systematic risk. All else the same, the expected risk premium on the
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) Increase or decrease, more information is needed.
Answer: C

Topic: EXPECTED RETURNS


41. The return priced into a stock in an efficient market is the ___________ return.
A) actual
B) unsystematic
C) systematic
D) unexpected
E) expected
Answer: E

Topic: UNEXPECTED RETURNS


42. New information regarding a security, when received by the market, leads to
a(n):
A) Unexpected return.
B) Expected return.
C) Actual return.
D) Systematic return.
E) Non-diversifiable return.
Answer: A

Topic: EXPECTED RETURNS


43. _____________ returns are reflected in the current market price of a security.
A) Unexpected
B) Actual
C) Unsystematic
D) Expected
E) Surprise
Answer: D
Topic: PORTFOLIO WEIGHTS
44. Ed Lawrence has $100,000 invested. Of that, $30,000 is invested in IBM stock,
$25,000 is invested in T-bills, and the remainder is invested in corporate bonds. Which of the
following is true regarding his portfolio?
A) Ed has 30% of his portfolio invested in stocks.
B) Ed has 55% of his portfolio invested in corporate bonds.
C) If IBM has a beta less than one, the portfolio has a beta greater than one.
D) Ed has 70% of his portfolio invested in risk-free assets.
E) Changes in the return on IBM stock will have the greatest impact on changes in
the portfolio return.
Answer: A

Topic: EXPECTED RETURNS


45. A telecommunications company just announced that earnings for the first quarter
of the current year fell at an annualized rate of 20%, much worse than the previous quarter's
performance. Upon the announcement, the stock price did not change. (The market in general was
also unchanged.) Which of the following is most likely correct?
A) The market was surprised by the announcement.
B) Interest rates in the economy must have increased.
C) Investors likely anticipated the news release.
D) The price didn't change because the market in general didn't change either.
E) The firm must have a beta coefficient equal to one.
Answer: C

Topic: PORTFOLIO WEIGHTS


46. On a relative basis, the security in a portfolio that causes the biggest change in
portfolio return is the security with:
A) The largest portfolio weight.
B) The smallest portfolio weight.
C) The average portfolio weight.
D) The smallest beta coefficient.
E) The smallest standard deviation of returns.
Answer: A

Topic: TOTAL RISK


47. Which of the following statements is true?
A) Total risk = market risk + unique risk.
B) Total risk = systematic risk + undiversifiable risk.
C) Market risk = undiversifiable risk + asset-specific risk.
D) Announcement return = expected return + market return.
E) Total return = asset-specific return + unexpected return.
Answer: A
Topic: SYSTEMATIC RISK
48. For a large mutual fund that owns many stocks, the addition of one more stock
will likely:
A) Decrease the fund's systematic risk.
B) Increase the fund's systematic risk.
C) Increase the fund's diversifiable risk.
D) Decrease the fund's diversifiable risk.
E) Increase the fund's beta coefficient.
Answer: D

Topic: REWARD TO RISK RATIO


49. The following information is given: 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.
Answer: D

Topic: SECURITY MARKET LINE


50. 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%.
Answer: E

III. PROBLEMS

Topic: PORTFOLIO WEIGHTS


51. You own 50 shares of stock A, which has a price of $12 per share, and 100
shares of stock B, which has a price of $3 per share. What is the portfolio weight for stock A in
your portfolio?
A) 25%
B) 33%
C) 50%
D) 67%
E) 75%
Answer: D
Response: 50($12) + 100(3) = $900; wA = $600 / 900 = .67
Topic: EXPECTED RETURN
52. What is the expected return for the following stock?

A) .05
B) .08
C) .09
D) .10
E) .12
Answer: C
Response: 50(.25) + .35(.05) + .15(-.35) = .09

Topic: RISK PREMIUM


53. What is the risk premium for the following returns if the risk-free rate is 4%?

A) 0.3325
B) 0.1525
C) 0.0525
D) 0.1825
E) 0.2225
Answer: D
Response: .20(.75) + .55(.25) + .15(-10)+ .10(-50) = .2225; RP = .2225 .04 =
.1825
Topic: VARIANCE
54. What is the variance of the following returns?

A) 0.0413
B) 0.1239
C) 0.1944
D) 0.2601
E) 0.3519
Answer: B
Response:

.20(.75 - .2225)2 + .55(.25 - .2225)2 + .15(-.10 - .2225)2 + .10(-.50 - .2225)2 =


.1239

Topic: PORTFOLIO EXPECTED RETURN


55. What is the expected portfolio return given the following information:

A) 6.75%
B) 9.50%
C) 16.75%
D) 18.25%
E) 21.50%
Answer: C
Response: .35(.20) + .15(.35) + .25(.06) + .25(.12) = .1675
Topic: CAPM
56. What is the expected return on asset A if it has a beta of 0.6, the expected market
return is 15%, and the risk-free rate is 6%?
A) 5.4%
B) 9.6%
C) 11.4%
D) 15.0%
Answer: C
Response: 6 + .6(15 - 6) = 11.4%
Topic: CAPM
57. What is the expected market return if the expected return on asset A is 19% and
the risk-free rate is 5%? Asset A has a beta of 1.4.
A) 14%
B) 15%
C) 16%
D) 19%
E) 24%
Answer: B
Response: [(.19 - .05) / 1.4 ] + .05 = .15

Topic: CAPM
58. Asset A has an expected return of 10%. The expected market return is 14% and
the risk-free rate is 5%. What is asset A's beta?
A) 0.33
B) 0.56
C) 0.67
D) 0.88
E) 1.15
Answer: B
Response: (.10 - .05) / (.14 - .05) = 0.56

Topic: CAPM
59. Asset A has an expected return of 20.4% and a beta of 1.6. The expected market
return is 15%. What is the risk-free rate?
A) 2%
B) 4%
C) 5%
D) 6%
E) 8%
Answer: D
Response: [1.6(.15) - .204] / (1.6 - 1) = .06

Topic: CAPM
60. Asset A has an expected return of 14.5% and a beta of 1.15. The risk-free rate is
5%. What is the market risk premium?
A) 8.3%
B) 9.7%
C) 11.5%
D) 12.4%
E) 14.5%
Answer: A
Response: E(RM) Rf = (.145 - .05) / 1.15 = .0826
Topic: PORTFOLIO BETA
61. What is the portfolio beta if 60% of your money is invested in the market
portfolio, and the remainder is invested in a risk-free asset?
A) 0.40
B) 0.50
C) 0.60
D) 0.75
E) 1.00
Answer: C
Response: .60(1) + .40(0) = .60

Topic: PORTFOLIO BETA


62. What is the portfolio beta with 140% of your funds invested in the market
portfolio via borrowing 40% of the funds at the risk-free interest rate?
A) 0.40
B) 0.50
C) 0.60
D) 1.00
E) 1.40
Answer: E
Response: 1.4(1) - .4(0) = 1.4

Topic: PORTFOLIO BETA


63. What is the portfolio beta if 33% of your funds are invested in the market
portfolio, 33% in an asset with twice as much risk as the market portfolio, and the remainder in a
risk-free asset?
A) 0.33
B) 0.67
C) 1.00
D) 1.33
E) 1.67
Answer: C
Response: .33(1) + .33(2) +.33(0) = 1.00

Topic: PORTFOLIO BETA


64. 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
Answer: C
Response: .25(1) + .25(.5) + .25(2) + .25(0) = .875
Topic: PORTFOLIO BETA
65. You hold three stocks in your portfolio: A, B, and C. The portfolio beta is 1.40.
Stock A comprises 15% 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) 0.60
B) 0.88
C) 1.00
D) 1.25
E) 1.40
Answer: D
Response: 1.4 - .15(1) = 1.25

Topic: REWARD TO RISK RATIO


66. Asset A has a reward to risk ratio of .06 and a beta of 1.2. The risk-free rate is
4%. What is the expected return on A?
A) 6.6%
B) 8.0%
C) 9.4%
D) 10.6%
E) 11.2%
Answer: E
Response: (.06 x 1.2) + .04 = .112

Topic: PORTFOLIO BETA


67. Port Company has three divisions. Division A is the stable products division, and
has a beta of 0.7. 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
2.5. 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) 0.7
B) 0.8
C) 1.1
D) 1.4
E) 1.7
Answer: D
Response: 1/3 (.7) + 1/3 (1) + 1/3 (2.5) = 1.4
Topic: PORTFOLIO WEIGHTS
68. You own two risky assets, both of which plot on the security market line. Asset
A has an expected return of 11% and a beta of 0.7. Asset B has an expected return of 20% and a
beta of 1.5. 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) 0.63
D) 0.75
E) 0.88
Answer: C
Response: wA = .5 / .8 = .625

Topic: PORTFOLIO BETA


69. You hold four stocks in your portfolio: A, B, C, and D. The portfolio beta is 1.10.
Stock C comprises 30% of the dollar value of your holdings and has a beta of 1.50. 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 0.8), what will be your new portfolio beta?
A) 0.72
B) 0.89
C) 1.00
D) 1.05
E) 1.22
Answer: B
Response: .3(1.5) + x = 1.1; x = .65; .65 + .3(0.8) = 0.89

Topic: PORTFOLIO STANDARD DEVIATION


70. Given the following information, what is the portfolio standard deviation?

State
Probability
Return
Boom
.25
.40
Good
.50
.15
Recession
.25
.05

A) 1.67%
B) 6.47%
C) 9.61%
D) 12.93%
E) 16.80%
Answer: D

Response: Var. = .25(.40 - .1875)2 + .5(.15 - .1875)2 + .25(.05 - .1875)2 = .0167;


SD = .1293
Topic: PORTFOLIO BETA
71. What is the beta for the following portfolio?

A) 0.73
B) 0.81
C) 0.86
D) 0.94
E) 1.07
Answer: C
Response: [(25)(.75) + (10)(.95) + (15)(1.25) + (40)(1.5) + (35)(0)] / 125 = 0.856

Topic: PORTFOLIO BETA


72. What is the beta of a portfolio made up of two risky assets and a risk-free asset?
You invest 35% in asset A with a beta of 1.2 and 35% in asset B with a beta of 1.1.
A) 0.66
B) 0.81
C) 1.03
D) 1.14
E) 1.29
Answer: B
Response: .35(1.2) + .35(1.1) + .30(0) = 0.805

Topic: PORTFOLIO BETA


73. You form a portfolio by investing equally in A (beta=0.6), B (beta=1.6), the risk-
free asset, and the market portfolio. What is your portfolio beta?
A) 0.6
B) 0.8
C) 1.0
D) 1.2
E) 1.6
Answer: B
Response: 1/4 (.6) + 1/4 (1.6) + 1/4 (0) + 1/4 (1) = .80
Topic: EXPECTED RETURN
74. Which of the following stocks has the greatest expected return and by how
much?

A) A by 8%
B) B by 8%
C) A by 4%
D) B by 4%
E) A and B have the same expected return.
Answer: B
Response: A: .2(.5) + .6(.2) + .2(0) = .22; B: .2(.4) + .6(.3) + .2(.2) = .30

Topic: PORTFOLIO EXPECTED RETURN


75. What is the expected return for the following portfolio?

Asset
Investment
Return
A
$800
0.10
B
$500
0.25
C
$200
0.20
A) 0.1000
B) 0.1125
C) 0.1267
D) 0.1500
E) 0.1633
Answer: E
Response: (8/15)(.10) + (5/15)(.25) + (2/15)(.20) = 0.1633

Use the following to answer questions 76-78:

Standard Deviation
Beta
Security X
0.35
1.45
Security Y
0.28
1.06
Security Z
0.44
1.22

Topic: TOTAL RISK


76. 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.
Answer: A
Topic: SYSTEMATIC RISK
77. 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.
Answer: B

Topic: EXPECTED RETURN


78. 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.
Answer: B

Use the following to answer questions 79-83:

Topic: EXPECTED RETURN


79. What is the expected return on security B?
A) 0.0733
B) 0.0867
C) 0.0950
D) 0.1025
E) 0.1250
Answer: D
Response: .65(.05) + .35(.20) = .1025

Topic: PORTFOLIO EXPECTED RETURN


80. What is the expected return on a portfolio that is 70% invested in A and 30%
invested in B?
A) 0.1413
B) 0.1592
C) 0.1918
D) 0.2247
E) 0.2300
Answer: C
Response:
A: .65(.3) + .35(.1) = .23; B: .65(.05) + .35(.20) = .1025; portfolio: .7(.23) +
.3(.1025) = .1918
Topic: PORTFOLIO EXPECTED RETURN
81. What is the expected return on a portfolio that is equally-weighted amongst A, B,
and the risk-free asset? The risk free rate is 5%.
A) 0.0925
B) 0.1275
C) 0.1450
D) 0.1633
E) 0.1825
Answer: B
Response:
A: .65(.3) + .35(.1) = .23; B: .65(.05) + .35(.20) = .1025
portfolio: 1/3 (.23) + 1/3 (.1025) + 1/3 (.05) = .1275

Topic: STANDARD DEVIATION


82. What is the standard deviation of security A?
A) 0.0091
B) 0.0365
C) 0.0954
D) 0.1247
E) 0.1630
Answer: C

Response: Var. = .65(.3 - .23)2 + .35(.1 - .23)2 = .0091; SD = .0954

Topic: PORTFOLIO STANDARD DEVIATION


83. What is the standard deviation of a portfolio with one-quarter of the funds in A?
A) 0%
B) 1%
C) 2%
D) 3%
E) 4%
Answer: D
Response:
Boom: .25(.3) + .75(.05) = .1125; Bust: .25(.1) + .75(.20) = .1750

Var. = .65(.1125 .1344)2 + .35(.1750 .1344)2 = .0009; SD = .0298

Use the following to answer questions 84-87:

Security
Return
Standard Deviation
Beta
A
16%
20%
1.2
B
12%
25%
0.8
Risk-free asset
4%
???
???
Topic: TOTAL VS. SYSTEMATIC RISK
84. Which of A and B has the least total risk? The least systematic risk?
A) A; A
B) A; B
C) B; A
D) B; B
E) Cannot be determined without more information.
Answer: B

Topic: PORTFOLIO BETA


85. What is the value of systematic risk for a portfolio with 2/3 of the funds invested
in A and 1/3 of the funds invested in B?
A) 0.875
B) 1.067
C) 1.333
D) 1.625
E) 2.167
Answer: B
Response: (2/3)(1.2) + (1/3)(.8) = 1.067

Topic: PORTFOLIO RETURN AND BETA


86. What is the portfolio expected return and the portfolio beta if you invest 35% in
A, 45% in B and 20% in the risk-free asset?
A) 10.2%; 1.12
B) 10.2%; 1.00
C) 11.8%; 0.94
D) 11.8%; 0.72
E) 11.8%; 0.78
Answer: E
Response:
E(R) = .35(.16) + .45(.12) + .2(.04) = .118; = .35(1.2) + .45(.8) + .2(0) = 0.78

Topic: PORTFOLIO RETURN WITH SHORT POSITION


87. What is the portfolio expected return with 140% invested in A and the remainder
in the risk-free asset via borrowing at the risk-free interest rate?
A) 13.7%
B) 16.0%
C) 18.3%
D) 20.8%
E) 24.1%
Answer: D
Response: 1.4(.16) + (-.4)(.04) = .208
Use the following to answer questions 88-92:

Topic: EXPECTED RETURN


88. What is the expected return for asset A?
A) 7.35%
B) 8.50%
C) 9.75%
D) 10.65%
E) 11.90%
Answer: D
Response: .25(.15) + .65(.10) + .10(.04) = .1065

Topic: STANDARD DEVIATION


89. What is the standard deviation of returns for asset A?
A) 1.3%
B) 1.8%
C) 2.6%
D) 3.1%
E) 4.5%
Answer: D

Response: Var. = .25(.15 - .1065)2 + .65(.10 - .1065)2 + .10(.04 - .1065)2 =


.000943; SD = .0307

Topic: STANDARD DEVIATION


90. What is the standard deviation of returns for asset B?
A) 1.4%
B) 2.2%
C) 2.9%
D) 3.6%
E) 5.2%
Answer: D

Response: Var. = .25(.0275)2 + .65(.04 - .0275)2 + .10(.09 - .0275)2 = .001319;


SD = .0363

Topic: PORTFOLIO RETURN


91. What is the expected return on a portfolio with weights of 40% in asset A and
60% in asset B?
A) 3.1%
B) 4.5%
C) 5.9%
D) 8.4%
E) 9.3%
Answer: C
Response: .4(.1065) + .6(.0275) = .0591
Topic: PORTFOLIO STANDARD DEVIATION
92. What is the standard deviation of a portfolio with weights of 40% in security A
and the remainder in security B?
A) 1.0%
B) 1.4%
C) 1.9%
D) 2.3%
E) 3.6%
Answer: A
Response:

Var. = .25(.042 .0591)2 + .65(.064 .0591)2 + .10(.070 .0591)2 = .000101; SD =


.0100

IV. ESSAYS

Topic: CAPM
93. 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.

Answer:
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.

Topic: SECURITY MARKET LINE


94. 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.

Answer:
The student should draw a picture similar to Figure 11.3, 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.
Topic: REWARD TO RISK RATIOS
95. Explain what we mean when we say all assets have the same reward to risk ratio.
What does this mean for investors?

Answer:
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.

Topic: DIVERSIFIABLE RISK


96. Why are some risks diversifiable and some nondiversifiable? Give an example of
each.

Answer:
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.

Topic: RISK
97. 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?)

Answer:
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.
Topic: EMH, CAPM, AND THE MARKET VALUE RULE
98. 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?

Answer:
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 6 & 7). Finally, any valuation model we
employ will require us to quantify return and risk (Chapters 10 and 11).

Topic: BETA
99. Explain in words what beta is and why it is important.

Answer:
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.

Topic: NEGATIVE BETA


100. Is it possible for an asset to have a negative beta? (Hint: yes.) What would the
expected return on such an asset be? Why?

Answer:
While it is unlikely to observe a negative beta asset, it would have less systematic risk than the
risk-free 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).

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