Question 1

The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation.

Accepted Answer

A tighter probability distribution means that the potential range of future returns is narrower, reducing the variability and standard deviation of potential outcomes, which in turn reduces investment risk.

Question 2

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the isolated risks of individual stocks. Thus, the relevant risk is an individual stock's contribution to the overall riskiness of the portfolio.

Accepted Answer

The CAPM assumes that investors are concerned with the risk of their overall portfolio, rather than just the risk of individual stocks. This is because the risk of an individual stock is largely diversifiable, meaning that it can be reduced by holding a well-diversified portfolio. Therefore, investors should focus on a stock's contribution to the portfolio's overall risk, rather than its isolated risk.

Question 3

Businesses earn returns for security holders by purchasing and operating physical assets. The relevant risk of any physical asset must be measured in terms of its effect on the risk of the firm's securities.

Accepted Answer

Physical assets can contribute to the overall risk of the firm, which in turn affects the risk of its securities. Therefore, it is important to measure the relevant risk of physical assets in terms of their impact on the firm's securities.

Question 4

Portfolio diversification reduces the variability of the returns on each security held in the portfolio.

Accepted Answer

Portfolio diversification reduces the overall risk of the portfolio by spreading investments across various assets, but it does not reduce the variability of returns on each individual security.

Question 5

A security's beta measures its nondiversifiable (or market) risk relative to that of most other securities.

Accepted Answer

This is an accurate definition of beta. Beta measures the volatility of a security's return in relation to the overall market, indicating its sensitivity to market movements. It represents the nondiversifiable risk inherent in the security, which cannot be eliminated through diversification, as it is tied to the market as a whole.

Question 6

Diversifiable risk, which is measured by beta, can be lowered by adding more stocks to a portfolio.

Accepted Answer

Beta measures systematic risk, not diversifiable risk. Diversifiable risk can be reduced by adding more stocks to a portfolio, but beta does not measure this type of risk.

Question 7

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above average market risk will tend to be more volatile than an average stock, and it will definitely have a beta which is greater than 1.0.

Accepted Answer

This is true. Stocks with higher market risk will have a beta greater than 1.0 because they tend to move in the same direction as the overall market, which has a beta of 1.0.

Question 8

When adding new securities to an existing portfolio, the higher or more positive the degree of correlation between the new securities and those already in the portfolio, the greater the benefits of the additional portfolio diversification.

Accepted Answer

The statement is false. The lower or more negative the degree of correlation between the new securities and those already in the portfolio, the greater the benefits of the additional portfolio diversification.

Question 9

If investors become more averse to risk, the slope of the Security Market Line (SML) will increase.

Accepted Answer

When investors become more averse to risk, they require a higher return for the same level of risk. This results in an increase in the market risk premium (the difference between the expected return on the overall market and the risk-free rate), which in turn increases the slope of the Security Market Line (SML).

Question 10

One key result of applying the Capital Asset Pricing Model is that the risk and return of an individual security should be analyzed by how that security affects the risk and return of the portfolio in which it is held.

Accepted Answer

This is one of the main principles of the Capital Asset Pricing Model. The model states that the expected return of an individual security is related to the risk-free rate, the market risk premium, and the security's beta, which measures its volatility compared to the overall market. However, the model also emphasizes that investors should consider how a security affects the risk and return of the overall portfolio in which it is held, rather than analyzing it in isolation. This is based on the idea that the risk and return of a portfolio depend not only on the individual securities it contains, but on how those securities interact with each other.

Question 11

Companies should deliberately increase their risk relative to the market only if the actions that increase the risk also increase the expected rate of return on the firm's assets by enough to completely compensate for the higher risk.

Accepted Answer

This statement is related to the concept of the risk-return tradeoff, which states that higher returns can only be earned by taking on higher levels of risk. However, a company should only deliberately increase their risk if the expected rate of return on their assets also increases sufficiently to justify the higher risk. This principle is the basis for many investment strategies and is generally considered to be a sound approach to managing risk in a portfolio.

Question 12

A stock's beta is more relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only one stock.

Accepted Answer

A well-diversified portfolio reduces the overall risk of an investor's holdings by spreading investments across multiple stocks and asset classes. In this context, a stock's beta becomes a more relevant measure of risk as it indicates how much the stock's price movements are correlated with the overall market. On the other hand, an investor who holds only one stock is already exposed to the specific risks of that company and is therefore more concerned with its individual factors such as financial health, management, competition, and growth prospects.

Question 13

The required return on a firm's common stock is determined by the firm's market risk. If its market risk is known, and if it is expected to remain constant, the analyst has sufficient information to specify the firm's required return.

Accepted Answer

The answer of The required return on a firm's common...

Question 14

If we develop a weighted average of the possible return outcomes, multiplying each outcome or "state" by its respective probability of occurrence for a particular stock, we can construct a payoff matrix of expected returns.

Accepted Answer

This statement is true.

Question 15

The coefficient of variation, calculated as the standard deviation divided by the expected return, is a standardized measure of the risk per unit of expected return.

Accepted Answer

The statement correctly describes the coefficient of variation as a standardized measure of risk per unit of expected return.

Question 16

The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of the securities being compared differ significantly.

Accepted Answer

The coefficient of variation takes into account the standard deviation of the returns and the expected returns, making it a better measure of risk when comparing securities with different expected returns. The standard deviation alone does not consider expected returns, so it may not accurately represent the level of risk for securities with different expected returns.

Question 17

A firm cannot change its beta through any managerial decision because betas are completely market determined.

Accepted Answer

A firm can change its beta through managerial decisions such as altering its capital structure, changing its business operations, or diversifying its product lines, which can affect its risk profile and thus its beta.

Question 18

The realized portfolio return is the weighted average of the relative weights of securities in the portfolio multiplied by their respective expected returns.

Accepted Answer

The realized portfolio return is the weighted average of the actual returns of the securities in the portfolio, not their expected returns.

Question 19

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

Accepted Answer

The slope of the Security Market Line (SML) is determined by the market risk premium, not by the value of beta. Beta measures the sensitivity of a security's returns to the returns of the market, but the slope of the SML is the difference between the expected return on the market portfolio and the risk-free rate, which represents the market risk premium.

Question 20

When investors require higher rates of return for investments that demonstrate higher variability of returns, this is evidence of risk aversion.

Accepted Answer

Risk aversion refers to the tendency of investors to prefer investments with lower variability of returns or less risk. Therefore, when investors require higher rates of return for investments that demonstrate higher variability of returns, it is evidence of risk aversion.

Quiz 2: Risk and Return: Part I