FIN 3310: Ch.8

Combining two stocks to form a portfolio offers maximum diversification benefits when _____.

Combining two stocks to form a portfolio offers maximum diversification benefits when _____.

the stocks have a correlation coefficient equal to –1

• Two stocks that are perfectly negatively correlated can be combined to form a portfolio that has no unsystematic risk. See 8-3: Portfolio Risk—Holding Combinations of Investments

Which of the following statements about the various kinds of risks is correct?

Interest rate risk is a systematic risk, hence it should be rewarded by the market.

• Interest rate risk is a systematic risk, which means it cannot be diversified, and hence it should be rewarded by the market in the form of additional returns. See 8-6: Different Types of Risk

The expected returns for Stocks A, B, C, D, and E are 7 percent, 10 percent, 12 percent, 25 percent, and 18 percent, respectively. The corresponding standard deviations for these stocks are 12 percent, 18 percent, 15 percent, 23 percent, and 15 percent, respectively. Which one of the securities should a risk-averse investor purchase if the investment will be held in isolation (by itself)?

E

• The coefficient of variation = Standard deviation / Expected return

  Coefficient of variation of Stock A = 12% / 7% = 1.71

  Coefficient of variation of Stock B = 18% / 10% = 1.80

  Coefficient of variation of Stock C = 15% / 12% = 1.25

  Coefficient of variation of Stock D = 23% / 25% = 0.92

  Coefficient of variation of Stock E = 15% / 18% = 0.83

  Stock E is the best investment because it has the lowest coefficient of variation; that is, Stock E has the best risk-return relationship. See 8-2: Expected Rate of Return

The part of a security's risk associated with random outcomes generated by events or behaviors specific to the firm is known as _____.

unsystematic risk

• Unsystematic risk, or firm-specific risk, is that part of a security's risk that is associated with random outcomes generated by events or behaviors, specific to the firm. It can be eliminated, or at least reduced, through proper diversification. See 8-3: Portfolio Risk—Holding Combinations of Investments

Which of the following is the only risk that is relevant to a rational, diversified investor, because it cannot be eliminated or reduced through diversification?

Market risk

• Market risk is the only risk that is relevant to a rational, diversified investor because it cannot be eliminated (or reduced) through diversification. See 8-3: Portfolio Risk—Holding Combinations of Investments

Which of the following measures captures the effects of both risk and return, which makes it a better measure than standard deviation for evaluating stand-alone risk in situations where investments differ with respect to both their amounts of total risk and their expected returns?

Coefficient of variation

• Coefficient of variation of the investment captures the effects of both risk and return for evaluating investments that differ with respect to both their amounts of total risk and their expected returns. See 8-2: Expected Rate of Return

Stock A has a beta coefficient (β) equal to 2.1, and Stock B has a beta coefficient (β) equal to 0.7. According to the capital asset pricing model (CAPM), which of the following statements is correct?

The risk premium associated with Stock A, RP_A, should be three times the risk premium associated with Stock B, RP_B.

Because the beta of Stock A (2.1) is three times the beta of Stock B (0.7), the risk premium associated with Stock A, RPA, should be three times of the risk premium associated with Stock B, RPB. An investment's required rate of return is rs = rRF + RPMβs. In this equation rRF is the same for all investors at a particular point in time, which means that required rates of return on investments differ only because the risk premium of each investment, RPMβs, differs. Because the market risk premium, RPM, is the same for every investment, it is clear that risk premiums differ because the beta coefficients of investments differ. See 8-4: The Relationship between Risk and Rates of Return: The CAPM

The probability distribution of the payoffs on an investment consists of a _____.

listing of all possible outcomes with a chance of occurrence assigned to each outcome

• The probability distribution refers to a listing of all possible outcomes or events, with a probability (chance of occurrence) assigned to each outcome. See 8-1: Defining and Measuring Risk

The _____ of an investment is a measure of the tightness, or variability, of its set of returns.

standard deviation of the returns

• A measure of the tightness, or variability, of a set of returns of an investment is known as the standard deviation of the returns of the investment. It measures the stand-alone or the total risk of a stock. See 8-2: Expected Rate of Return

According to the capital asset pricing model (CAPM), investors should expect to be rewarded for _____.

only the systematic risk associated with an individual investment, which is measured by the beta coefficient

• According to the CAPM, investors should not be rewarded for all of the risk associated with an individual investment—that is, its total, or stand-alone, risk— because some risk can be eliminated through diversification. They should expect to be rewarded for only the systematic risk associated with an individual investment, which is measured by the beta coefficient. See 8-6: Different Types of Risk

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?

Stock E

• The required rate of return of a Stock = Risk-free rate + (Market risk premium × Beta of the stock)

  The required rate of return of Stock A = 5% + [(8% − 5%) × (0.75)] = 7.25%; Expected rate of return of Stock A = 8%

  The required rate of return of Stock B = 5% + [(8% − 5%) × (0.50)] = 6.50%; Expected rate of return of Stock B = 6.5%

  The required rate of return of Stock C = 5% + [(8% − 5%) × (0.25)] = 5.75%; Expected rate of return of Stock C = 7%

  The required rate of return of Stock D = 5% + [(8% − 5%) × (1.50)] = 9.50%; Expected rate of return of Stock D = 11%

  The required rate of return of Stock E = 5% + [(8% − 5%) × (1.25)] = 8.75%; Expected rate of return of Stock E = 7%

  The required rate of return of Stock E is greater than its expected rate of return. Therefore, the investor should sell Stock E. See 8-5: Stock Market Equilibrium

Which of the following statements about correlation is correct?

The weaker the positive correlation two stocks exhibit, the more risk can be reduced when they are combined in a portfolio.

• The weaker (lower) the positive correlation or the stronger (higher) the negative correlation two stocks exhibit, the more risk can be reduced when they are combined in a portfolio—that is, the greater the diversification effect. See 8-3: Portfolio Risk—Holding Combinations of Investments

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

Inflation risk is a systematic risk.

• Inflation risk is a systematic risk that affects all firms. It is the relevant risk, which is the risk for which investors should be compensated. See 8-6: Different Types of Risk

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

Market risk and relevant risk

• Market risk is a nondiversifiable risk, and the investors are rewarded only for this component of risk; thus, it is the relevant risk of an investment. See 8-6: Different Types of Risk

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?

An investor should not buy Stock A because its expected rate of return is less than the required rate of return.

• The required rate of return of Stock A = Risk-free rate + (Market risk premium × Beta of the stock)

  = 6% + [(13% – 6%) × 2.1] = 20.70%

  Because the required rate of return is greater than the expected rate of return, the investor should not buy Stock A.

  See 8-5: Stock Market Equilibrium

Diversification refers to the reduction of the _____.

stand-alone risk of an individual investment, which is measured by the standard deviation of its returns, by combining it with other investments in a portfolio

• Reduction of the stand-alone risk of an individual investment by combining it with other investments in a portfolio is called diversification. The stand-alone risk of an investment is measured by the standard deviation of its returns. See 8-3: Portfolio Risk—Holding Combinations of Investments

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?

2.0

• Required rate of return on Security J = Risk-free rate(r_RF) + [Market return(r_M) – Risk-free rate(r_RF)] × Stock's beta(β)

  13% = 7% + (10% − 7%)β_J

  β_J = (13% − 7%)/ 3% = 2.0

  See 8-4: The Relationship between Risk and Rates of Return: The CAPM

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

Systematic risk

• Market risk is a systematic risk, and the investors are rewarded only for this component of risk. See 8-6: Different Types of Risk

Diversifiable risk includes _____.

• business risk

  Business risk is the risk that is inherent in the firm's basic operations, which includes factors such as labor conditions, product safety, quality of management, competitive conditions, and so forth; it is the company's firm-specific risk. See 8-6: Different Types of Risk

Which of the following statements about risk measures is correct?

Beta is a measure of systematic risk, whereas standard deviation is the measure of total risk.

• Standard deviation is the measure of the total risk of an investment, whereas beta is the measure of systematic risk. An investor should be rewarded only for the systematic risk of an investment. See 8-6: Different Types of Risk

Which of the following statements about beta is correct?

Firms with greater systematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are less than 1.0.

The part of a security's risk associated with economic factors that affect all firms to some extent is known as the _____.

market risk

• Market risk is the part of a security's risk associated with economic, or market, factors that systematically affect all firms to some extent. It cannot be eliminated through diversification. See 8-3: Portfolio Risk—Holding Combinations of Investments

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

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.

• 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. As risk aversion increases, so does the risk premium, and, therefore, so does the slope of the SML. See 8-4: The Relationship between Risk and Rates of Return: The CAPM

Dividing the standard deviation of the returns of a stock by the stock's expected return gives us the stock's _____.

coefficient of variation

• The coefficient of variation is the standardized measure of the risk per unit of return. It is calculated by dividing the standard deviation by the expected return. See 8-2: Expected Rate of Return

Which of the following statements about the risk-return relationship observed in investing is correct?

An increase in the expected inflation rate would lead to an increase in the required return on all the risky assets by the same amount, assuming all other things were held constant.

• Because the inflation premium is built into the required rates of return of both riskless and risky assets, the increase in expected inflation would cause an equal increase in the rates of return on all risky assets. See 8-4: The Relationship between Risk and Rates of Return: The CAPM