Deck 9: Analysis of Risk and Return

Question 1

The ____ is an absolute measure of risk, and the ____ is a relative measure of risk.

A) systematic risk;, unsystematic risk
B) standard deviation; coefficient of variation
C) correlation; covariance
D) security market line; characteristic line

Answer 1

B

Question 2

The ____ of a portfolio of two or more securities is equal to the weighted average of the ____ of each of the individual securities in the portfolio.

A) standard deviation; standard deviation
B) risk; risk
C) expected return; expected return
D) standard deviation; risk

Answer 2

C

Question 3

Which of the following is NOT an example of a source of systematic risk?

A) interest rate changes
B) foreign competition with an industry's products
C) changes in the overall economic outlook
D) changes in the inflation rate

Answer 3

B

Question 4

The possibility that actual returns will deviate from expected returns is known as ____.

A) risk
B) interest
C) beta
D) standard deviation

Question 5

A security that is completely uncorrelated (ρ_j,m = 0) with the market portfolio would have a beta of ____.

A) -1
B) 0
C) +1
D) -100

Question 6

The slope of the characteristic line for a specific security is an estimate of ____ for that security.

A) alpha
B) beta
C) total risk
D) relative risk

Question 7

The security market line ____.

A) is defined as the slope of a line relating an individual security's return to the returns of other securities in that firm's primary industry
B) provides a picture of the risk-return tradeoff required by diversified investors considering various risky assets
C) has as its slope the beta of the security
D) is determined by the prevailing level of risk-free interest rates minus a risk premium

Question 8

When comparing two equal-sized investments, the ____ is an appropriate measure of total risk.

A) standard deviation
B) coefficient of variation
C) correlation
D) covariance

Question 9

The ____ is the ratio of ____ to the ____.

A) standard deviation; covariance; expected value
B) covariance; expected value; standard deviation
C) coefficient of variation; standard deviation; expected value
D) coefficient of variation; systematic risk; expected value

Question 10

Values of the ____ can range from +1.0 to -1.0.

A) coefficient of variation
B) correlation coefficient
C) standard deviation
D) covariance

Question 11

The security market line can be thought of as expressing relationships between required rates of return and ____.

A) the time value of money
B) beta
C) total risk
D) portfolio diversification

Question 12

Systematic risk ____.

A) cannot be mitigated via diversification
B) can be mitigated via diversification
C) is unique to each firm
D) is affected by factors such as strikes

Question 13

The ____ the standard deviation, the ____ the investment.

A) smaller; larger the expected return on
B) larger; riskier
C) smaller; riskier
D) larger; smaller the expected return on

Question 14

A beta value of 0.5 for a security indicates that the security has ____.

A) average systematic risk
B) above-average systematic risk
C) no unsystematic risk
D) below-average systematic risk

Question 15

All other things being equal, what is the major impact that an increase in the expected inflation rate would be anticipated to have on the security market line?

A) reduce its slope
B) shift it down and to the right
C) shift it up and to the left
D) reduce required returns for investors in any individual asset

Question 16

The ____ is a statistical measure of the mean or average value of the possible outcomes.

A) probability distribution
B) standard deviation
C) expected value
D) coefficient of variation

Question 17

Beta is defined as ____.

A) a measure of volatility of a security's returns relative to the returns of a broad-based market portfolio of securities
B) the ratio of the variance of market returns to the covariance of returns on a security with the market
C) the inverse of the slope of the security regression line
D) All of these are correct

Question 18

Users of the CAPM should be aware of some of the problems in its practical application. These problems include which of the following?

A) estimating expected future market returns
B) determining the most appropriate measure of the risk- free rate
C) determining the best estimate of an asset's future beta
D) All of these are correct

Question 19

Security A's expected return is 10%, while the expected return of B is 14%. The standard deviation of A's returns is 5%, and it is 9% for B. An investor plans to invest equal amounts in A and B. Which of the following statements is true about this portfolio consisting of stock A and stock B?

A) The risk of the portfolio is equal to 7%.
B) The lower the correlation of returns between the two stocks, the higher the portfolio's risk.
C) The risk of the portfolio is primarily dependent on the utility function of the investor.
D) The higher the correlation of returns between the two stocks, the higher the portfolio's risk.

Question 20

The expected value of one roll of a standard six-sided die is ____.

A) 6
B) 3
C) 3.5
D) 4

Question 21

The most relevant risk that must be considered for any widely traded individual security is its ____.

A) unsystematic risk
B) standard deviation
C) covariance risk
D) systematic risk

Question 22

An increase in uncertainty regarding the future economic outlook has the effect of ____.

A) increasing the slope of the security market line
B) shifting the security market line upward
C) reducing risk
D) None of these are correct

Question 23

The risk-free rate of return can be thought of as consisting of ____ and ____.

A) a real rate of return; a default premium
B) unanticipated inflation; bond default premium
C) a real rate of return; an inflation premium
D) a zero beta component; an expectation premium

Question 24

An increase in the expected future inflation rate has the effect of ____.

A) increasing the slope of the security market line
B) shifting the security market line upward by the amount of the expected increase in inflation
C) increasing systematic risk
D) None of these are correct

Question 25

Empirical studies of the Capital Asset Pricing Model have produced ____ results.

A) universally adoring
B) mixed
C) mostly negative
D) mostly positive

Question 26

A set of numbers that is ____ will have a ____ standard deviation.

A) perfectly consistent; nonzero
B) inconsistent; low
C) consistent; high
D) consistent; low

Question 27

Unsystematic risk ____.

A) is caused by factors affecting the market as a whole
B) is the predominant determinant of individual security risk premium
C) cannot be mitigated via diversification
D) can be mitigated via diversification

Question 28

An important risk dimension other than variability of returns that motivates investors is ____.

A) standard deviation
B) beta
C) risk of failure
D) coefficient of variation

Question 29

A ____ probability distribution assigns probabilities to a limited number of outcomes.

A) discrete
B) continuous
C) lazy
D) systematic

Question 30

A portfolio is efficient if which of the following is true?

A) For a given standard deviation, there is no other portfolio with a higher expected return.
B) For a given expected return, there is no other portfolio with a lower standard deviation.
C) For a given expected return, the correlation coefficient is equal to +1.0.
D) All of these are correct.

Question 31

What will happen to the Security Market Line if (1) inflation expectations increase and (2) investors become more risk averse?

A) It will shift up and have a steeper slope.
B) It will shift down and have the same slope.
C) It will shift down and have a steeper slope.
D) It will shift up but have less slope.

Question 32

In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset portfolio, the correlation coefficient between the securities must be ____.

A) less than +1.0
B) equal to 0.0
C) less than 0.0
D) equal to -1.0

Question 33

What is the standard deviation of {5, 5, 5, 5, 5}?

A) 2.5
B) 5
C) 1
D) 0

Question 34

The security returns from multinational companies tend to have ____ systematic risk than those of domestic companies.

A) more
B) less options with
C) less
D) neither more nor less

Question 35

Texas Computers (TC) stock has a beta of 1.5, and American Water (AW) stock has a beta of 0.5. Which of the following statements will be true about these securities?

A) The addition of TC would reduce portfolio risk more than the addition of AW.
B) The addition of AW would reduce total portfolio risk more than the addition of TC.
C) The required return for TC is greater than the required return for AW.
D) The required return for AW is greater than the required return of TC.

Question 36

All of the following factors have their primary impact on unsystematic risk EXCEPT ____.

A) availability of raw materials
B) effects of foreign competition
C) changes in inflation
D) strikes

Question 37

The risk remaining after extensive diversification is primarily ____.

A) unsystematic risk
B) systematic risk
C) coefficient of variation risk
D) standard deviation risk

Question 38

The risk premium for an individual security is equal to the ____.

A) beta times the market return
B) difference between the required return and the risk-free rate
C) weighted average of the individual security betas in a portfolio
D) security's covariance divided by the variance of the market

Question 39

In general, when the correlation coefficient between the returns on two securities is ____, the risk of a portfolio is ____ the weighted average of the total risk of the two individual securities.

A) equal to +1.0; equal to
B) less than +1.0; greater than
C) greater than -1.0; less than
D) None of these are correct

Question 40

The ____ correlated the returns from two securities are, the ____ will be the portfolio effects of risk reduction.

A) more positively; greater
B) greater; greater
C) less positively; greater
D) lower; lower

Question 41

Business risk is influenced by all the following factors EXCEPT ____.

A) variability in interest expenses
B) variability in sales
C) diversity of its product line
D) choice of production technology

Question 42

The ability of an investor to buy and sell a company's securities quickly and without a significant loss of value is known as the ____ risk.

A) financial
B) marketability
C) business
D) security

Question 43

The maturity premium reflects a preference by many lenders for ____.

A) shorter maturities
B) reducing yields
C) high yield securities
D) longer maturities

Question 44

Common stockholders require a higher rate of return than do holders of Aaa-rated bonds. This reflects which type of risk premium?

A) maturity
B) default
C) seniority
D) marketability

Question 45

Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: $$\begin{array} { l l l } \text { Price } & \text { Rate of Return } & \text { Probability } \\\$ 16 & - 20 \% & 0.25 \\\$ 20 & 0 \% & 0.30 \\\$ 24 & + 20 \% & 0.25 \\\$ 28 & + 40 \% & 0.20\end{array}$$ Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the coefficient of variation for the rate of return on Phoenix stock.

A) 0.0
B) 2.68
C) 2.61
D) 0.275

Question 46

Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: $$\begin{array} { l l l } \text { Price } & \text { Rate of Return } & \text { Probability } \\\$ 16 & - 20 \% & 0.25 \\\$ 20 & 0 \% & 0.30 \\\$ 24 & + 20 \% & 0.25 \\\$ 28 & + 40 \% & 0.20\end{array}$$ Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the standard deviation of possible rates of return on Phoenix stock (to the nearest tenth of a percent).

A) 45.6%
B) 20.9%
C) 2.2%
D) 21.4%

Question 47

The default risk premium reflects the fact that ____.

A) the premium remains constant over time
B) there is a positive relationship between risk and maturity
C) there is a positive relationship between default risk and required returns
D) the premium varies depending on the time to maturity

Question 48

The ____ theory holds that the securities markets are demarcated by maturity.

A) boondoggle
B) liquidity premium
C) expectations
D) market segmentation

Question 49

The following yields on 20-year bonds prevailed in January for the three securities shown: $\begin{array}{lr}\text { Aa-rated corporate bond } & 9.98 \% \\\text { Baa-rated corporate bond } & 10.34 \% \\\text { B-rated corporate bond } & 11.12 \%\end{array}$ The difference in yields is due primarily to ____ risk premium.

A) maturity
B) default
C) seniority
D) financial

Question 50

On the capital market line (CML), any risk-return combination beyond the Market Portfolio (m) is obtained by ____.

A) lending money
B) borrowing money
C) reducing risk
D) investing in index funds

Question 51

The ____ theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity.

A) MacGuffin
B) market segmentation
C) expectations
D) liquidity premium

Question 52

The term structure of interest rates is related to the ____ risk premium.

A) default
B) seniority
C) marketability
D) maturity

Question 53

The term structure of interest rates is the pattern of interest rate yields for securities that differ only in ____.

A) default risk
B) liquidity premiums
C) the yield to maturity
D) the length of time to maturity

Question 54

The ____ theory of the yield curve takes into account the supply and demand interactions between buyers and lenders of securities.

A) expectations
B) market segmentation
C) preferred habitat
D) liquidity premium

Question 55

Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: $$\begin{array} { l l l } \text { Price } & \text { Rate of Return } & \text { Probability } \\\$ 16 & - 20 \% & 0.25 \\\$ 20 & 0 \% & 0.30 \\\$ 24 & + 20 \% & 0.25 \\\$ 28 & + 40 \% & 0.20\end{array}$$ Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the expected rate of return on Phoenix Stock.

A) 8%
B) 0%
C) 10%
D) 40%

Question 56

The business risk of a firm refers to the ____.

A) results from using fixed-cost sources of funds
B) variability in the price of a firm's securities
C) variability in the firm's operating earnings over time
D) influence of government regulations on business earnings

Question 57

According to the ____, long-term interest rates are a function of expected short-term interest rates.

A) maturity theory
B) expectations theory
C) market segmentation theory
D) preferred habitat theory

Question 58

The expectations, liquidity premium, and market segmentation theories all attempt to ____.

A) account for the differences between systematic and unsystematic risks in the securities market
B) define investors' required rates of return
C) predict the values of effective interest rates
D) explain the shape of the yield curve

Question 59

Investors can obtain high returns in their investments if they ____.

A) use hedging techniques
B) assume high risks
C) invest only international securities
D) invest in legal Ponzi type securities

Question 60

____ can be achieved by investing in a set of securities that have different risk-return characteristics.

A) Indexing
B) Capital Asset pricing
C) Diversification
D) Asset allocation

Question 61

The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of 14% and a standard deviation of 7%. Determine the probability of earning more than 21% on FTC common stock. (Note: Table V is required to work this problem.)

A) 1.00
B) 0.8413
C) 0.0013
D) 0.1587

Question 62

Assume you want to construct a portfolio with a 14% return from the following two securities: $$\begin{array} { l l l } \text { Security } & \text { Expected Return } & \text { Beta } \\1 & 16 \% & 1.12 \\2 & 12.5 \% & 0.94\end{array}$$ What percentage of your portfolio should be invested in Security 1?

A) 57%
B) 47%
C) 43%
D) 53%

Question 63

Over the 10-year period from 1978 through 1987, the compound annual rate of return on U.S. Treasury bills was 9.17%. Over the same time period, the average annual inflation rate was 6.39%. Therefore, the ____.

A) inflation premium was 2.78 percentage points
B) real expected rate of return was 9.17 percentage points
C) realized real rate of return was 2.78 percentage points
D) required rate of return was 6.39 percentage points

Question 64

Sally's broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities have an expected return of 10.3% and 20% have an expected return of 12.8%, what is the expected return of the remaining portion of her portfolio?

A) 20.9%
B) 18.8%
C) 12.5%
D) Cannot be determined

Question 65

The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of 14% and a standard deviation of 7%. Determine the probability of earning a negative rate of return (i.e. less than 0%) on FTC common stock. (Note: Table V is required to work this problem.)

A) 0.0228
B) 2.00
C) 0.5000
D) 0.9772

Question 66

An investor plans to invest 75% of her funds in the common stock of Gamma Industries and 25% in Epsilon Company. The expected return on Gamma is 12%, and the expected return on Epsilon is 16%. The standard deviation of returns for Gamma is 8% and for Epsilon is 12%. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the expected return on the investor's portfolio.

A) 14%
B) 12%
C) 13%
D) 9%

Question 67

An investor plans to invest 75% of her funds in the common stock of Gamma Industries and 25% in Epsilon Company. The expected return on Gamma is 12%, and the expected return on Epsilon is 16%. The standard deviation of returns for Gamma is 8% and for Epsilon is 12%. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the standard deviation of returns for this investor's portfolio.

A) 73.8%
B) 6.71%
C) 3.00%
D) 8.59%

Question 68

If the return on U.S. Treasury bills is 7.02%, the risk premium is 2.32%, and the inflation rate is 4.16%, then the real rate of return is ____.

A) 2.86%
B) 7.02%
C) 4.70%
D) 6.48%

Question 69

Elephant Company common stock has a beta of 1.2. The risk-free rate is 6%, and the expected market rate of return is 12%. Determine the required rate of return on the security.

A) 7.2%
B) 14.4%
C) 19.2%
D) 13.2%

Question 70

Determine the beta of a portfolio consisting of equal investments in the following common stocks: $\begin{array}{ll}\text { Security } & \text { Beta } \\\text { Apple Computer } & 1.15 \\\text { Coca-Cola } & 1.05 \\\text { Harley-Davidson } & 1.50 \\\text { Homestake Mining } & 0.50\end{array}$

A) 1.05
B) 1.00
C) 1.10
D) 0.95

Question 71

The yield to maturity on ACL bonds maturing in 2025 is 8.75%. The yield to maturity on a similar maturity U.S. Government Treasury bond is 7.06%, and the yield on Treasury bills is 6.51%. What is the default risk premium on the ACL bond?

A) 2.24%
B) 1.69%
C) 0.55%
D) 8.75%

Question 72

The real rate of interest is expected to be 3%, and the expected rate of inflation for next year is expected to be 5.5%. If the default risk premium is 1.1 percentage points, and the seniority risk premium is 0.4 percentage points, what is the required return on a 1-year U.S. Treasury security?

A) 9.6%
B) 10.0%
C) 8.5%
D) 8.9%

Question 73

A college student owns two securities: Apple and Coca- Cola. Apple has an expected return of 15%, with a standard deviation of those returns being 11%. Coca-Cola has an expected return of 12% and a standard deviation of 7%. The correlation of returns between Apple and Coca-Cola is 0.81. If the portfolio consist of $6,000 in Coca-Cola and $4,000 in Apple, what is the expected standard deviation of portfolio returns?

A) 8.18%
B) 13.20%
C) 8.60%
D) 9.71%

Question 74

The risk-free rate of return is 5.51%, based on an expected inflation premium of 2.54%. The expected return on the market is 12.8%. What is the required rate of return for Envoy common stock which has a beta of 1.35?

A) 6.98%
B) 16.24%
C) 15.35%
D) 12.80%

Question 75

Don has $3,000 invested in AT&T with an expected return of 11.6%; $10,000 in IBM with an expected return of 12.8%; and $6,000 in GM with an expected return of 12.2%. What is Don's expected return on his portfolio?

A) 12.42%
B) 12.20%
C) 11.81%
D) Cannot be determined

Question 76

The expected rate of return for 3COM is 18%, with a standard deviation of 10.98%. The expected rate of return for Just the Fax is 26%, with a standard deviation of 15.86%. Which firm would be considered the riskier from a total risk perspective?

A) 3COM
B) Just the Fax
C) Neither, as both have the same risk
D) Cannot be determined

Question 77

The return expected from a risky investment is 24%, and the standard deviation of this return is 17%. If returns from this investment are normally distributed, what is the probability that the investment may earn a negative rate of return? (Note: Table V is required to work this problem.)

A) 8.33%
B) 7.93%
C) 6.88%
D) 5.44%

Question 78

Twin City Knitting (TCK) pays a current dividend of $2.20, and dividends are expected to grow at a rate of 7% annually in the foreseeable future. The beta of TCK is 1.2. If the risk-free rate is 9.2% and the market risk premium is 6%, at what price would you expect TCK's common stock to sell?

A) $14.35
B) $33.63
C) $23.40
D) $25.04

Question 79

Dana has a portfolio of 8 securities, each with a market value of $5,000. The current beta of the portfolio is 1.28, and the beta of the riskiest security is 1.75. Dana wishes to reduce her portfolio beta to 1.15 by selling the riskiest security and replacing it with another security with a lower beta. What must be the beta of the replacement security?

A) 1.21
B) 0.91
C) 0.73
D) 1.62

Question 80

Compute the risk premium for the stock of Omega Tools if the risk-free rate is 6%, the expected market return is 12%, and Omega's stock has a beta of 0.8.

A) 10.8%
B) 4.8%
C) 48.0%
D) 16.8%