Question 1

The following information is available in general and about investments in stocks J and K. The market return (k_M)= 9% The risk free rate (k_RF)= 5% Stock J's beta = 0.8 Expected constant growth rate for Stock J = 6% Investment in Stock J = $80,000 Stock K's beta = 1.4 Expected constant growth rate for Stock K = 7% Investment in Stock K = $120,000 a. What are the expected returns on Stock J and Stock K individually? b. What is the expected return on the portfolio? c. If Stock K just paid a dividend of $2.50, what is Stock K's intrinsic value?

Accepted Answer

The answer of The following information is available in general...

Question 2

The beta coefficient of a stock is reflected in the slope of its characteristic line.

Accepted Answer

This is a true statement. The characteristic line is a graphical representation of the linear relationship between the stock's returns and the returns of the market as a whole. The slope of this line represents the stock's beta coefficient, which measures the stock's volatility relative to the market.

Question 3

The SML represents a state of stable equilibrium at which expected and required returns are at least equal. Suppose a stock is displaced so that its expected return is below its required return. Describe the market forces that tend to push the returns back together.

Accepted Answer

The answer of The SML represents a state of stable...

Question 4

A portfolio is characterized by the following: 
  a. Calculate the portfolio's expected return. 
b. Calculate the beta of the portfolio. 
c. If the return on the market is 10% and the risk-free rate is 3%, what is the required return on the portfolio?

Accepted Answer

The answer of A portfolio is characterized by the following:...

Question 5

How can a stock have different risk characteristics in and out of a portfolio?

Accepted Answer

The answer of How can a stock have different risk...

Question 6

Explain systematic risk and unsystematic risk.

Accepted Answer

The answer of Explain systematic risk and unsystematic risk....

Question 7

Because events causing business-specific risks are random, their effects simply cancel out when added together over a substantial number of stocks. This canceling effect enables us to say that business-specific can be "diversified away."

Accepted Answer

Business-specific risks can be diversified away by investing in a variety of stocks, as the random nature of these risks causes their effects to cancel out when added together over a large number of stocks. This is a fundamental principle of modern portfolio theory.

Question 8

When a new stock is introduced into a portfolio and the "peaks" in its return occur with the "valleys" in the portfolio's return, the stock's return is said to be perfectly negatively correlated with the portfolio's, and its addition will reduce the portfolio's risk.

Accepted Answer

This statement correctly describes the concept of negative correlation between individual stock returns and portfolio returns. When a stock's returns move in the opposite direction of the overall portfolio's returns (i.e. "peaks" occur when the portfolio experiences "valleys"), it is considered to have negative correlation. Adding such a stock to a portfolio can reduce the portfolio's overall risk, as it provides diversification benefits by moving independently of the other portfolio holdings.

Question 9

Stocks with equal stand-alone risk can have opposite risk impacts on a portfolio because of the timing of the variations in their returns.

Accepted Answer

Even though stocks may have the same stand-alone risk, their returns may vary at different times. This can result in one stock having a positive impact on the portfolio while the other may have a negative impact, depending on the timing of their returns. Therefore, stocks with equal stand-alone risks can have opposite risk impacts on a portfolio.

Question 10

According to the SML, investors are rewarded for bearing market risk and not for bearing business-specific risk.

Accepted Answer

The SML asserts that investors are compensated for exposure to systematic or market risk, not for company-specific or unsystematic risk. This is because market risk cannot be diversified away, whereas unsystematic risk can be reduced by diversifying a portfolio.

Question 11

Stock A's returns over the past ten years have been: 10.0%, 8.0%, 12.0%, (5.0%), 10.0%, 12.0%, 10.0%, (4.0%), 8.0%, 9.0%. 
a. What is the mean of Stock A's return over the past 10 years? 
b. What is the standard deviation of Stock A's return over the past 10 years? 
c. What is the coefficient of variation of Stock A's return over the past 10 years

Accepted Answer

The answer of Stock A's returns over the past ten...

Question 12

When a new stock is introduced into a portfolio and the ups and downs of its return appear to coincide with those of the portfolio's return, the stock's return is said to be perfectly positively correlated with the portfolio's, and its addition will reduce portfolio risk.

Accepted Answer

Perfect positive correlation means the stock moves exactly in tandem with the portfolio, but adding such a stock does not reduce portfolio risk; diversification, which involves adding assets with low or negative correlation, is what typically reduces risk.

Question 13

If the expected return on a stock exceeds the return required by investors, the market will generate enough demand for the security to elevate the price to the point at which required and expected returns become equal.

Accepted Answer

This statement is true according to the principles of efficient markets. If the expected return on a stock is higher than the return required by investors, then demand for the stock will increase, causing the price to rise until the expected return equals the required return.

Question 14

A theoretically ideal way to eliminate market risk is to diversify into the stocks of companies that make products investors buy when the stock market is depressed.

Accepted Answer

Diversifying into the stocks of companies that make products investors buy during a market downturn can help mitigate the impact of market risk on a portfolio. This is because even if the market as a whole is down, these companies may experience increased demand for their products and therefore may still see growth in their stock prices. However, it is important to note that diversification cannot completely eliminate market risk.

Question 15

Why is the thinking behind the Capital Asset Pricing Model dangerous for small investors?

Accepted Answer

The answer of Why is the thinking behind the Capital...

Question 16

The beta coefficient, representing the relationship between the performance of the market and the performance of the stock, is theoretically not sensitive to business-specific risk factors.

Accepted Answer

The beta coefficient only measures the volatility of a stock relative to the market as a whole, and does not take into account any business-specific risk factors. Therefore, it is theoretically not sensitive to such factors.

Question 17

A stock's beta coefficient is developed by plotting the historical relationship between the stock's return and the market's return.

Accepted Answer

A stock's beta coefficient is calculated by measuring the sensitivity of its returns to the overall market's returns. It is developed by plotting the stock's historical returns against those of the market, usually represented by a market index such as the S&P 500.

Question 18

The slope of the security market line is a reflection of the risk tolerance or level of risk aversion of the investment community. As the line becomes steeper, investors become more risk averse and demand higher risk premiums.

Accepted Answer

The statement is true. The slope of the security market line (SML) represents the market's risk premium, which is the additional return investors demand for taking on the risk of investing in a particular security. A steeper SML indicates that investors require higher risk premiums for accepting additional risk, which implies greater risk aversion. Conversely, a flatter SML indicates that investors are more willing to take on risk for a lower expected return, reflecting lower risk aversion.

Question 19

What is the market risk premium?

Accepted Answer

The answer of What is the market risk premium?...

Question 20

Portfolio risk is best reduced through diversification into stocks in fundamentally different industries.

Accepted Answer

Diversification helps reduce portfolio risk by spreading investments across different industries, thereby decreasing the overall impact of any single company or sector on the portfolio's performance.

Quiz 9: Risk and Return