Question 1

Risk is the chance that the actual outcome is different from the expected outcome.

Accepted Answer

A) True 
 B)False

Question 2

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

Accepted Answer

A)  −1.0 
B)  −0.5 
C)  0 
D)  0.5 
E)  1.0

Question 3

Which of the following statements is false?

Accepted Answer

A)  One key result of applying the Capital Asset Pricing Model is that the risk and return of an individual security should be analyzed by how that security affects the risk and return of the portfolio in which it is held. 
B)  According to the Capital Asset Pricing Model,investors are primarily concerned with portfolio risk,not the isolated risks of individual stocks.Thus,the relevant risk is an individual stock's contribution to the overall riskiness of the portfolio. 
C)  The CAPM is built on expected conditions,although we are limited in most cases to using past data in applying it.Betas used in the CAPM which are calculated using historical data are always subject to changes in future volatility,and this is a limitation on the use of the CAPM. 
D)  If the price of money increases due to greater anticipated inflation,the risk-free rate will reflect this fact.Although rRF will increase,it is possible that the SML required rate of return for a stock will decrease because the market risk premium (rM − rRF)will decrease.(Assume that beta remains constant. ) 
E)  Any change in beta is likely to affect the required rate of return on a security which implies that a change in beta will likely have an impact on the security's price.

Question 4

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

A) True 
 B)False

Question 5

Which of the following statements is correct?

Accepted Answer

A)  If the returns from two stocks are perfectly positively correlated and the two stocks have equal variance,an equally weighted portfolio of the two stocks will have a variance which is less than that of the individual stocks. 
B)  If a stock has a negative beta,its expected return must be negative. 
C)  According to the CAPM,stocks with higher standard deviations of returns will have higher expected returns. 
D)  A portfolio with a large number of randomly selected stocks will have less market risk than a single stock which has a beta equal to 0.5. 
E)  None of the above statements is correct.

Question 6

In a market dominated by risk-averse investors,riskier securities must have higher expected returns,as estimated by the average investor,than less risky securities.

Accepted Answer

A) True 
 B)False

Question 7

Given the following probability distribution,what is the expected return and the standard deviation of returns for Security J?

Accepted Answer

A)  15%;6.50% 
B)  12%;5.18% 
C)  15%;3.16% 
D)  15%;10.00% 
E)  20%;5.00%

Question 8

Calculate the standard deviation of the expected dollar returns for Ditto Copier Center,given the following distribution of returns:

Accepted Answer

A)  $36.0 
B)  $23.0 
C)  $18.0 
D)  $13.0 
E)  $30.0

Question 9

The Security Market Line (SML)relates risk to return,for a given set of financial market conditions.If investors conclude that the inflation rate is going to increase,which of the following changes would be most likely to occur?

Accepted Answer

A)  The market risk premium would increase. 
B)  Beta would increase. 
C)  The slope of the SML would increase. 
D)  The required return on an average stock,rA = rM,would increase. 
E)  None of the indicated changes would be likely to occur.

Question 10

As financial manager of Material Supplies Inc. ,you have recently participated in an executive committee decision to enter into the plastics business.Much to your surprise,the price of the firm's common stock subsequently declined from $40 per share to $30 per share.While there have been several changes in financial markets during this period,you are anxious to determine how the market perceives the relevant risk of your firm.Assume that the market is in equilibrium.From the following data you find that the beta value associated with your firm has changed from an old beta of ____ to a new beta of ____. (1)The real risk-free rate is 2 percent,but the inflation premium has increased from 4 percent to 6 percent.
(2)The expected growth rate has been re-evaluated by security analysts,and a 10.5 percent rate is considered to be more realistic than the previous 5 percent rate.This change had nothing to do with the move into plastics;it would have occurred anyway.
(3)The risk aversion attitude of the market has shifted somewhat,and now the market risk premium is 3 percent instead of 2 percent.
(4)The next dividend,D1,was expected to be $2 per share,assuming the "old" 5 percent growth rate.

Accepted Answer

A)  2.00;1.50 
B)  1.50;3.00 
C)  2.00;3.17 
D)  1.67;2.00 
E)  1.50;1.67

Question 11

Calculate the required rate of return for Mercury Inc. ,assuming that investors expect a 5 percent rate of inflation in the future.The real risk-free rate is equal to 3 percent and the market risk premium is 5 percent.Mercury has a beta of 2.0,and its realized rate of return has averaged 15 percent over the last 5 years.

Accepted Answer

A)  15% 
B)  16% 
C)  17% 
D)  18% 
E)  20%

Question 12

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

A) True 
 B)False

Question 13

Which of the following statements concerning measures of risk is correct?

Accepted Answer

A)  Combining stocks together in portfolios reduces risk as long as the correlation between the returns on the securities is not perfect . 
B)  Even if the correlation between the returns on two different securities is perfectly positive,if the securities are combined in the correct unequal proportions,the resulting portfolio can have less risk than either security held alone. 
C)  The coefficient of variation,calculated as the expected return divided by the standard deviation,is a standardized measure of the correlation of risk and return. 
D)  The tighter the probability distribution of expected future returns the smaller the risk of a given investment as measured by both the variance and the standard deviation. 
E)  Variance is a measure of the variability of returns and because it involves squaring each deviation of the required return from the expected return,it is always larger than its square root,the standard deviation.

Question 14

Choose the correct answer for the following: (1)Which is the best measure of risk for choosing an asset which is to be held in isolation? (2)Which is the best measure for choosing an asset to be held as part of a diversified portfolio?

Accepted Answer

A)  Variance;correlation coefficient. 
B)  Standard deviation;correlation coefficient. 
C)  Beta;variance. 
D)  Coefficient of variation;beta. 
E)  Beta;beta.

Question 15

The probability distribution for rM for the coming year is as follows:  If rRF = 6.05% and Stock X has a beta of 2.0,an expected constant growth rate of 7 percent,and D0 = $2,what market price gives the investor a return consistent with the stock's risk?

Accepted Answer

A)  $25.00 
B)  $37.50 
C)  $21.72 
D)  $42.38 
E)  $56.94

Question 16

Which of the following statements is most correct?

Accepted Answer

A)  A portfolio with a beta of minus 2 has the same degree of risk to its holder,relative to the market,as a portfolio with a beta of plus 2.However,the holder of either portfolio could lower his or her risk exposure by buying some "normal" stocks. 
B)  A stock with a beta of −1.0 has zero systematic (or market)risk. 
C)  It is possible for a stock to have a positive beta even in situations where the correlation between the returns on it and those on another stock are negative. 
D)  Diversifiable risk,which is measured by beta,can be lowered by adding more stocks to a portfolio. 
E)  Statements a and c are both correct.

Question 17

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?

Accepted Answer

A)  45% 
B)  30% 
C)  25% 
D)  100%

Question 18

All else equal,a risk averse investor choosing between two individual stocks to be held in isolation would prefer the stock with higher coefficient of variation.

Accepted Answer

A) True 
 B)False

Question 19

You have developed the following data on three stocks:  If you are a risk minimizer,you should choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.

Accepted Answer

A)  A;A 
B)  A;B 
C)  B;A 
D)  C;A 
E)  C;B

Question 20

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

A) True 
 B)False

Exam 11: Risk and Rates of Return

Risk is the chance that the actual outcome is different from the expected outcome.

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

Which of the following statements is false?

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.

Which of the following statements is correct?

In a market dominated by risk-averse investors,riskier securities must have higher expected returns,as estimated by the average investor,than less risky securities.

Given the following probability distribution,what is the expected return and the standard deviation of returns for Security J?

Calculate the standard deviation of the expected dollar returns for Ditto Copier Center,given the following distribution of returns:

The Security Market Line (SML) relates risk to return,for a given set of financial market conditions.If investors conclude that the inflation rate is going to increase,which of the following changes would be most likely to occur?

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.

Which of the following statements concerning measures of risk is correct?

Choose the correct answer for the following: (1) Which is the best measure of risk for choosing an asset which is to be held in isolation? (2) Which is the best measure for choosing an asset to be held as part of a diversified portfolio?

The probability distribution for r_M for the coming year is as follows: If r_RF = 6.05% and Stock X has a beta of 2.0,an expected constant growth rate of 7 percent,and D₀ = $2,what market price gives the investor a return consistent with the stock's risk?

Which of the following statements is most correct?

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?

All else equal,a risk averse investor choosing between two individual stocks to be held in isolation would prefer the stock with higher coefficient of variation.

You have developed the following data on three stocks: If you are a risk minimizer,you should choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.

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.