Question 1

Here are the expected returns on two stocks:  If you form a 50−50 portfolio of the two stocks, what is the portfolio's standard deviation?
A) 8.1%
B) 10.5%
C) 13.4%
D) 16.5%
E) 20.0%

Accepted Answer

The answer of Here are the expected returns on two...

Question 2

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 expected return for any given level of risk. This means that the slope of the SML will increase, as the required return on any given asset will increase for a higher level of systematic risk.

Question 3

When considering stock and bond valuation models, we implicitly assume that the marginal investor is risk averse, which means that he or she requires a higher rate of return for a given level of risk than a risk neutral individual, other things held constant.

Accepted Answer

This is a foundational concept in finance theory known as the risk premium, which states that investors must be compensated for taking on additional risk. As a result, the marginal investor is assumed to be risk averse and requires a higher rate of return to compensate for the additional risk.

Question 4

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

Accepted Answer

While diversification typically lowers relevant risk, it is possible for the security in Portfolio A to have a lower level of risk than any of the individual securities in Portfolio B. However, overall Portfolio B would still have lower risk due to the diversification effect.

Question 5

Which type of risk can be eliminated through diversification?
A) total risk
B) market risk
C) firm specific risk
D) none of the above

Accepted Answer

Diversification can eliminate firm-specific risk, also known as unsystematic risk or idiosyncratic risk. This is the risk that is specific to a particular company or industry, such as the risk of a single stock underperforming due to company-specific factors such as poor management, product failure, or legal issues. By diversifying one’s portfolio across multiple companies and industries, this risk can be minimized or eliminated. However, market risk, also known as systematic risk, cannot be eliminated through diversification as it is the risk that affects the overall market, such as changes in interest rates, inflation, or geopolitical events. Total risk is the combination of both firm-specific risk and market risk and cannot be eliminated completely.

Question 6

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 answer of The realized portfolio return is the weighted...

Question 7

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

Accepted Answer

The answer of A firm cannot change its beta through...

Question 8

Assume Stock A has a standard deviation of 0.21 while Stock B has a standard deviation of 0.10.If both Stock A and Stock B must be held in isolation, and if investors are risk averse, we can conclude that Stock A will have a greater required return.However, if the assets could be held in portfolios, it is conceivable that the required return could be higher on the low standard deviation stock.

Accepted Answer

This is because when held in isolation, the higher standard deviation of Stock A makes it riskier and therefore demands a higher required return for investors to compensate for the additional risk. However, when held in a portfolio, the lower standard deviation of Stock B could decrease the overall risk of the portfolio and allow for a higher required return.

Question 9

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 accurately describes how to construct a payoff matrix of expected returns.

Question 10

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 have a beta which is greater than 1.0.

Accepted Answer

This is a correct definition of market risk, and a stock with a beta of greater than 1.0 is considered to have above-average market risk.

Question 11

____ is the appropriate measure for stand-alone risk and ____ is the appropriate measure of risk when adding an asset to a diversified portfolio.
A) beta; variance
B) beta; standard deviation
C) standard deviation; beta
D) standard deviation; variance

Accepted Answer

Standard deviation is a measure of total risk, including both diversifiable and non-diversifiable risk, and is appropriate for stand-alone risk. Beta, on the other hand, measures only systematic risk and is therefore appropriate for measuring the risk of an asset only within a diversified portfolio.

Question 12

The beta of any portfolio can be computed as the
A) slope of the security market line
B) sum of the betas for each asset held in the portfolio divided by the number of assets in the portfolio.
C) the standard deviation of the expected returns of the portfolio minus the risk-free rate.
D) weighted average of the betas for each asset held in the portfolio.

Accepted Answer

The beta of a portfolio can be calculated as a weighted average of the betas of individual assets held in the portfolio. This means that the beta of each asset is multiplied by its weight (proportion of the investment) in the portfolio and the results are summed up to get the beta of the entire portfolio. Therefore, choice D (weighted average of the betas for each asset held in the portfolio) is the correct answer.

Question 13

When combining many assets into a portfolio the correlation between the variables has a(n) ____ impact on the overall risk of the portfolio than the overall risk of each asset.
A) larger
B) equal
C) smaller
D) none of the above

Accepted Answer

Correlation measures how assets move in relation to each other. When combining many assets into a portfolio, the correlation between the variables has a larger impact on the overall risk of the portfolio than the overall risk of each asset. This is because if assets are highly correlated, they tend to move in the same direction, increasing the overall risk of the portfolio. Conversely, if assets are negatively correlated, they tend to move in opposite directions, reducing the overall risk of the portfolio. Therefore, it is important to consider correlation when constructing a portfolio to manage risk.

Question 14

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

This statement is true. The risk of any physical asset owned by a business can have an impact on the risk of the firm's securities, as these assets can affect the business's overall financial performance and ability to generate returns for security holders. Therefore, it is important for businesses to measure and manage the relevant risk of their physical assets.

Question 15

Risk averse investors require ____ rates of return for investments with ____ risk.
A) higher; lower
B) lower; higher
C) lower; lower
D) higher; higher
E) both c and d are correct

Accepted Answer

Risk averse investors require higher rates of return for investments with lower risk. This is because they want to be compensated for the lower risk they are taking by receiving a higher return.

Question 16

Because of differences in the expected returns of different securities, the standard deviation is not always an adequate measure of risk.However, the coefficient of variation always will allow an investor to properly compare the relative risks of any two securities.

Accepted Answer

The answer of Because of differences in the expected returns...

Question 17

The biggest reduction in risk would be achieved by combining two assets into a portfolio with a correlation coefficient equal to ____.
A) −1.0
B) −0.5
C) 0
D) 0.5
E) 1.0

Accepted Answer

A correlation coefficient of -1.0 indicates a perfectly negative correlation, meaning that the two assets move in opposite directions with the same degree of magnitude. By combining these two assets, the investor can achieve a highly diversified portfolio with the biggest possible reduction in risk.

Question 18

Suppose that two firms, A and B, have identical expected returns but Firm A has the possibility of a much higher return than Firm B.We can conclude from this that Firm A will have a higher coefficient of variation than Firm B.

Accepted Answer

The answer of Suppose that two firms, A and B,...

Question 19

Assume there are only three possible states of nature for the economy in the future: boom, normal, and recession.If there is a 25% chance of a recession and a 30% chance of a boom, then what is the probability of a normal economy in the future?
A) 45%
B) 30%
C) 25%
D) 100%

Accepted Answer

The probability of all possible outcomes (boom, normal, recession) must sum to 100%. Given a 25% chance of recession and a 30% chance of a boom, the probability of a normal economy is 100% - 25% - 30% = 45%.

Question 20

The ____ the probability distribution, the ____ variability there is and the ____ likely it is that the actual outcome will approach the expected value.
A) looser; less; more
B) tighter; more; less
C) tighter; less; more
D) looser; more; less
E) both c and d are correct.

Accepted Answer

The answer of The ____ the probability distribution, the ____...

Quiz 11: Risk and Rates of Return

Here are the expected returns on two stocks: If you form a 50−50 portfolio of the two stocks, what is the portfolio's standard deviation?

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

When considering stock and bond valuation models, we implicitly assume that the marginal investor is risk averse, which means that he or she requires a higher rate of return for a given level of risk than a risk neutral individual, other things held constant.

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

Which type of risk can be eliminated through diversification?

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

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

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.

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 have a beta which is greater than 1.0.

is the appropriate measure for stand-alone risk and is the appropriate measure of risk when adding an asset to a diversified portfolio.

The beta of any portfolio can be computed as the

When combining many assets into a portfolio the correlation between the variables has a(n) ____ impact on the overall risk of the portfolio than the overall risk of each asset.

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.

Risk averse investors require rates of return for investments with risk.

Because of differences in the expected returns of different securities, the standard deviation is not always an adequate measure of risk.However, the coefficient of variation always will allow an investor to properly compare the relative risks of any two securities.

The biggest reduction in risk would be achieved by combining two assets into a portfolio with a correlation coefficient equal to ____.

Suppose that two firms, A and B, have identical expected returns but Firm A has the possibility of a much higher return than Firm B.We can conclude from this that Firm A will have a higher coefficient of variation than Firm B.

Assume there are only three possible states of nature for the economy in the future: boom, normal, and recession.If there is a 25% chance of a recession and a 30% chance of a boom, then what is the probability of a normal economy in the future?

The the probability distribution, the variability there is and the likely it is that the actual outcome will approach the expected value.