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Exam 6: Risk and Return

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Question 71

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Which of the following statements is CORRECT?

A) Portfolio diversification reduces the variability of returns on an individual stock.
B) Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.
C) The SML relates a stock's required return to its market risk.The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs.
D) A stock with a beta of −1.0 has zero market risk if held in a 1-stock portfolio.
E) When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.

F) A) and B)
G) B) and C)

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Question 72

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Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk.If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

A) True
B) False

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Question 73

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A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

A stock with a beta equal to −1.0 has zero systematic (or market) risk.

Assume that investors have recently become more risk averse, so the market risk premium has increased.Also, assume that the risk-free rate and expected inflation have not changed.Which of the following is most likely to occur?

The slope of the SML is determined by the value of beta.

Assume that the market is in equilibrium and that Portfolio AB has 50% invested in Stock A and 50% invested in Stock B.Stock A has an expected return of 10% and a standard deviation of 20%.Stock B has an expected return of 13% and a standard deviation of 30%.The risk-free rate is 5% and the market risk premium, r_M − r_RF, is 6%.The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero.Which of the following statements is CORRECT?

Assume that your cousin holds just one stock, Eastman Chemical Bonding (ECB) , which he thinks has very little risk.You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified.You obtain the following returns data for Wilder's Creations and Buildings (WCB) .Both companies have had less variability than most other stocks over the past 5 years.Measured by the standard deviation of returns, by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) $\begin{array}{rrr}&\text { Year }&\text { ECB }&W C B\\&2011 & 40.00 \% & 40.00 \% \\&2012 & -10.00 \% & 15.00 \% \\&2013 & 35.00 \% & -5.00 \% \\&2014 & -5.00 \% & -10.00 \% \\&2015 & 15.00 \% & 35.00 \%\\\text { Average return }= & 15.00 \% & 15.00 \% \\\text { Standard deviation }= & 22.64 \% & 22.64 \%\end{array}$

The SML relates required returns to firms' systematic (or market) risk.The slope and intercept of this line can be influenced by a manager's actions.

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio.It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value.Because of its diversification, Portfolio B will by definition be riskless.

Fiske Roofing Supplies' stock has a beta of 1.23, its required return is 11.75%, and the risk-free rate is 4.30%.What is the required rate of return on the market? (Hint: First find the market risk premium.)

The slope of the SML is determined by investors' aversion to risk.The greater the average investor's risk aversion, the steeper the SML.

Stock A has a beta = 0.8, while Stock B has a beta = 1.6.Which of the following statements is CORRECT?

Portfolio P has equal amounts invested in each of the three stocks, A, B, and C.Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2.Each of the stocks has a standard deviation of 25%.The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero) .Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged.Which of the following statements is CORRECT?

Suppose Stan holds a portfolio consisting of a $10,000 investment in each of 8 different common stocks.The portfolio's beta is 1.25.Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35.What would the portfolio's new beta be?

Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5.The market is in equilibrium, with required returns equaling expected returns.Which of the following statements is CORRECT?

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.