risk and rates of return exercise

8/12/2019 RISK AND RATES OF RETURN EXERCISE

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(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/Fstatements are used in the MC questions. See the preface for information on the AACS letterindicators !F, M, etc." on the sub#ect lines.

Multiple Choice: True/alse

(8-2) Standard deviation F N Answer: b EASY

1. The tighter the probability distribution of its expected future returns,the greater the risk of a given investment as measured by its standarddeviation.

a. Trueb. False

(8-2) Coefficient of variation F N Answer: a EASY

2. The coefficient of variation, calculated as the standard deviation ofexpected returns divided by the expected return, is a standardizedmeasure of the risk per unit of expected return.

a. Trueb. False

(8-2) CV vs. SD F N Answer: b EASY

3. The standard deviation is a better measure of risk than the coefficient

of variation if the expected returns of the securities being compareddiffer significantly.

a. Trueb. False

(8-2) is! aversion F N Answer: a EASY

. !isk"averse investors re#uire higher rates of return on investments$hose returns are highly uncertain, and most investors are risk averse.

a. Trueb. False

(8-") #ortfo$io ris! F N Answer: a EASY%. &hen adding a randomly chosen ne$ stock to an existing portfolio, the

higher 'or more positive( the degree of correlation bet$een the ne$stock and stocks already in the portfolio, the less the additional stock$ill reduce the portfolio)s risk.

a. Trueb. False

Chapter 8: Risk and Return True/False Page 7

2013 Cengage Learning. ll Rights Reser!ed. "a# n$t %e &$pied' s&anned' $r dupli&ated' in (h$le $r in part' e)&ept *$r use as per+itted ina li&ense distri%uted (ith a &ertain pr$du&t $r ser!i&e $r $ther(ise $n a pass($rd,pr$te&ted (e%site *$r &lassr$$+ use.

CH!"TE# $#%&' !D #!TE& #ET*#


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(8-") #ortfo$io ris! F N Answer: a EASY

*. +iversification $ill normally reduce the riskiness of a portfolio ofstocks.

a. Trueb. False

(8-") #ortfo$io ris! F N Answer: a EASY

. -n portfolio analysis, $e often use ex post 'historical( returns andstandard deviations, despite the fact that $e are really interested inex ante 'future( data.

a. Trueb. False

(8-") #ortfo$io ret%rn F N Answer: b EASY

. The realized return on a stock portfolio is the $eighted average of theexpected returns on the stocks in the portfolio.

a. Trueb. False

(8-") &ar!et ris! F N Answer: a EASY

/. 0arket risk refers to the tendency of a stock to move $ith the generalstock market. stock $ith above"average market risk $ill tend to bemore volatile than an average stock, and its beta $ill be greater than1..

a. Trueb. False

(8-") &ar!et ris! F N Answer: b EASY

1. n individual stock)s diversifiable risk, $hich is measured by its beta,can be lo$ered by adding more stocks to the portfolio in $hich the stockis held.

a. Trueb. False

(8-") is! and e'ected ret%rns F N Answer: b EASY

11. 0anagers should under no conditions take actions that increase theirfirm)s risk relative to the market, regardless of ho$ much those actions$ould increase the firm)s expected rate of return.

a. Trueb. False

(8-") CA#& and ris! F N Answer: a EASY

12. ne key conclusion of the 4apital sset 5ricing 0odel is that the valueof an asset should be measured by considering both the risk and theexpected return of the asset, assuming that the asset is held in a $ell"diversified portfolio. The risk of the asset held in isolation is notrelevant under the 450.

Page 8 True/False Chapter 8: Risk and Return



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a. Trueb. False

(8-") CA#& and ris! F N Answer: a EASY

13. ccording to the 4apital sset 5ricing 0odel, investors are primarily

concerned $ith portfolio risk, not the risks of individual stocks heldin isolation. Thus, the relevant risk of a stock is the stock)scontribution to the riskiness of a $ell"diversified portfolio.

a. Trueb. False

(8-) S&* and ris! aversion F N Answer: b EASY

1. -f investors become less averse to risk, the slope of the 6ecurity0arket 7ine '607( $ill increase.

a. Trueb. False

(8-+) #,sica$ assets F N Answer: a EASY

1%. 0ost corporations earn returns for their stockholders by ac#uiring andoperating tangible and intangible assets. The relevant risk of eachasset should be measured in terms of its effect on the risk of thefirm)s stockholders.

a. Trueb. False

(8-2) Variance F N Answer: a &ED/&

1*. 8ariance is a measure of the variability of returns, and since itinvolves s#uaring the deviation of each actual return from the expected

return, it is al$ays larger than its s#uare root, the standarddeviation.

a. Trueb. False

(8-2) Coefficient of variation F N Answer: a &ED/&

1. 9ecause of differences in the expected returns on different investments,the standard deviation is not al$ays an ade#uate measure of risk.:o$ever, the coefficient of variation ad;usts for differences inexpected returns and thus allo$s investors to make better comparisons ofinvestments) stand"alone risk.

a. Trueb. False

(8-2) is! aversion F N Answer: a &ED/&

1.

a. Trueb. False

Chapter 8: Risk and Return True/False Page -



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(8-2) is! aversion F N Answer: a &ED/&

1/. -f investors are risk averse and hold only one stock, $e can concludethat the re#uired rate of return on a stock $hose standard deviation is.21 $ill be greater than the re#uired return on a stock $hose standarddeviation is .1. :o$ever, if stocks are held in portfolios, it ispossible that the re#uired return could be higher on the stock $ith the

lo$er standard deviation.

a. Trueb. False

(8-2) is! re0. and ris! aversion F N Answer: a &ED/&

2. 6omeone $ho is risk averse has a general dislike for risk and apreference for certainty. -f risk aversion exists in the market, theninvestors in general are $illing to accept some$hat lo$er returns onless risky securities. +ifferent investors have different degrees ofrisk aversion, and the end result is that investors $ith greater riskaversion tend to hold securities $ith lo$er risk 'and therefore a lo$erexpected return( than investors $ho have more tolerance for risk.

a. Trueb. False

(8-") 1eta coefficient F N Answer: b &ED/&

21. stock)s beta measures its diversifiable risk relative to thediversifiable risks of other firms.

a. Trueb. False

(8-") 1eta coefficient F N Answer: b &ED/&

22. stock)s beta is more relevant as a measure of risk to an investor $ho

holds only one stock than to an investor $ho holds a $ell"diversifiedportfolio.

a. Trueb. False

(8-") 1eta coefficient F N Answer: a &ED/&

23. -f the returns of t$o firms are negatively correlated, then one of themmust have a negative beta.

a. Trueb. False

(8-") 1eta coefficient F N Answer: b &ED/& 2. stock $ith a beta e#ual to "1. has zero systematic 'or market( risk.

a. Trueb. False

Chapter 8: Risk and Return True/False Page 11



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(8-") 1eta coefficient F N Answer: a &ED/&

2%. -t is possible for a firm to have a positive beta, even if thecorrelation bet$een its returns and those of another firm is negative.

a. Trueb. False

(8-") #ortfo$io ris! F N Answer: a &ED/&

2*. 5ortfolio has but one security, $hile 5ortfolio 9 has 1 securities.9ecause of diversification effects, $e $ould expect 5ortfolio 9 to havethe lo$er risk. :o$ever, it is possible for 5ortfolio to be lessrisky.

a. Trueb. False

(8-") #ortfo$io ris! F N Answer: b &ED/&

2. 5ortfolio has but one stock, $hile 5ortfolio 9 consists of all stocksthat trade in the market, each held in proportion to its market value.

9ecause of its diversification, 5ortfolio 9 $ill by definition beriskless.

a. Trueb. False

(8-") #ortfo$io ris! F N Answer: b &ED/&

2. portfolio)s risk is measured by the $eighted average of the standarddeviations of the securities in the portfolio. -t is this aspect ofportfolios that allo$s investors to combine stocks and thus reduce theriskiness of their portfolios.

a. True

b. False

(8-") #ortfo$io ris! and ret%rn F N Answer: b &ED/&

2/. The distributions of rates of return for 4ompanies and 99 are givenbelo$>

6tate of the 5robability of?conomy This 6tate ccurring 999oom .2 3@ "1@Aormal .* 1@ %@!ecession .2 "%@ %@

&e can conclude from the above information that any rational, risk"

averse investor $ould be better off adding 6ecurity to a $ell"diversified portfolio over 6ecurity 99.

a. Trueb. False

(8-") Cor. coefficient and ris! F N Answer: b &ED/&

3. ?ven if the correlation bet$een the returns on t$o securities is B1.,if the securities are combined in the correct proportions, the resulting




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2"asset portfolio $ill have less risk than either security held alone.

a. Trueb. False

(8-") Co0an-secific ris! F N Answer: a &ED/&

31

. 9ad managerial ;udgments or unforeseen negative events that happen to afirm are defined as


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(8-) C,an3es in beta F N Answer: a &ED/&

3. firm can change its beta through managerial decisions, includingcapital budgeting and capital structure decisions.

a. True

b. False

(8-) C,an3es in beta F N Answer: a &ED/&

3. ny change in its beta is likely to affect the re#uired rate of returnon a stock, $hich implies that a change in beta $ill likely have animpact on the stock)s price, other things held constant.

a. Trueb. False

(8-) S&* F N Answer: b &ED/&

3/. The slope of the 607 is determined by the value of beta.

a. Trueb. False

(8-) S&* F N Answer: a &ED/&

. The slope of the 607 is determined by investors) aversion to risk. Thegreater the average investor)s risk aversion, the steeper the 607.

a. Trueb. False


1. -f you plotted the returns of a company against those of the market andfound that the slope of your line $as negative, the 450 $ould indicatethat the re#uired rate of return on the stock should be less than therisk"free rate for a $ell"diversified investor, assuming that theobserved relationship is expected to continue in the future.

a. Trueb. False


2. -f you plotted the returns on a given stock against those of the market,and if you found that the slope of the regression line $as negative, the450 $ould indicate that the re#uired rate of return on the stock shouldbe greater than the risk"free rate for a $ell"diversified investor,assuming that the observed relationship is expected to continue into thefuture.

a. Trueb. False


3. The D"axis intercept of the 607 represents the re#uired return of aportfolio $ith a beta of zero, $hich is the risk"free rate.




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a. Trueb. False


. The 607 relates re#uired returns to firms) systematic 'or market( risk.The slope and intercept of this line can be influenced by a manager)s

actions.

a. Trueb. False


%. The D"axis intercept of the 607 indicates the re#uired return on anindividual asset $henever the realized return on an average 'b E 1(stock is zero.

a. Trueb. False

(8-) CA#& and inf$ation F N Answer: a &ED/& *. -f the price of money 'e.g., interest rates and e#uity capital costs(

increases due to an increase in anticipated inflation, the risk"freerate $ill also increase. -f there is no change in investors) riskaversion, then the market risk premium 'r0 r!F( $ill remain constant.lso, if there is no change in stocks) betas, then the re#uired rate ofreturn on each stock as measured by the 450 $ill increase by the sameamount as the increase in expected inflation.

a. Trueb. False

(8-) &ar!et ris! re0i%0 F N Answer: a &ED/&

. 6ince the market return represents the expected return on an averagestock, the market return reflects a certain amount of risk. s aresult, there exists a market risk premium, $hich is the amount over andabove the risk"free rate, that is re#uired to compensate stock investorsfor assuming an average amount of risk.

a. Trueb. False

(8-") 1eta coefficient F N Answer: a 4AD

. ssume that t$o investors each hold a portfolio, and that portfolio istheir only asset. -nvestor )s portfolio has a beta of minus 2., $hile-nvestor 9)s portfolio has a beta of plus 2.. ssuming that theunsystematic risks of the stocks in the t$o portfolios are the same,then the t$o investors face the same amount of risk. :o$ever, theholders of either portfolio could lo$er their risks, and by exactly thesame amount, by adding some


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/. The 450 is a multi"period model that takes account of differences insecurities) maturities, and it can be used to determine the re#uiredrate of return for any given level of systematic risk.

a. Trueb. False




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Multiple Choice: Conceptual

(8-") is! aversion C N Answer: c &ED/&

%. Dou have the follo$ing data on three stocks>

6tock 6tandard +eviation 9eta

2@ .%/9 1@ .*14 12@ 1.2/

-f you are a strict risk minimizer, you $ould choose 6tock GGGG if it isto be held in isolation and 6tock GGGG if it is to be held as part of a$ell"diversified portfolio.

a. H .b. H 9.c. 9H .d. 4H .e. 4H 9.

(8-") is! 0eas%res C N Answer: d &ED/&

%1. &hich is the best measure of risk for a single asset held in isolation,and $hich is the best measure for an asset held in a diversifiedportfolioI

a. 8arianceH correlation coefficient.b. 6tandard deviationH correlation coefficient.c. 9etaH variance.d. 4oefficient of variationH beta.e. 9etaH beta.

(8-") Stoc! se$ection in ortfo$io C N Answer: c &ED/&

%2. highly risk"averse investor is considering adding one additional stockto a 3"stock portfolio, to form a "stock portfolio. The three stockscurrently held all have b E 1., and they are perfectly positivelycorrelated $ith the market. 5otential ne$ 6tocks and 9 both haveexpected returns of 1%@, are in e#uilibrium, and are e#ually correlated$ith the market, $ith r E .%. :o$ever, 6tock )s standard deviationof returns is 12@ versus @ for 6tock 9. &hich stock should thisinvestor add to his or her portfolio, or does the choice not matterI

a. ?ither or 9, i.e., the investor should be indifferent bet$een thet$o.

b. 6tock .c. 6tock 9.

d. Aeither nor 9, as neither has a return sufficient to compensate forrisk.

e. dd , since its beta must be lo$er.

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(8-") 1eta coefficients C N Answer: c &ED/&

%3. &hich of the follo$ing is AT a potential problem $hen estimating andusing betas, i.e., $hich statement is F76?I

a. The fact that a security or pro;ect may not have a past history thatcan be used as the basis for calculating beta.

b. 6ometimes, during a period $hen the company is undergoing a changesuch as to$ard more leverage or riskier assets, the calculated beta$ill be drastically different from the


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(8-") 1eta coefficients C N Answer: b &ED/&

%%. &hich of the follo$ing statements is 4!!?4TI

a. 4ollections -nc. is in the business of collecting past"due accountsfor other companies, i.e., it is a collection agency. 4ollections)revenues, profits, and stock price tend to rise during recessions.

This suggests that 4ollections -nc.)s beta should be #uite high, say2., because it does so much better than most other companies $henthe economy is $eak.

b. 6uppose the returns on t$o stocks are negatively correlated. ne hasa beta of 1.2 as determined in a regression analysis using data forthe last % years, $hile the other has a beta of ".*. The returns onthe stock $ith the negative beta must have been negatively correlated$ith returns on most other stocks during that %"year period.

c. 6uppose you are managing a stock portfolio, and you have informationthat leads you to believe the stock market is likely to be verystrong in the immediate future. That is, you are convinced that themarket is about to rise sharply. Dou should sell your high"betastocks and buy lo$"beta stocks in order to take advantage of the

expected market move.d. Dou think that investor sentiment is about to change, and investorsare about to become more risk averse. This suggests that you shouldrebalance your portfolio to include more high"beta stocks.

e. -f the market risk premium remains constant, but the risk"free ratedeclines, then the re#uired returns on lo$"beta stocks $ill rise$hile those on high"beta stocks $ill decline.

(8-") 1eta coefficients C N Answer: e &ED/&

%*. &hich of the follo$ing statements is 4!!?4TI

a. -f a company $ith a high beta merges $ith a lo$"beta company, thebest estimate of the ne$ merged company)s beta is 1..

b. 7ogically, it is easier to estimate the betas associated $ith capitalbudgeting pro;ects than the betas associated $ith stocks, especiallyif the pro;ects are closely associated $ith research and developmentactivities.

c. The beta of an


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b. -n e#uilibrium, the expected return on 6tock 9 $ill be greater thanthat on 6tock .

c. &hen held in isolation, 6tock has more risk than 6tock 9.d. 6tock 9 $ould be a more desirable addition to a portfolio than .e. -n e#uilibrium, the expected return on 6tock $ill be greater than

that on 9.

(8-") 1eta coefficients C N Answer: c &ED/&

%. 6tock J has a beta of .% and 6tock D has a beta of 1.%. &hich of thefollo$ing statements must be true, according to the 450I

a. -f you invest K%, in 6tock J and K%, in 6tock D, your 2"stockportfolio $ould have a beta significantly lo$er than 1., providedthe returns on the t$o stocks are not perfectly correlated.

b. 6tock D)s realized return during the coming year $ill be higher than6tock J)s return.

c. -f the expected rate of inflation increases but the market riskpremium is unchanged, the re#uired returns on the t$o stocks shouldincrease by the same amount.

d. 6tock D)s return has a higher standard deviation than 6tock J.e. -f the market risk premium declines, but the risk"free rate isunchanged, 6tock J $ill have a larger decline in its re#uired returnthan $ill 6tock D.

(8-") 1eta coefficients C N Answer: d &ED/&

%/. Dou have the follo$ing data on '1( the average annual returns of themarket for the past % years and '2( similar information on 6tocks and9. &hich of the possible ans$ers best describes the historical betasfor and 9I

Dears 0arket 6tock 6tock 91 .3 .1* .%

2 ".% .2 .%3 .1 .1 .% ".1 .2% .%% .* .1 .%

a. bL H b9E 1.b. bL B1H b9E .c. bE H b9E "1.d. bM H b9E .e. bM "1H b9E 1.

(8-") #ortfo$io ris! C N Answer: e &ED/&

*. &hich of the follo$ing statements is 4!!?4TI

a. n investor can eliminate virtually all market risk if he or sheholds a very large and $ell diversified portfolio of stocks.

b. The higher the correlation bet$een the stocks in a portfolio, thelo$er the risk inherent in the portfolio.

c. -t is impossible to have a situation $here the market risk of asingle stock is less than that of a portfolio that includes thestock.

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d. nce a portfolio has about stocks, adding additional stocks $illnot reduce its risk by even a small amount.

e. n investor can eliminate virtually all diversifiable risk if he orshe holds a very large, $ell"diversified portfolio of stocks.




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(8-") #ortfo$io ris! and beta C N Answer: c &ED/&

*1. &hich of the follo$ing statements is 4!!?4TI

a. -f you add enough randomly selected stocks to a portfolio, you cancompletely eliminate all of the market risk from the portfolio.

b. -f you $ere restricted to investing in publicly traded common stocks,

yet you $anted to minimize the riskiness of your portfolio asmeasured by its beta, then according to the 450 theory you shouldinvest an e#ual amount of money in each stock in the market. Thatis, if there $ere 1, traded stocks in the $orld, the least riskypossible portfolio $ould include some shares of each one.

c. -f you formed a portfolio that consisted of all stocks $ith betasless than 1., $hich is about half of all stocks, the portfolio $oulditself have a beta coefficient that is e#ual to the $eighted averagebeta of the stocks in the portfolio, and that portfolio $ould haveless risk than a portfolio that consisted of all stocks in themarket.

d. 0arket risk can be eliminated by forming a large portfolio, and ifsome Treasury bonds are held in the portfolio, the portfolio can be

made to be completely riskless.e. portfolio that consists of all stocks in the market $ould have are#uired return that is e#ual to the riskless rate.

(8-") &ar!et ris! C N Answer: c &ED/&

*2. -nflation, recession, and high interest rates are economic events thatare best characterized as being

a. systematic risk factors that can be diversified a$ay.b. company"specific risk factors that can be diversified a$ay.c. among the factors that are responsible for market risk.d. risks that are beyond the control of investors and thus should not be

considered by security analysts or portfolio managers.

e. irrelevant except to governmental authorities like the Federal!eserve.

(8-") is! and ort. divers. C N Answer: e &ED/&

*3. &hich of the follo$ing statements is 4!!?4TI

a. stock)s beta is less relevant as a measure of risk to an investor$ith a $ell"diversified portfolio than to an investor $ho holds onlythat one stock.

b. -f an investor buys enough stocks, he or she can, throughdiversification, eliminate all of the diversifiable risk inherent ino$ning stocks. Therefore, if a portfolio contained all publiclytraded stocks, it $ould be essentially riskless.

c. The re#uired return on a firm)s common stock is, in theory,determined solely by its market risk. -f the market risk is kno$n,and if that risk is expected to remain constant, then no otherinformation is re#uired to specify the firm)s re#uired return.

d. 5ortfolio diversification reduces the variability of returns 'asmeasured by the standard deviation( of each individual stock held ina portfolio.

e. security)s beta measures its non"diversifiable, or market, riskrelative to that of an average stock.




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(8-") is! and ort. divers. C N Answer: b &ED/&


a. large portfolio of randomly selected stocks $ill al$ays have astandard deviation of returns that is less than the standarddeviation of a portfolio $ith fe$er stocks, regardless of ho$ the

stocks in the smaller portfolio are selected.b. +iversifiable risk can be reduced by forming a large portfolio, but

normally even highly"diversified portfolios are sub;ect to market 'orsystematic( risk.

c. large portfolio of randomly selected stocks $ill have a standarddeviation of returns that is greater than the standard deviation of a1"stock portfolio if that one stock has a beta less than 1..

d. large portfolio of stocks $hose betas are greater than 1. $illhave less market risk than a single stock $ith a beta E ..

e. -f you add enough randomly selected stocks to a portfolio, you cancompletely eliminate all of the market risk from the portfolio.

(8-") #ort. ris!6 ret%rn6 and beta C N Answer: b &ED/&

*%. &hich of the follo$ing statements is 4!!?4TI

a. t$o"stock portfolio $ill al$ays have a lo$er standard deviationthan a one"stock portfolio.

b. portfolio that consists of stocks that are not highly correlated$ith


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c. 5ortfolio 9)s re#uired return is greater than the re#uired return on6tock .

d. 5ortfolio 94)s expected return is 1.****@.e. 5ortfolio 94 has a standard deviation of 2@.

(8-") #ort. ret%rn6 CA#&6 and beta C N Answer: b &ED/&


a. -f the returns on t$o stocks are perfectly positively correlated'i.e., the correlation coefficient is B1.( and these stocks haveidentical standard deviations, an e#ually $eighted portfolio of thet$o stocks $ill have a standard deviation that is less than that ofthe individual stocks.

b. portfolio $ith a large number of randomly selected stocks $ouldhave more market risk than a single stock that has a beta of .%,assuming that the stock)s beta $as correctly calculated and isstable.

c. -f a stock has a negative beta, its expected return must be negative.d. portfolio $ith a large number of randomly selected stocks $ould

have less market risk than a single stock that has a beta of .%.e. ccording to the 450, stocks $ith higher standard deviations ofreturns must also have higher expected returns.

(8-") #ortfo$io ris! and ret%rn C N Answer: d &ED/&

*. For a portfolio of randomly selected stocks, $hich of the follo$ingis most likely to be trueI

a. The riskiness of the portfolio is greater than the riskiness of eachof the stocks if each $as held in isolation.

b. The riskiness of the portfolio is the same as the riskiness of eachstock if it $as held in isolation.

c. The beta of the portfolio is less than the $eighted average of the

betas of the individual stocks.d. The beta of the portfolio is e#ual to the $eighted average of the

betas of the individual stocks.e. The beta of the portfolio is larger than the $eighted average of the

betas of the individual stocks.

(8-") #ortfo$io ris! and ret%rn C N Answer: a &ED/&

*/. &hich of the follo$ing statements best describes $hat you should expectif you randomly select stocks and add them to your portfolioI

a. dding more such stocks $ill reduce the portfolio)s unsystematic, ordiversifiable, risk.

b. dding more such stocks $ill increase the portfolio)s expected rate

of return.c. dding more such stocks $ill reduce the portfolio)s beta coefficient

and thus its systematic risk.d. dding more such stocks $ill have no effect on the portfolio)s risk.e. dding more such stocks $ill reduce the portfolio)s market risk but

not its unsystematic risk.




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(8-") #ortfo$io ris! and ret%rn C N Answer: b &ED/&

. 9ob has a K%, stock portfolio $ith a beta of 1.2, an expected returnof 1.@, and a standard deviation of 2%@. 9ecky also has a K%,portfolio, but it has a beta of ., an expected return of /.2@, and astandard deviation that is also 2%@. The correlation coefficient, r,bet$een 9ob)s and 9ecky)s portfolios is zero. -f 9ob and 9ecky marry

and combine their portfolios, $hich of the follo$ing best describestheir combined K1, portfolioI

a. The combined portfolio)s expected return $ill be less than the simple$eighted average of the expected returns of the t$o individualportfolios, 1.@.

b. The combined portfolio)s beta $ill be e#ual to a simple $eightedaverage of the betas of the t$o individual portfolios, 1.H itsexpected return $ill be e#ual to a simple $eighted average of theexpected returns of the t$o individual portfolios, 1.@H and itsstandard deviation $ill be less than the simple average of the t$oportfolios) standard deviations, 2%@.

c. The combined portfolio)s expected return $ill be greater than the

simple $eighted average of the expected returns of the t$o individualportfolios, [email protected]. The combined portfolio)s standard deviation $ill be greater than the

simple average of the t$o portfolios) standard deviations, 2%@.e. The combined portfolio)s standard deviation $ill be e#ual to a simple

average of the t$o portfolios) standard deviations, 2%@.

(8-") #ortfo$io ris! and ret%rn C N Answer: c &ED/&

1. Dour portfolio consists of K%, invested in 6tock J and K%,invested in 6tock D. 9oth stocks have an expected return of 1%@, betasof 1.*, and standard deviations of 3@. The returns of the t$o stocksare independent, so the correlation coefficient bet$een them, rJD, iszero. &hich of the follo$ing statements best describes the

characteristics of your 2"stock portfolioI

a. Dour portfolio has a standard deviation of 3@, and its expectedreturn is 1%@.

b. Dour portfolio has a standard deviation less than 3@, and its betais greater than 1.*.

c. Dour portfolio has a beta e#ual to 1.*, and its expected return is1%@.

d. Dour portfolio has a beta greater than 1.*, and its expected returnis greater than 1%@.

e. Dour portfolio has a standard deviation greater than 3@ and a betae#ual to 1.*.

(8-") #ortfo$io ris! and ret%rn C N Answer: a &ED/& 2. &hich of the follo$ing is most likely to occur as you add randomly

selected stocks to your portfolio, $hich currently consists of 3 averagestocksI

a. The diversifiable risk of your portfolio $ill likely decline, but theexpected market risk should not change.

b. The expected return of your portfolio is likely to decline.




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c. The diversifiable risk $ill remain the same, but the market risk $illlikely decline.

d. 9oth the diversifiable risk and the market risk of your portfolio arelikely to decline.

e. The total risk of your portfolio should decline, and as a result, theexpected rate of return on the portfolio should also decline.

(8-") #ortfo$io ris! and ret%rn C N Answer: c &ED/&

3. Nane has a portfolio of 2 average stocks, and +ick has a portfolio of 2average stocks. ssuming the market is in e#uilibrium, $hich of thefollo$ing statements is 4!!?4TI

a. Nane)s portfolio $ill have less diversifiable risk and also lessmarket risk than +ick)s portfolio.

b. The re#uired return on Nane)s portfolio $ill be lo$er than that on+ick)s portfolio because Nane)s portfolio $ill have less total risk.

c. +ick)s portfolio $ill have more diversifiable risk, the same marketrisk, and thus more total risk than Nane)s portfolio, but there#uired 'and expected( returns $ill be the same on both portfolios.

d. -f the t$o portfolios have the same beta, their re#uired returns $illbe the same, but Nane)s portfolio $ill have less market risk than+ick)s.

e. The expected return on Nane)s portfolio must be lo$er than theexpected return on +ick)s portfolio because Nane is more diversified.


. 6tocks and 9 each have an expected return of 12@, a beta of 1.2, and astandard deviation of 2%@. The returns on the t$o stocks have acorrelation of B.*. 5ortfolio 5 has %@ in 6tock and %@ in 6tock 9.&hich of the follo$ing statements is 4!!?4TI

a. 5ortfolio 5 has a beta that is greater than 1.2.

b. 5ortfolio 5 has a standard deviation that is greater than 2%@.c. 5ortfolio 5 has an expected return that is less than [email protected]. 5ortfolio 5 has a standard deviation that is less than 2%@.e. 5ortfolio 5 has a beta that is less than 1.2.

(8-") #ortfo$io ris! and ret%rn C N Answer: e &ED/&

%. 6tocks , 9, and 4 all have an expected return of 1@ and a standarddeviation of 2%@. 6tocks and 9 have returns that are independent ofone another, i.e., their correlation coefficient, r, e#uals zero.6tocks and 4 have returns that are negatively correlated $ith oneanother, i.e., r is less than . 5ortfolio 9 is a portfolio $ith halfof its money invested in 6tock and half in 6tock 9. 5ortfolio 4 is aportfolio $ith half of its money invested in 6tock and half invested

in 6tock 4. &hich of the follo$ing statements is 4!!?4TI

a. 5ortfolio 4 has an expected return that is less than [email protected]. 5ortfolio 4 has an expected return that is greater than 2%@.c. 5ortfolio 9 has a standard deviation that is greater than 2%@.d. 5ortfolio 9 has a standard deviation that is e#ual to 2%@.e. 5ortfolio 4 has a standard deviation that is less than 2%@.

(8-") #ortfo$io ris! and ret%rn C N Answer: b &ED/&




22/61

*. 6tocks and 9 each have an expected return of 1%@, a standard deviationof 2@, and a beta of 1.2. The returns on the t$o stocks have acorrelation coefficient of B.*. Dou have a portfolio that consists of%@ and %@ 9. &hich of the follo$ing statements is 4!!?4TI

a. The portfolio)s beta is less than 1.2.b. The portfolio)s expected return is 1%@.c. The portfolio)s standard deviation is greater than [email protected]. The portfolio)s beta is greater than 1.2.e. The portfolio)s standard deviation is 2@.




23/61


. 6tock has a beta of ., 6tock 9 has a beta of 1., and 6tock 4 has abeta of 1.2. 5ortfolio 5 has 1O3 of its value invested in each stock.?ach stock has a standard deviation of 2%@, and their returns areindependent of one another, i.e., the correlation coefficients bet$eeneach pair of stocks is zero. ssuming the market is in e#uilibrium,

$hich of the follo$ing statements is 4!!?4TI

a. 5ortfolio 5)s expected return is greater than the expected return on6tock 9.

b. 5ortfolio 5)s expected return is e#ual to the expected return on6tock .

c. 5ortfolio 5)s expected return is less than the expected return on6tock 9.

d. 5ortfolio 5)s expected return is e#ual to the expected return on6tock 9.

e. 5ortfolio 5)s expected return is greater than the expected return on6tock 4.

(8-") #ortfo$io ris! and ret%rn C N Answer: c &ED/& . -n a portfolio of three randomly selected stocks, $hich of the follo$ing

could AT be true, i.e., $hich statement is falseI

a. The riskiness of the portfolio is less than the riskiness of each ofthe stocks if they $ere held in isolation.

b. The riskiness of the portfolio is greater than the riskiness of oneor t$o of the stocks.

c. The beta of the portfolio is lo$er than the lo$est of the threebetas.

d. The beta of the portfolio is higher than the highest of the threebetas.

e. The beta of the portfolio is calculated as a $eighted average of the

individual stocksP betas.

(8-) #ort. ris! 7 ret. re$ations,is C N Answer: b &ED/&

/. 6tock has a beta E ., $hile 6tock 9 has a beta E 1.*. &hich of thefollo$ing statements is 4!!?4TI

a. 6tock 9)s re#uired return is double that of 6tock )s.b. -f the marginal investor becomes more risk averse, the re#uired

return on 6tock 9 $ill increase by more than the re#uired return on6tock .

c. n e#ually $eighted portfolio of 6tocks and 9 $ill have a betalo$er than 1.2.

d. -f the marginal investor becomes more risk averse, the re#uired

return on 6tock $ill increase by more than the re#uired return on6tock 9.

e. -f the risk"free rate increases but the market risk premium remainsconstant, the re#uired return on 6tock $ill increase by more thanthat on 6tock 9.

Chapter 8: Risk and Return C$n&eptual "/C Page 2-



24/61

(8-) #ort. ris! 7 ret. re$ations,is C N Answer: b &ED/&

. 6tock has an expected return of 12@, a beta of 1.2, and a standarddeviation of 2@. 6tock 9 also has a beta of 1.2, but its expectedreturn is 1@ and its standard deviation is 1%@. 5ortfolio 9 hasK/, invested in 6tock and K3, invested in 6tock 9. Thecorrelation bet$een the t$o stocks) returns is zero 'that is, r,9E (.

&hich of the follo$ing statements is 4!!?4TI

a. 5ortfolio 9)s standard deviation is 1.%@.b. The stocks are not in e#uilibrium based on the 450H if is valued

correctly, then 9 is overvalued.c. The stocks are not in e#uilibrium based on the 450H if is valued

correctly, then 9 is undervalued.d. 5ortfolio 9)s expected return is [email protected]. 5ortfolio 9)s beta is less than 1.2.

(8-) #ort. ris! 7 ret. re$ations,is C N Answer: e &ED/&

1. 6tock J has a beta of . and 6tock D has a beta of 1.3. The standarddeviation of each stock)s returns is 2@. The stocks) returns are

independent of each other, i.e., the correlation coefficient, r, bet$eenthem is zero. 5ortfolio 5 consists of %@ J and %@ D. Qiven thisinformation, $hich of the follo$ing statements is 4!!?4TI

a. 5ortfolio 5 has a standard deviation of [email protected]. The re#uired return on 5ortfolio 5 is e#ual to the market risk

premium 'r0 r!F(.c. 5ortfolio 5 has a beta of ..d. 5ortfolio 5 has a beta of 1. and a re#uired return that is e#ual to

the riskless rate, r!F.e. 5ortfolio 5 has the same re#uired return as the market 'r0(.

(8-) &ar!et ris! re0i%0 C N Answer: d &ED/&

2. &hich of the follo$ing statements is 4!!?4TI 'ssume that the risk"free rate is a constant.(

a. -f the market risk premium increases by 1@, then the re#uired return$ill increase for stocks that have a beta greater than 1., but it$ill decrease for stocks that have a beta less than 1..

b. The effect of a change in the market risk premium depends on theslope of the yield curve.

c. -f the market risk premium increases by 1@, then the re#uired returnon all stocks $ill rise by 1@.

d. -f the market risk premium increases by 1@, then the re#uired return$ill increase by 1@ for a stock that has a beta of 1..

e. The effect of a change in the market risk premium depends on the

level of the risk"free rate.




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(8-) is! 7 ret. re$ations,is C N Answer: c &ED/&

3. ver the past years, $e have observed that investments $ith thehighest average annual returns also tend to have the highest standarddeviations of annual returns. This observation supports the notion thatthere is a positive correlation bet$een risk and return. &hich of thefollo$ing ans$ers correctly ranks investments from highest to lo$est

risk 'and return(, $here the security $ith the highest risk is sho$nfirst, the one $ith the lo$est risk lastI

a. 6mall"company stocks, long"term corporate bonds, large"companystocks, long"term government bonds, C.6. Treasury bills.

b. 7arge"company stocks, small"company stocks, long"term corporatebonds, C.6. Treasury bills, long"term government bonds.

c. 6mall"company stocks, large"company stocks, long"term corporatebonds, long"term government bonds, C.6. Treasury bills.

d. C.6. Treasury bills, long"term government bonds, long"term corporatebonds, small"company stocks, large"company stocks.

e. 7arge"company stocks, small"company stocks, long"term corporatebonds, long"term government bonds, C.6. Treasury bills.

(8-) e%ired ret%rn C N Answer: c &ED/&

. +uring the coming year, the market risk premium 'r0 r!F(, is expectedto fall, $hile the risk"free rate, r!F, is expected to remain the same.Qiven this forecast, $hich of the follo$ing statements is 4!!?4TI

a. The re#uired return $ill increase for stocks $ith a beta less than1. and $ill decrease for stocks $ith a beta greater than 1..

b. The re#uired return on all stocks $ill remain unchanged.c. The re#uired return $ill fall for all stocks, but it $ill fall more

for stocks $ith higher betas.d. The re#uired return for all stocks $ill fall by the same amount.e. The re#uired return $ill fall for all stocks, but it $ill fall less

for stocks $ith higher betas.

(8-) CA#& C N Answer: c &ED/&

%. The risk"free rate is *@H 6tock has a beta of 1.H 6tock 9 has a betaof 2.H and the market risk premium, r0 r!F, is positive. &hich of thefollo$ing statements is 4!!?4TI

a. -f the risk"free rate increases but the market risk premium staysunchanged, 6tock 9)s re#uired return $ill increase by more than 6tock)s.

b. 6tock 9)s re#uired rate of return is t$ice that of 6tock .c. -f 6tock )s re#uired return is 11@, then the market risk premium is

%@.

d. -f 6tock 9)s re#uired return is 11@, then the market risk premium is%@.

e. -f the risk"free rate remains constant but the market risk premiumincreases, 6tock )s re#uired return $ill increase by more than 6tock9)s.




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(8-) CA#& and re%ired ret%rn C N Answer: b &ED/&

*. ssume that in recent years both expected inflation and the market riskpremium 'r0 r!F( have declined. ssume also that all stocks havepositive betas. &hich of the follo$ing $ould be most likely to haveoccurred as a result of these changesI

a. The re#uired returns on all stocks have fallen, but the decline hasbeen greater for stocks $ith lo$er betas.

b. The re#uired returns on all stocks have fallen, but the fall has beengreater for stocks $ith higher betas.

c. The average re#uired return on the market, r0, has remained constant,but the re#uired returns have fallen for stocks that have betasgreater than 1..

d. !e#uired returns have increased for stocks $ith betas greater than1. but have declined for stocks $ith betas less than 1..

e. The re#uired returns on all stocks have fallen by the same amount.

(8-) CA#& and re%ired ret%rn C N Answer: a &ED/&

. ssume that the risk"free rate is %@. &hich of the follo$ing statements

is 4!!?4TI

a. -f a stock has a negative beta, its re#uired return under the 450$ould be less than %@.

b. -f a stock)s beta doubled, its re#uired return under the 450 $ouldalso double.

c. -f a stock)s beta doubled, its re#uired return under the 450 $ouldmore than double.

d. -f a stock)s beta $ere 1., its re#uired return under the 450 $ouldbe %@.

e. -f a stock)s beta $ere less than 1., its re#uired return under the450 $ould be less than %@.

(8-) CA#& and re%ired ret%rn C N Answer: b &ED/& . 6tock :9 has a beta of 1.% and 6tock 79 has a beta of .%. The market

is in e#uilibrium, $ith re#uired returns e#ualing expected returns.&hich of the follo$ing statements is 4!!?4TI

a. -f expected inflation remains constant but the market risk premium'r0 r!F( declines, the re#uired return of 6tock 79 $ill decline butthe re#uired return of 6tock :9 $ill increase.

b. -f both expected inflation and the market risk premium 'r0 r!F(increase, the re#uired return on 6tock :9 $ill increase by more thanthat on 6tock 79.

c. -f both expected inflation and the market risk premium 'r0 r!F(increase, the re#uired returns of both stocks $ill increase by the

same amount.d. 6ince the market is in e#uilibrium, the re#uired returns of the t$o

stocks should be the same.e. -f expected inflation remains constant but the market risk premium

'r0 r!F( declines, the re#uired return of 6tock :9 $ill decline butthe re#uired return of 6tock 79 $ill increase.




27/61

(8-) CA#& and re%ired ret%rn C N Answer: b &ED/&

/. 6tock has a beta of ., 6tock 9 has a beta of 1., and 6tock 4 has abeta of 1.2. 5ortfolio 5 has e#ual amounts invested in each of thethree stocks. ?ach of the stocks has a standard deviation of 2%@. Thereturns on the three stocks are independent of one another 'i.e., thecorrelation coefficients all e#ual zero(. ssume that there is an

increase in the market risk premium, but the risk"free rate remainsunchanged. &hich of the follo$ing statements is 4!!?4TI

a. The re#uired return of all stocks $ill remain unchanged since there$as no change in their betas.

b. The re#uired return on 6tock $ill increase by less than theincrease in the market risk premium, $hile the re#uired return on6tock 4 $ill increase by more than the increase in the market riskpremium.

c. The re#uired return on the average stock $ill remain unchanged, butthe returns of riskier stocks 'such as 6tock 4( $ill increase $hilethe returns of safer stocks 'such as 6tock ( $ill decrease.

d. The re#uired returns on all three stocks $ill increase by the amount

of the increase in the market risk premium.e. The re#uired return on the average stock $ill remain unchanged, butthe returns on riskier stocks 'such as 6tock 4( $ill decrease $hilethe returns on safer stocks 'such as 6tock ( $ill increase.

(8-) CA#& and re%ired ret%rn C N Answer: e &ED/&

/. &hich of the follo$ing statements is 4!!?4TI

a. -f a company)s beta doubles, then its re#uired rate of return $illalso double.

b. ther things held constant, if investors suddenly become convincedthat there $ill be deflation in the economy, then the re#uiredreturns on all stocks should increase.

c. -f a company)s beta $ere cut in half, then its re#uired rate ofreturn $ould also be halved.

d. -f the risk"free rate rises by .%@ but the market risk premiumdeclines by that same amount, then the re#uired rates of return onstocks $ith betas less than 1. $ill decline $hile returns on stocks$ith betas above 1. $ill increase.

e. -f the risk"free rate rises by .%@ but the market risk premiumdeclines by that same amount, then the re#uired rate of return on anaverage stock $ill remain unchanged, but re#uired returns on stocks$ith betas less than 1. $ill rise.

(8-) CA#&6 beta6 and re. ret%rn C N Answer: a &ED/&

/1. ssume that the risk"free rate is *@ and the market risk premium is %@.

Qiven this information, $hich of the follo$ing statements is 4!!?4TI

a. n index fund $ith beta E 1. should have a re#uired return of [email protected]. -f a stock has a negative beta, its re#uired return must also be

negative.c. n index fund $ith beta E 1. should have a re#uired return less than

[email protected]. -f a stock)s beta doubles, its re#uired return must also double.




28/61

e. n index fund $ith beta E 1. should have a re#uired return greaterthan 11@.




29/61

(8-) S&* C N Answer: a &ED/&

/2. &hich of the follo$ing statements is 4!!?4TI

a. The slope of the security market line is e#ual to the market riskpremium.

b. 7o$er beta stocks have higher re#uired returns.

c. stock)s beta indicates its diversifiable risk.d. +iversifiable risk cannot be completely diversified a$ay.e. T$o securities $ith the same stand"alone risk must have the same

betas.

(8-) S&* C N Answer: e &ED/&

/3. &hich of the follo$ing statements is 4!!?4TI

a. 9eta is measured by the slope of the security market line.b. -f the risk"free rate rises, then the market risk premium must also

rise.c. -f a company)s beta is halved, then its re#uired return $ill also be

halved.

d. -f a company)s beta doubles, then its re#uired return $ill alsodouble.

e. The slope of the security market line is e#ual to the market riskpremium, 'r0 r!F(.


/. 6tock has a beta of 1.2 and a standard deviation of 2@. 6tock 9 hasa beta of . and a standard deviation of 2%@. 5ortfolio 5 has K2,consisting of K1, invested in 6tock and K1, in 6tock 9.&hich of the follo$ing statements is 4!!?4TI 'ssume that the stocksare in e#uilibrium.(

a. 6tock )s returns are less highly correlated $ith the returns on mostother stocks than are 9)s returns.

b. 6tock 9 has a higher re#uired rate of return than 6tock .c. 5ortfolio 5 has a standard deviation of 22.%@.d. 0ore information is needed to determine the portfolio)s beta.e. 5ortfolio 5 has a beta of 1..

(8-) S&* C N Answer: d &ED/&

/%. Aile Food)s stock has a beta of 1., $hile ?lba ?ateries) stock has abeta of .. ssume that the risk"free rate, r!F, is %.%@ and themarket risk premium, 'r0 r!F(, e#uals @. &hich of the follo$ingstatements is 4!!?4TI

a. -f the risk"free rate increases but the market risk premium remains

unchanged, the re#uired return $ill increase for both stocks but theincrease $ill be larger for Aile since it has a higher beta.

b. -f the market risk premium increases but the risk"free rate remainsunchanged, Aile)s re#uired return $ill increase because it has a betagreater than 1. but ?lba)s re#uired return $ill decline because ithas a beta less than 1..

c. 6ince Aile)s beta is t$ice that of ?lba)s, its re#uired rate ofreturn $ill also be t$ice that of ?lba)s.




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d. -f the risk"free rate increases $hile the market risk premium remainsconstant, then the re#uired return on an average stock $ill increase.

e. -f the market risk premium decreases but the risk"free rate remainsunchanged, Aile)s re#uired return $ill decrease because it has a betagreater than 1. and ?lba)s $ill also decrease, but by more thanAile)s because it has a beta less than 1..


/*. 6tock J has a beta of .*, $hile 6tock D has a beta of 1.. &hich ofthe follo$ing statements is 4!!?4TI

a. portfolio consisting of K%, invested in 6tock J and K%,invested in 6tock D $ill have a re#uired return that exceeds that ofthe overall market.

b. 6tock D must have a higher expected return and a higher standarddeviation than 6tock J.

c. -f expected inflation increases but the market risk premium isunchanged, then the re#uired return on both stocks $ill fall by thesame amount.

d. -f the market risk premium declines but expected inflation isunchanged, the re#uired return on both stocks $ill decrease, but thedecrease $ill be greater for 6tock D.

e. -f expected inflation declines but the market risk premium isunchanged, then the re#uired return on both stocks $ill decrease butthe decrease $ill be greater for 6tock D.


/. 6tock has a beta of . and 6tock 9 has a beta of 1.2. %@ of5ortfolio 5 is invested in 6tock and %@ is invested in 6tock 9. -fthe market risk premium 'r0 r!F( $ere to increase but the risk"freerate 'r!F( remained constant, $hich of the follo$ing $ould occurI

a. The re#uired return $ould increase for both stocks but the increase$ould be greater for 6tock 9 than for 6tock .

b. The re#uired return $ould decrease by the same amount for both6tock and 6tock 9.

c. The re#uired return $ould increase for 6tock but decrease for6tock 9.

d. The re#uired return on 5ortfolio 5 $ould remain unchanged.e. The re#uired return $ould increase for 6tock 9 but decrease for

6tock .


/. 6tock has a beta of ., $hereas 6tock 9 has a beta of 1.3. 5ortfolio5 has %@ invested in both and 9. &hich of the follo$ing $ould occur

if the market risk premium increased by 1@ but the risk"free rateremained constantI

a. The re#uired return on 5ortfolio 5 $ould increase by [email protected]. The re#uired return on both stocks $ould increase by [email protected]. The re#uired return on 5ortfolio 5 $ould remain unchanged.d. The re#uired return on 6tock $ould increase by more than 1@, $hile

the return on 6tock 9 $ould increase by less than 1@.




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e. The re#uired return for 6tock $ould fall, but the re#uired returnfor 6tock 9 $ould increase.


//. ssume that the risk"free rate remains constant, but the market riskpremium declines. &hich of the follo$ing is most likely to occurI

a. The re#uired return on a stock $ith beta E 1. $ill not change.b. The re#uired return on a stock $ith beta L 1. $ill increase.c. The return on


32/61

b. The re#uired return $ill decline for stocks that have a beta lessthan 1. but $ill increase for stocks that have a beta greater than1..

c. 6ince the overall return on the market stays constant, the re#uiredreturn on each individual stock $ill also remain constant.

d. The re#uired return $ill increase for stocks that have a beta lessthan 1. but decline for stocks that have a beta greater than 1..

e. The re#uired return of all stocks $ill fall by the amount of thedecline in the market risk premium.




33/61


13. ssume that to cool off the economy and decrease expectations forinflation, the Federal !eserve tightened the money supply, causing anincrease in the risk"free rate, r!F. -nvestors also became concernedthat the Fed)s actions $ould lead to a recession, and that led to anincrease in the market risk premium, 'r0" r!F(. Cnder these conditions,

$ith other things held constant, $hich of the follo$ing statements ismost correctI

a. The re#uired return on all stocks $ould increase by the same amount.b. The re#uired return on all stocks $ould increase, but the increase

$ould be greatest for stocks $ith betas of less than 1..c. 6tocks) re#uired returns $ould change, but so $ould expected returns,

and the result $ould be no change in stocks) prices.d. The prices of all stocks $ould decline, but the decline $ould be

greatest for high"beta stocks.e. The prices of all stocks $ould increase, but the increase $ould be

greatest for high"beta stocks.

(8-) S&*6 CA#&6 and beta C N Answer: e &ED/& 1. &hich of the follo$ing statements is 4!!?4TI

a. -f a stock has a beta of to 1., its re#uired rate of return $ill beunaffected by changes in the market risk premium.

b. The slope of the 6ecurity 0arket 7ine is beta.c. ny stock $ith a negative beta must in theory have a negative

re#uired rate of return, provided r!Fis positive.d. -f a stock)s beta doubles, its re#uired rate of return must also

double.e. -f a stock)s returns are negatively correlated $ith returns on most

other stocks, the stock)s beta $ill be negative.

(8-) S&* and ris! aversion C N Answer: a &ED/& 1%. ssume that investors have recently become more risk averse, so the

market risk premium has increased. lso, assume that the risk"free rateand expected inflation have not changed. &hich of the follo$ing is mostlikely to occurI

a. The re#uired rate of return for an average stock $ill increase by anamount e#ual to the increase in the market risk premium.

b. The re#uired rate of return $ill decline for stocks $hose betas areless than 1..

c. The re#uired rate of return on the market, r0, $ill not change as aresult of these changes.

d. The re#uired rate of return for each individual stock in the market

$ill increase by an amount e#ual to the increase in the market riskpremium.

e. The re#uired rate of return on a riskless bond $ill decline.

Chapter 8: Risk and Return C$n&eptual "/C Page 3-



34/61


35/61

(Co0.) is! 0eas%res C N Answer: b &ED/&

1/. Dou observe the follo$ing information regarding 4ompanies J and D>

4ompany J has a higher expected return than 4ompany D.

4ompany J has a lo$er standard deviation of returns than 4ompany D.

4ompany J has a higher beta than 4ompany D.

Qiven this information, $hich of the follo$ing statements is 4!!?4TI

a. 4ompany J has more diversifiable risk than 4ompany D.b. 4ompany J has a lo$er coefficient of variation than 4ompany D.c. 4ompany J has less market risk than 4ompany D.d. 4ompany J)s returns $ill be negative $hen D)s returns are positive.e. 4ompany J)s stock is a better buy than 4ompany D)s stock.

(8-") #ortfo$io ris! C N Answer: c &ED/&4AD

11. 6tocks and 9 both have an expected return of 1@ and a standarddeviation of returns of 2%@. 6tock has a beta of . and 6tock 9 has

a beta of 1.2. The correlation coefficient, r, bet$een the t$o stocksis B.*. 5ortfolio 5 has %@ invested in 6tock and %@ invested in 9.&hich of the follo$ing statements is 4!!?4TI

a. 5ortfolio 5 has a standard deviation of 2%@ and a beta of 1..b. 9ased on the information $e are given, and assuming those are the

vie$s of the marginal investor, it is apparent that the t$o stocksare in e#uilibrium.

c. 5ortfolio 5 has more market risk than 6tock but less market riskthan 9.

d. 6tock should have a higher expected return than 6tock 9 as vie$edby the marginal investor.

e. 5ortfolio 5 has a coefficient of variation e#ual to 2.%.

(8-) #ort. ris! 7 ret. re$ations,is C N Answer: d 4AD

111. The risk"free rate is *@ and the market risk premium is %@. Dour K1million portfolio consists of K, invested in a stock that has abeta of 1.2 and K3, invested in a stock that has a beta of ..&hich of the follo$ing statements is 4!!?4TI

a. -f the stock market is efficient, your portfolio)s expected returnshould e#ual the expected return on the market, $hich is 11@.

b. The re#uired return on the market is [email protected]. The portfolio)s re#uired return is less than [email protected]. -f the risk"free rate remains unchanged but the market risk premium

increases by 2@, your portfolio)s re#uired return $ill increase by

more than [email protected]. -f the market risk premium remains unchanged but expected inflationincreases by 2@, your portfolio)s re#uired return $ill increase bymore than 2@.




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(8-) #ort. ris! 7 ret. re$ations,is C N Answer: a 4AD

112. 6tock has an expected return of 1@ and a standard deviation of [email protected] 9 has an expected return of 13@ and a standard deviation of [email protected] risk"free rate is %@ and the market risk premium, r0 r!F, is *@.ssume that the market is in e#uilibrium. 5ortfolio 9 has %@ investedin 6tock and %@ invested in 6tock 9. The returns of 6tock and

6tock 9 are independent of one another, i.e., the correlationcoefficient bet$een them is zero. &hich of the follo$ing statements is4!!?4TI

a. 6tock )s beta is .333.b. 6ince the t$o stocks have zero correlation, 5ortfolio 9 is riskless.c. 6tock 9)s beta is 1..d. 5ortfolio 9)s re#uired return is [email protected]. 5ortfolio 9)s standard deviation is 2%@.

(8-) #ort. ris! 7 ret. re$ations,is C N Answer: c 4AD

113. 6tock has a beta of 1.2 and a standard deviation of 2%@. 6tock 9 hasa beta of 1. and a standard deviation of 2@. 5ortfolio 9 $as created

by investing in a combination of 6tocks and 9. 5ortfolio 9 has abeta of 1.2% and a standard deviation of 1@. &hich of the follo$ingstatements is 4!!?4TI

a. 6tock has more market risk than 5ortfolio 9.b. 6tock has more market risk than 6tock 9 but less stand"alone risk.c. 5ortfolio 9 has more money invested in 6tock than in 6tock 9.d. 5ortfolio 9 has the same amount of money invested in each of the t$o

stocks.e. 5ortfolio 9 has more money invested in 6tock 9 than in 6tock .

(8-) S&* C N Answer: e 4AD

11. &hich of the follo$ing statements is 4!!?4TI

a. -f 0utual Fund held e#ual amounts of 1 stocks, each of $hich hada beta of 1., and 0utual Fund 9 held e#ual amounts of 1 stocks $ithbetas of 1., then the t$o mutual funds $ould both have betas of 1..Thus, they $ould be e#ually risky from an investor)s standpoint,assuming the investor)s only asset is one or the other of the mutualfunds.

b. -f investors become more risk averse but r!Fdoes not change, thenthe re#uired rate of return on high"beta stocks $ill rise and there#uired return on lo$"beta stocks $ill decline, but the re#uiredreturn on an average"risk stock $ill not change.

c. n investor $ho holds ;ust one stock $ill generally be exposed tomore risk than an investor $ho holds a portfolio of stocks, assuming

the stocks are all e#ually risky. 6ince the holder of the 1"stockportfolio is exposed to more risk, he or she can expect to earn ahigher rate of return to compensate for the greater risk.

d. There is no reason to think that the slope of the yield curve $ouldhave any effect on the slope of the 607.

e. ssume that the re#uired rate of return on the market, r0, is givenand fixed at 1@. -f the yield curve $ere up$ard sloping, then the6ecurity 0arket 7ine '607( $ould have a steeper slope if 1"year




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Treasury securities $ere used as the risk"free rate than if 3"yearTreasury bonds $ere used for r!F.




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Multiple Choice: "ro+lems

$enerall%, the SM& is used to find the required return, but on occasion the required return is'iven and we must solve for one of the other variables. (e warn our students before the test thatto answer a number of the questions the% will have to transform the SM& equation to solve forbeta, the mar)et ris) premium, the ris)*free rate, or the mar)et return.

(8-2) E'ected ret%rn C N Answer: c EASY

11%. Taggart -nc.)s stock has a %@ chance of producing a 2%@ return, a 3@chance of producing a1@ return, and a 2@ chance of producing a "2@return. &hat is the firm)s expected rate of returnI

a. /.1@b. /.*%@c. /./@d. 1.1%@e. 1.@

(8-2) E'ected ret%rn C N Answer: d EASY

11*. +othan -nc.)s stock has a 2%@ chance of producing a 3@ return, a %@chance of producing a12@ return, and a 2%@ chance of producing a "1@return. &hat is the firm)s expected rate of returnI

a. .2@b. .12@c. .%%@d. /.@e. /.%@

(8-2) Coefficient of variation C N Answer: a EASY

11. 4heng -nc. is considering a capital budgeting pro;ect that has an

expected return of 2%@ and a standard deviation of 3@. &hat is thepro;ect)s coefficient of variationI

a. 1.2b. 1.2*c. 1.32d. 1.3/e. 1.*

(8-2) Coefficient of variation C N Answer: a EASY

11. 9ae -nc. is considering an investment that has an expected return of 1%@and a standard deviation of 1@. &hat is the investment)s coefficientof variationI

a. .*b. .3c. .1d. ./e. ./

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(8-") #ortfo$io beta C N Answer: e EASY

11/. 9ill +ukes has K1, invested in a 2"stock portfolio. K3%, isinvested in 6tock J and the remainder is invested in 6tock D. J)s betais 1.% and DPs beta is.. &hat is the portfolio)s betaI

a. .*%

b. .2c. .d. ./e. ./

(8-") #ortfo$io beta C N Answer: a EASY

12. Tom )9rien has a 2"stock portfolio $ith a total value of K1,.K3,%is invested in 6tock $ith a beta of .% and the remainder isinvested in 6tock 9 $ith a beta of 1.2. &hat is his portfolioPs betaI

a. 1.1b. 1.23c. 1.2/

d. 1.3%e. 1.2

(8-") #ortfo$io beta C N Answer: b EASY

121. ssume that you hold a $ell"diversified portfolio that has an expectedreturn of 11.@ and a beta of 1.2. Dou are in the process of buying1, shares of lpha 4orp at K1 a share and adding it to yourportfolio. lpha has an expected return of 13.@ and a beta of 1.%.The total value of your current portfolio is K/,. &hat $ill theexpected return and beta on the portfolio be after the purchase of thelpha stockI

a. 1.*@H 1.1b. 11.2@H 1.23c. 11.*@H 1.2/d. 12.3%@H 1.3*e. 12./@H 1.2

(8-) CA#&: re%ired rate of ret%rn C N Answer: d EASY

122. 4alculate the re#uired rate of return for 4limax -nc., assuming that '1(investors expect a .@ rate of inflation in the future, '2( the realrisk"free rate is 3.@, '3( the market risk premium is %.@, '( thefirm has a beta of 1., and '%( its realized rate of return hasaveraged 1%.@ over the last % years.

a. 1.2/@b. 1.3@c. 11.@d. 12.@e. 12.*@

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d. 1./e. 1.13

(8-") #ortfo$io beta C N Answer: b &ED/&

12. Nill ngel holds a K2, portfolio consisting of the follo$ingstocks. The portfolio)s beta is .%.

6tock -nvestment 9eta K %, .%9 %, .4 %, 1.+ %, 1.2

Total K2,

-f Nill replaces 6tock $ith another stock, ?, $hich has a beta of1.%, $hat $ill the portfolio)s ne$ beta beI

a. 1.b. 1.13

c. 1.1d. 1.2e. 1.3

(8-") #ortfo$io beta C N Answer: b &ED/&

12. 0ike Flannery holds the follo$ing portfolio>

6tock -nvestment 9eta K1%, 1.9 %, .4 1, 1.+ %, 1.2

Total K3%,

&hat is the portfolio)s betaI

a. 1.*b. 1.1c. 1.2/d. 1.2e. 1.%*

(8-") #ortfo$io beta C N Answer: d &ED/&

12/. Tom Aoel holds the follo$ing portfolio>

6tock -nvestment 9eta

K1%, 1.9 %, .4 1, 1.+ %, 1.2

Total K3%,

Tom plans to sell 6tock and replace it $ith 6tock ?, $hich has a betaof .%. 9y ho$ much $ill the portfolio beta changeI

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a. ".1/b. ".211c. ".23d. ".2*e. ".2*

(8-") #ortfo$io beta C N Answer: e &ED/&

13. Dou hold a diversified K1, portfolio consisting of 2 stocks $ithK%, invested in each. The portfolio)s beta is 1.12. Dou plan tosell a stock $ith b E ./ and use the proceeds to buy a ne$ stock $ithb E 1.. &hat $ill the portfolio)s ne$ beta beI

a. 1.2*b. 1.2%%c. 1.22d. 1.1/e. 1.1*%

(8-) CA#&: re. rate of ret%rn C N Answer: a &ED/&

131. 0ikkelson 4orporation)s stock had a re#uired return of 11.%@ last year,$hen the risk"free rate $as %.%@ and the market risk premium $as .%@.Then an increase in investor risk aversion caused the market riskpremium to rise by 2@. The risk"free rate and the firm)s beta remainunchanged. &hat is the company)s ne$ re#uired rate of returnI ':int>First calculate the beta, then find the re#uired return.(

a. 1.3@b. 1.@c. 1%.11@d. 1%./@e. 1%.@

(8-) CA#&: re. rate of ret%rn C N Answer: e &ED/& 132. 4ompany has a beta of ., $hile 4ompany 9)s beta is 1.2. The

re#uired return on the stock market is 11.@, and the risk"free rate is.2%@. &hat is the difference bet$een )s and 9)s re#uired rates ofreturnI ':int> First find the market risk premium, then find there#uired returns on the stocks.(

a. 2.%@b. 2./@c. 3.%@d. 3.21@e. 3.3@

(8-) CA#&: re. rate of ret%rn C N Answer: c &ED/& 133. 6tock )s stock has a beta of 1.3, and its re#uired return is 12.@.

6tock 9)s beta is .. -f the risk"free rate is .%@, $hat is there#uired rate of return on 9)s stockI ':int> First find the marketrisk premium.(

a. .*@b. ./@c. /.21@

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d. /.@e. /.*@

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e. 11.@

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(8-) CA#&: re. rate of ret%rn C N Answer: a &ED/&

13. +ata for +ana -ndustries is sho$n belo$. Ao$ +ana ac#uires some riskyassets that cause its beta to increase by 3@. -n addition, expectedinflation increases by 2.@. &hat is the stock)s ne$ re#uired rate ofreturnI

-nitial beta 1.-nitial re#uired return 'rs( 1.2@0arket risk premium, !50 *.@5ercentage increase in beta 3.@-ncrease in inflation premium, -5 2.@

a. 1.@b. 1.@c. 1%.@d. 1*.21@e. 1.2@

(8-) et%rn on t,e 0ar!et C N Answer: a &ED/&

13/. 0ulherin)s stock has a beta of 1.23, its re#uired return is 11.%@, andthe risk"free rate is.3@. &hat is the re#uired rate of return on themarketI ':int> First find the market risk premium.(

a. 1.3*@b. 1.*2@c. 1.@d. 11.1%@e. 11.3@

(8-") #ortfo$io beta C N Answer: c &ED/&4AD

1. 6uppose you hold a portfolio consisting of a K1, investment in eachof different common stocks. The portfolioPs beta is 1.2%. Ao$suppose you decided to sell one of your stocks that has a beta of 1.and to use the proceeds to buy a replacement stock $ith a beta of 1.3%.&hat $ould the portfolioPs ne$ beta beI

a. 1.1b. 1.23c. 1.2/d. 1.3*e. 1.3

(8-2) Std. dev.6 ,istorica$ ret%rns C N Answer: b 4AD

11. !eturns for the +ayton 4ompany over the last 3 years are sho$n belo$.

&hat)s the standard deviation of the firm)s returnsI ':int> This is asample, not a complete population, so the sample standard deviationformula should be used.(

Dear !eturn212 21.@211 "12.%@21 2%.@

a. 2.@

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receive another K%. million, $hich you invest in stocks $ith anaverage beta of .*%. &hat is the re#uired rate of return on the ne$portfolioI ':int> Dou must first find the market risk premium, thenfind the ne$ portfolio beta.(

a. .3@b. /.%@c. /.2@d. /.%1@e. /.@

(8-") #ortfo$io beta C N Answer: b 4AD

1%. mutual fund manager has a K million portfolio $ith a beta of 1..The risk"free rate is .2%@, and the market risk premium is *.@. Themanager expects to receive an additional K* million $hich she plans toinvest in additional stocks. fter investing the additional funds, she$ants the fundPs re#uired and expected return to be 13.@. &hat mustthe average beta of the ne$ stocks be to achieve the target re#uiredrate of returnI

a. 1.*b. 1.*c. 1.%d. 1./e. 2.

(8-) #ort. beta and re. ret. C N Answer: c 4AD

1*. ssume that you are the portfolio manager of the 6F Fund, a K3 millionhedge fund that contains the follo$ing stocks. The re#uired rate ofreturn on the market is 11.@ and the risk"free rate is %.@. &hatrate of return should investors expect 'and re#uire( on this fundI

6tock mount 9eta K1,%, 1.29 *%, .%4 %, 1.+ %, .%

K3,,

a. 1.%*@b. 1.3@c. 11.11@d. 11.3@e. 11.*@

(8-) CA#&: re. rate of ret%rn C N Answer: c 4AD1. 444 4orp has a beta of 1.% and is currently in e#uilibrium. The

re#uired rate of return on the stock is 12.@ versus a re#uired returnon an average stock of 1.@. Ao$ the re#uired return on an averagestock increases by 3.@ 'not percentage points(. Aeither betas nor therisk"free rate change. &hat $ould 444)s ne$ re#uired return beI

a. 1./@b. 1%.*@

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c. 1*.%@d. 1.33@e. 1.1/@

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Page ns(ers Chapter 8: Risk and Return


CH!"TE# $!&E#& !D &L*T%&


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1. (8-2) Standard deviation F N Answer: b EASY

2. (8-2) Coefficient of variation F N Answer: a EASY

3. (8-2) CV vs. SD F N Answer: b EASY

. (8-2) is! aversion F N Answer: a EASY

%. (8-") #ortfo$io ris! F N Answer: a EASY

*. (8-") #ortfo$io ris! F N Answer: a EASY

. (8-") #ortfo$io ris! F N Answer: a EASY

. (8-") #ortfo$io ret%rn F N Answer: b EASY

/. (8-") &ar!et ris! F N Answer: a EASY

1. (8-") &ar!et ris! F N Answer: b EASY

11. (8-") is! and e'ected ret%rns F N Answer: b EASY

12. (8-") CA#& and ris! F N Answer: a EASY

13. (8-") CA#& and ris! F N Answer: a EASY

1. (8-) S&* and ris! aversion F N Answer: b EASY

1%. (8-+) #,sica$ assets F N Answer: a EASY

1*. (8-2) Variance F N Answer: a &ED/&

1. (8-2) Coefficient of variation F N Answer: a &ED/&

1. (8-2) is! aversion F N Answer: a &ED/&

1/. (8-2) is! aversion F N Answer: a &ED/&

2. (8-2) is! re0. and ris! aversion F N Answer: a &ED/&

21. (8-") 1eta coefficient F N Answer: b &ED/&


23. (8-") 1eta coefficient F N Answer: a &ED/&


2%. (8-") 1eta coefficient F N Answer: a &ED/&

2*. (8-") #ortfo$io ris! F N Answer: a &ED/&

2. (8-") #ortfo$io ris! F N Answer: b &ED/&

2. (8-") #ortfo$io ris! F N Answer: b &ED/&

2/. (8-") #ortfo$io ris! and ret%rn F N Answer: b &ED/&

The stocks have the same expected returns, but BB does badly in booms and well in recessions. Therefore, it

would do more to reduce risk.

3. (8-") Cor. coefficient and ris! F N Answer: b &ED/&


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8/12/2019 RISK AND RATES OF RETURN EX

risk and rates of return exercise

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