Question 1

We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

Accepted Answer

The beta of a diversified portfolio is generally more stable over time than the beta of a single security because diversification reduces the impact of individual security volatility on the portfolio.

Question 2

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 3

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

Accepted Answer

A stock's beta measures its systematic risk, not its diversifiable risk. Beta is a measure of the volatility of a stock or portfolio in relation to the overall market.

Question 4

It is possible for a firm to have a positive beta,even if the correlation between its returns and those of another firm is negative.

Accepted Answer

Beta measures the sensitivity of a stock or portfolio's returns to the market. It is possible for a firm to have a positive beta (meaning it tends to move in the same direction as the market) even if the correlation between its returns and those of another firm is negative. Correlation measures the degree to which two assets move in relation to each other, while beta measures the degree to which a single asset moves in relation to the market as a whole.

Question 5

If an investor buys enough stocks,he or she can,through diversification,eliminate all of the market risk inherent in owning stocks,but as a general rule it will not be possible to eliminate all diversifiable risk.

Accepted Answer

Diversification can help reduce unsystematic (diversifiable) risk, which is specific to individual stocks or sectors, but it cannot eliminate systematic (market) risk, which affects the entire market.

Question 6

Even if the correlation between the returns on two securities is +1.0,if the securities are combined in the correct proportions,the resulting 2-asset portfolio will have less risk than either security held alone.

Accepted Answer

If the correlation between the returns on two securities is +1.0, it means they move perfectly in sync with each other. Therefore, combining them in any proportion will not reduce the portfolio's risk compared to holding either security alone, as their returns are perfectly positively correlated, leading to no diversification benefit.

Question 7

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.

Accepted Answer

A portfolio's risk is not measured by the weighted average of the standard deviations of the securities in the portfolio, but rather by the portfolio's overall standard deviation, which takes into account the correlation between the returns of the securities in the portfolio. Diversification reduces risk when the returns of the securities are not perfectly correlated.

Question 8

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

Accepted Answer

A stock with zero systematic risk would have a beta of 0. A beta of 1.0 indicates that the stock's returns are highly correlated with the market, and therefore it has systematic risk.

Question 9

We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

Accepted Answer

The beta of a diversified portfolio is generally more stable over time than the beta of a single security. This is because the diversification of the portfolio helps to reduce the impact of individual security-specific events on the portfolio's overall beta. Over time, the portfolio's beta will reflect the underlying risk and return characteristics of the portfolio as a whole, rather than the idiosyncrasies of any one particular security.

Question 10

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

Accepted Answer

Beta measures a stock's volatility relative to the overall market, implying its systematic risk. For an investor holding a well-diversified portfolio, beta remains relevant as it indicates the portfolio's sensitivity to market movements. However, for an investor holding only one stock, beta is less relevant since unsystematic (specific) risk, which can be diversified away, significantly impacts that stock's total risk.

Question 11

Any change in its beta is likely to affect the required rate of return on a stock,which implies that a change in beta will likely have an impact on the stock's price,other things held constant.

Accepted Answer

This statement is true. Beta is a measure of a stock's volatility compared to the overall market. A higher beta indicates more volatility, and therefore more risk. Investors require a higher rate of return to compensate for this added risk. If a stock's beta changes, the required rate of return will also change, which in turn will affect the stock's price.

Question 12

A firm can change its beta through managerial decisions,including capital budgeting and capital structure decisions.

Accepted Answer

The beta of a firm can be changed through managerial decisions such as increasing or decreasing leverage (through capital structure decisions) or investing in projects with different risk levels (through capital budgeting decisions).

Question 13

The CAPM is built on historic conditions,although in most cases we use expected future data in applying it.Because betas used in the CAPM are calculated using expected future data,they are not subject to changes in future volatility.This is one of the strengths of the CAPM.

Accepted Answer

The statement is false. The betas used in the CAPM are calculated using historic data and are subject to changes in future volatility. The CAPM assumes that beta is constant over time, which is a limitation of the model.

Question 14

The distributions of rates of return for Companies AA and BB are given below:
  
We can conclude from the above information that any rational,risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.

Accepted Answer

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.

Question 15

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

Accepted Answer

The answer of If the returns of two firms are...

Question 16

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.

Accepted Answer

While holding a portfolio with all stocks in the market can reduce specific risk associated with individual stocks, it does not eliminate market-wide risks such as economic downturns or geopolitical events that can affect all stocks. Therefore, it is not completely riskless.

Question 17

Portfolio A has but one security,while Portfolio B has 100 securities.Because of diversification effects,we would expect Portfolio B to have the lower risk.However,it is possible for Portfolio A to be less risky.

Accepted Answer

While diversification typically lowers risk, it is possible for the single security in Portfolio A to have a lower risk than all 100 securities in Portfolio B, which could outweigh the benefits of diversification. Therefore, Portfolio A could be less risky despite having only one security.

Question 18

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.

Accepted Answer

The answer of Under the CAPM,the required rate of return...

Question 19

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

Accepted Answer

This statement is true. The slope of the SML reflects the risk aversion of investors, with steeper slopes indicating higher levels of risk aversion. This is because risk averse investors require a higher return for taking on additional risk, leading to a greater difference between the expected return of a risky asset and the risk-free rate on the SML.

Question 20

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events,and their effects on investment risk can in theory be diversified away.

Accepted Answer

Company-specific events, also known as unsystematic events, are not related to overall market risk and can be diversified away by investing in a portfolio of diverse assets. Therefore, their impact on investment risk can be reduced, making it true that risks associated with such events can be diversified away.

Quiz 6: Risk and Return