Question 1

Which of the following statements about the various types of risks is true?
A)A firm's default risk is a nondiversifiable risk.
B)Interest rate risk is an unsystematic risk.
C)Inflation risk is a systematic risk.
D)Economic risk is a firm-specific risk.
E)Political risk is a diversifiable risk.

Accepted Answer

Inflation risk is a systematic risk because it affects the overall economy and impacts all investments in a similar way. A firm's default risk may be partially diversifiable by investing in a diversified portfolio of bonds, hence A is incorrect. Interest rate risk is a systematic risk as it impacts all investments dependent on interest rates, so B is incorrect. Economic risk includes factors such as inflation, exchange rates, and economic growth, and is therefore also a systematic risk, implying D is incorrect. Political risk is often considered nondiversifiable as the same risk affects all investors and investments in a country, making E incorrect.

Question 2

The risk-free rate is 5 percent and the market risk premium is 8 percent. Stock Y's beta is 1.85 and the standard deviation of its returns is 62.5 percent. What should be the stock's expected rate of return for the stock price to be considered in equilibrium?
A)10.55%
B)12.82%
C)15.54%
D)14.80%
E)19.80%

Accepted Answer

Using the Capital Asset Pricing Model (CAPM), the expected return on a stock is calculated as: Expected Return = Risk-Free Rate + Beta * (Market Risk Premium). Plugging in the given values: Expected Return = 5% + 1.85 * 8% = 5% + 14.8% = 19.8%.

Question 3

Which of the following is the relevant risk of an investment, for which investors should be rewarded?
A)Firm-specific risk
B)Total risk
C)Systematic risk
D)Unsystematic risk
E)Diversifiable risk

Accepted Answer

Systematic risk represents the overall market risk that is common to all investments, which cannot be diversified away. This is considered the relevant risk for which investors deserve a reward, as it is beyond their control and potentially can affect all their investments. Firm-specific risk, unsystematic risk and diversifiable risk can be diversified away and are not considered relevant risks. Total risk combines both systematic and unsystematic risks.

Question 4

The risk-free rate of return is 4 percent, and the market return is 10 percent. The betas of Stocks A, B, C, D, and E are 0.85, 0.95, 1.20, 1.35, and 0.5, respectively. The expected rates of return for Stocks A, B, C, D, and E are 8 percent, 9 percent, 10 percent, 14 percent, and 6 percent, respectively. Which stock should a rational investor purchase?
A)A
B)B
C)C
D)D
E)E

Accepted Answer

The expected rate of return for Stock D is the highest among all the stocks at 14 percent, which indicates that the market has the highest expectations from this stock's performance. Additionally, it has the highest beta, which means it is the most sensitive to market fluctuations. As a rational investor who seeks to maximize returns, Stock D should be purchased.

Question 5

The next expected dividend for Stock P is $2.50, the current price of the stock is $32.50, and the firm is expected to grow at a constant rate of 4 percent per year forever. The risk free rate is 3 percent, the market risk premium is 5.5 percent, and the stock's beta is 1.2. Based on the given information, which of the following statements is correct?
A)An investor should buy this stock because its expected rate of return, 11.69 percent, is greater than its required rate of return, 9.6 percent.
B)An investor should not buy this stock because its expected rate of return, 9.6 percent, is greater than its required rate of return, 11.69 percent.
C)An investor should not buy this stock because its intrinsic value, $44.64, is greater than its current price of $32.50.
D)An investor should not buy this stock because its current price, $32.50, is not equal to its intrinsic value, $44.64.
E)An investor should be indifferent toward buying or selling the stock because its required rate of return is equal to its expected rate of return, 11.69 percent.

Accepted Answer

To calculate the required rate of return, we use the capital asset pricing model (CAPM):

Required Rate of Return = Risk-Free Rate + Beta × (Market Risk Premium)
Required Rate of Return = 3% + 1.2 × 5.5%
Required Rate of Return = 9.6%

Using the constant growth dividend discount model, we can calculate the intrinsic value of the stock:

Intrinsic Value = Next Year's Dividend ÷ (Required Rate of Return − Growth Rate)
Intrinsic Value = $2.50 ÷ (9.6% − 4%)
Intrinsic Value = $44.64

Comparing the intrinsic value to the current price, we can see that the stock is undervalued. Additionally, the expected rate of return (11.69%) is higher than the required rate of return (9.6%), indicating that the stock is a good investment. Therefore, choice A is correct.

Question 6

Which of the following statements about relevant risk and irrelevant risk is correct?
A)Relevant risk includes inflation risk, but excludes political risk.
B)Relevant risk includes interest rate risk, but excludes a firm's default risk.
C)Relevant risk includes economic risk, but excludes exchange rate risk.
D)Relevant risk includes exchange rate risk, but excludes inflation risk.
E)Relevant risk includes a firm's default risk, but excludes political risk.

Accepted Answer

Relevant risks are those that affect the cash flows of an investment or project. Interest rate risk is relevant as it can affect the cost of financing the project, whereas a firm's default risk does not directly affect the project's cash flows.

Question 7

Which of the following statements about market risk and firm-specific risk is true?
A)Market risk is an unsystematic risk, whereas firm-specific risk is systematic risk.
B)Investors are not rewarded for taking market risk, whereas they are rewarded for taking firm-specific risk.
C)Market risk is a diversifiable risk, whereas firm-specific risk is a nondiversifiable risk.
D)Market risk is the relevant risk, whereas firm-specific risk is an irrelevant risk.
E)Market risk includes a firm's default risk, whereas firm-specific risk includes economic risk.

Accepted Answer

Market risk, also known as systematic risk, affects the entire market and cannot be eliminated through diversification. It is considered relevant because it impacts all investments. Firm-specific risk, or unsystematic risk, can be diversified away by holding a broad portfolio of assets, making it less relevant to a well-diversified investor.

Question 8

Diversifiable risk includes _____. 
A)reinvestment rate risk
B)economic risk
C)business risk
D)political risk
E)interest rate risk

Accepted Answer

Diversifiable risk, also known as unsystematic risk, is specific to a company or industry. Business risk, which is the risk associated with the specific operations of a company, is a type of diversifiable risk.

Question 9

The risk-free rate of return is 5 percent, and the market return is 8 percent. The betas of Stocks A, B, C, D, and E are 0.75, 0.50, 0.25, 1.50, and 1.25, respectively. The expected rates of return for Stocks A, B, C, D, and E are 8 percent, 6.5 percent, 7 percent, 11 percent, and 7 percent, respectively. Suppose an investor holds all of these stocks in a single portfolio. Based on the information given here, if the investor wants to sell one of the stocks so that only four stocks remain in the portfolio, which stock should be sold?
A)Stock A
B)Stock B
C)Stock C
D)Stock D
E)Stock E

Accepted Answer

Stock E should be sold because its expected return (7%) is lower than the return predicted by the Capital Asset Pricing Model (CAPM), which is 8.75% (5% + 1.25*(8%-5%)).

Question 10

The risk that is limited to a particular firm is also known as _____. 
A)unsystematic risk
B)non-diversifiable risk
C)market risk
D)relevant risk
E)combined risk

Accepted Answer

Unsystematic risk, also known as specific risk or diversifiable risk, is the risk that is limited to a particular firm or industry. This type of risk can be reduced or eliminated through diversification. Non-diversifiable risk (B) refers to the risk that cannot be eliminated through diversification, such as market risk. Market risk (C) is the risk that affects all investments in the market, while relevant risk (D) and combined risk (E) are not commonly used terms in finance.

Question 11

According to the capital asset pricing model (CAPM), _____. 
A)investors should expect to be rewarded for the total risk associated with an individual investment, which is measured by the standard deviation of returns on the investment
B)investors should expect to be rewarded for only the unsystematic risk associated with an individual investment, which is measured by the standard deviation of returns
C)investors should expect to be rewarded only for the systematic risk associated with an individual investment, which is measured by the standard deviation of returns
D)investors should expect to be rewarded for only the unsystematic risk associated with an individual investment, which is measured by the beta coefficient
E)investors should expect to be rewarded for only the systematic risk associated with an individual investment, which is measured by the beta coefficient

Accepted Answer

According to the CAPM, investors should expect to be rewarded for only the systematic risk associated with an individual investment, which is measured by the beta coefficient. The beta coefficient measures the sensitivity of an asset's returns to changes in the market as a whole. This means that investors are not rewarded for unsystematic risk, which is unique to a specific asset and can be diversified away. The CAPM assumes that investors are rational and risk-averse, and will only accept additional risk if they are compensated with higher expected returns.

Question 12

The total risk associated with an investment can be divided into _____. 
A)systematic risk and nondiversifiable risk
B)firm-specific risk and unsystematic risk
C)market risk and firm-specific risk
D)market risk and nondiversifiable risk
E)firm-specific risk and total risk

Accepted Answer

Market risk refers to the risk associated with macroeconomic factors such as changes in interest rates and economic conditions that affect the entire market. Firm-specific risk, on the other hand, refers to the risk associated with factors that affect a specific company or industry. Therefore, the total risk is comprised of market risk and firm-specific risk. Thus, choice C, market risk and firm-specific risk, is the best answer. Choices A, B, D, and E may contain overlapping or incorrect terms, making them less accurate options.

Question 13

Which of the following pairs of terms are names for the same risk?
A)Market risk and unsystematic risk
B)Market risk and relevant risk
C)Firm-specific risk and nondiversifiable risk
D)Firm-specific risk and systematic risk
E)Firm-specific risk and market risk

Accepted Answer

The answer of Which of the following pairs of terms...

Question 14

The beta coefficient of Zed Corporation is equal to 0.7 and the required rate of return on the stock equals 12 percent. If the expected return on the market is 12.5 percent, what is the risk-free rate of return?
A)11.56%
B)10.83%
C)9.52%
D)12.25%
E)8.89%

Accepted Answer

The answer of The beta coefficient of Zed Corporation is...

Question 15

The market for a stock is said to be in equilibrium when the _____. 
A)expected return on the stock is equal to its required return
B)expected return on the stock is equal to the risk-free rate of return
C)expected return on the stock is equal to the market risk premium
D)expected return on the stock is equal to the market return
E)expected return on the stock is equal to its historical return

Accepted Answer

Equilibrium in the stock market means that the expected return on the stock is equal to its required return. In other words, the price of the stock is such that investors are willing to buy and sell it at its fair value. This happens when the market efficiently incorporates all available information, and there is no reason to believe that the stock is overvalued or undervalued.

Question 16

Which of the following statements about risk measures is correct?
A)Beta is a measure of total risk, whereas standard deviation is the measure of unsystematic risk.
B)Beta is a measure of unsystematic risk, whereas standard deviation is the measure of total risk.
C)Beta is a measure of total risk, whereas standard deviation is the measure of systematic risk.
D)Beta is a measure of systematic risk, whereas standard deviation is the measure of total risk.
E)Beta is a measure of total risk, whereas Standard deviation is the measure of systematic risk.

Accepted Answer

Beta measures the systematic risk of an investment, while standard deviation measures the total risk (both systematic and unsystematic).

Question 17

The beta of Stock A is 2.1. The risk-free rate is 6 percent, and the market return is 13 percent. The expected rate of return of Stock A is 15.5 percent. Based on the above information, which of the following statements is true?
A)An investor should buy Stock A because its expected rate of return is less than the required rate of return.
B)An investor should buy Stock A because its expected rate of return is greater than the required rate of return.
C)An investor should not buy Stock A because its expected rate of return is greater than the required rate of return.
D)An investor should not buy Stock A because its expected rate of return is less than the required rate of return.
E)An investor should be indifferent towards buying or selling the stock.

Accepted Answer

The required rate of return can be calculated using the Capital Asset Pricing Model (CAPM) formula: Required Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Substituting the given values: Required Return = 6% + 2.1 * (13% - 6%) = 6% + 2.1 * 7% = 6% + 14.7% = 20.7%. Since the expected rate of return of Stock A (15.5%) is less than its required rate of return (20.7%), statement D is correct.

Question 18

Which of the following activities would most likely affect a particular company's systematic risk?
A)The company's CEO resigns.
B)The firm's sales this year probably will substantially lower than the amount forecasted by senior management.
C)According to the U.S. government, inflation is expected to increase during the next five years.
D)There is a good chance that the firm will experience a long labor strike in the near future.
E)Next year the company plans to introduce a new product line that has a 30 percent chance of failing.

Accepted Answer

The answer of Which of the following activities would most...

Question 19

Which of the following statements about the security market line (SML) and investor's risk aversion is correct?
A)The steeper the slope of the line, the lower the average investor's risk aversion, and thus the greater the return investors require as compensation for risk.
B)The steeper the slope of the line, the greater the average investor's risk aversion, and thus the greater the return investors require as compensation for risk.
C)The steeper the slope of the line, the lower the average investor's risk aversion, and thus the lower the return investors require as compensation for risk.
D)The steeper the slope of the line, the greater the average investor's risk aversion, and thus the lower the return investors require as compensation for risk.
E)The less steep the slope of the line, the greater the average investor's risk aversion, and thus the lower the return investors require as compensation for risk.

Accepted Answer

The security market line (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM) which shows the expected return of an investment based on its level of risk. The SML has a positive slope, indicating that as the level of risk increases, the expected return also increases. The slope of the SML is determined by the market risk premium, which is the difference between the expected return on the market and the risk-free rate. The greater the market risk premium, the steeper the slope of the SML. Investor's risk aversion is measured by the degree to which they are willing to accept risk for a given level of return. The steeper the slope of the SML, the greater the expected return for a given level of risk, indicating that investors are more risk-averse and require a higher return to compensate for the additional risk. Therefore, choice B is correct.

Question 20

If the risk-free rate is 7 percent, the expected return on the market is 10 percent, and the expected return on Security J is 13 percent, what is the beta of Security J?
A)1.0
B)1.5
C)2.0
D)2.5
E)3.0

Accepted Answer

The answer of If the risk-free rate is 7 percent,...

Quiz 8: Risk and Rates of Return

Which of the following statements about the various types of risks is true?

The risk-free rate is 5 percent and the market risk premium is 8 percent. Stock Y's beta is 1.85 and the standard deviation of its returns is 62.5 percent. What should be the stock's expected rate of return for the stock price to be considered in equilibrium?

Which of the following is the relevant risk of an investment, for which investors should be rewarded?

Which of the following statements about relevant risk and irrelevant risk is correct?

Which of the following statements about market risk and firm-specific risk is true?

Diversifiable risk includes _____.

The risk that is limited to a particular firm is also known as _____.

According to the capital asset pricing model (CAPM) , _____.

The total risk associated with an investment can be divided into _____.

Which of the following pairs of terms are names for the same risk?

The beta coefficient of Zed Corporation is equal to 0.7 and the required rate of return on the stock equals 12 percent. If the expected return on the market is 12.5 percent, what is the risk-free rate of return?

The market for a stock is said to be in equilibrium when the _____.

Which of the following statements about risk measures is correct?

The beta of Stock A is 2.1. The risk-free rate is 6 percent, and the market return is 13 percent. The expected rate of return of Stock A is 15.5 percent. Based on the above information, which of the following statements is true?

Which of the following activities would most likely affect a particular company's systematic risk?

Which of the following statements about the security market line (SML) and investor's risk aversion is correct?

If the risk-free rate is 7 percent, the expected return on the market is 10 percent, and the expected return on Security J is 13 percent, what is the beta of Security J?