Chapter 11, Risk and Return 1. A portfolio is. A) a group of assets, such as stocks and bonds, held as a collective unit by an investor B) the expected return on a risky asset C) the expected return on a collection of risky assets D) the variance of returns for a risky asset E) the standard deviation of returns for a collection of risky assets 2. The principle of diversification tells us that: A) Concentrating an investment in two or three large stocks will eliminate all of your risk. B) Concentrating an investment in two or three large stocks will reduce your overall risk. C) Spreading an investment across many diverse assets cannot (in an efficient market) eliminate any risk. D) Spreading an investment across many diverse assets will eliminate all of the risk. E) Spreading an investment across many diverse assets will eliminate some of the risk. 3. The linear relation between an asset's expected return and its beta coefficient is the: A) Reward to risk ratio. B) Portfolio weight. C) Portfolio risk. D) Security market line. E) Market risk premium. 4. Which of the following is FALSE about calculating expected portfolio returns and variances? A) You need to calculate the weight of each asset relative to the total portfolio to calculate the portfolio return and the portfolio variance. B) Portfolio return can be calculated using the expected return and portfolio weight for each asset. C) The portfolio return is needed to calculate the portfolio variance. D) The portfolio return and variance are dependent on the possible states of nature. E) The portfolio variance is a weighted average of the variances of the individual assets in the portfolio. Page 1
5. Diversification works because: A) Unsystematic risk exists. B) Forming stocks into portfolios reduces the standard deviation of returns for each stock. C) Firm-specific risk can be never be reduced. D) Stocks earn higher returns than bonds. E) Portfolios have higher returns than individual assets. 6. In market equilibrium: A) All assets will have the same degree of systematic risk. B) Assets will have the same reward to risk ratio. C) Each firm's reward to risk ratio will be based on a different risk-free rate of return. D) Systematic risk can be diversified away. E) All assets will have the same risk premium. 7. Stock A has a beta coefficient of 0.9, and stock B has a beta coefficient of 1.2. Which of the following statements is FALSE regarding these two stocks? A) Stock A is less risky from the market's perspective than a typical stock, and stock B is more risky than a typical stock. B) Stock B, if purchased, will increase the market risk of a portfolio more than stock A would (if purchased). C) Stock A necessarily must have a lower standard deviation of returns than stock B. D) Stock B must have a higher expected return than stock A if markets are efficient. E) Stock A has the same reward to risk ratio as stock B. 8. Which of the following is FALSE concerning diversification? Assume that the securities being considered for selection into a portfolio are not perfectly correlated. A) As more securities are added to the portfolio, the unsystematic risk of the portfolio declines. B) As more securities are added to the portfolio, the total risk of the portfolio declines. C) As more securities are added to the portfolio, the systematic risk of the portfolio declines. D) As more securities are added to the portfolio, the portfolio risk eventually approaches the level of systematic risk in the market. E) If you hold more than 100 securities, then there is little benefit to be gained by adding a 101 st security to the portfolio. 9. Portfolio risk is comprised of risk risk. A) firm-specific; plus diversifiable B) systematic; minus unsystematic C) diversifiable; plus unsystematic D) market; plus firm-specific E) market; plus non-diversifiable Page 2
10. Which of the following would decrease a portfolio's systematic risk? A) Common stock is sold and replaced with Treasury bills. B) Stocks with a beta equal to the market beta are added to a portfolio of Treasury bills. C) Low-beta stocks are sold and replaced with high-beta stocks. D) A stock is sold in favor of a different stock with the same beta. E) The portfolio beta is less than one and the risk-free rate declines. 11. The return priced into a stock in an efficient market is the return. A) actual B) unsystematic C) systematic D) unexpected E) expected 12. A telecommunications company just announced that earnings for the first quarter of the current year fell at an annualized rate of 20%, much worse than the previous quarter's performance. Upon the announcement, the stock price did not change. (The market in general was also unchanged.) Which of the following is most likely correct? A) The market was surprised by the announcement. B) Interest rates in the economy must have increased. C) Investors likely anticipated the news release. D) The price didn't change because the market in general didn't change either. E) The firm must have a beta coefficient equal to one. 13. The following information is given: The risk-free rate is 7%, the beta of stock A is 1.2, the beta of stock B is 0.8, the expected return on stock A is 13.5%, and the expected return on stock B is 11.0%. Further, we know that stock A is fairly priced and that the betas of stocks A and B are correct. Which of the following regarding stock B must be true? A) Stock B is also fairly priced. B) The expected return on stock B is too high. C) The expected return on stock A is too high. D) The price of stock B is too high. E) The price of stock A is too high. Page 3
14. What is the risk premium for the following returns if the risk-free rate is 4%? State Probability Return Boom.20.75 Good.55.25 Recession.15.10 Depression.10.50 A) 0.3325 B) 0.1525 C) 0.0525 D) 0.1825 E) 0.2225 15. What is the expected market return if the expected return on asset A is 19% and the risk-free rate is 5%? Asset A has a beta of 1.4. A) 14% B) 15% C) 16% D) 19% E) 24% 16. What is the portfolio beta if 60% of your money is invested in the market portfolio, and the remainder is invested in a risk-free asset? A) 0.40 B) 0.50 C) 0.60 D) 0.75 E) 1.00 17. You hold three stocks in your portfolio: A, B, and C. The portfolio beta is 1.40. Stock A comprises 15% of the dollar value of your holdings and has a beta of 1.0. If you sell all of your investment in A and invest the proceeds in the risk-free asset, your new portfolio beta will be: A) 0.60 B) 0.88 C) 1.00 D) 1.25 E) 1.40 Page 4
18. You hold four stocks in your portfolio: A, B, C, and D. The portfolio beta is 1.10. Stock C comprises 30% of the dollar value of your holdings and has a beta of 1.50. If you sell all of your holdings in stock C, and replace it with an equal investment in stock E (which has a beta of 0.8), what will be your new portfolio beta? A) 0.72 B) 0.89 C) 1.00 D) 1.05 E) 1.22 19. You form a portfolio by investing equally in A (beta=0.6), B (beta=1.6), the risk-free asset, and the market portfolio. What is your portfolio beta? A) 0.6 B) 0.8 C) 1.0 D) 1.2 E) 1.6 State Probability Return on A Return on B Boom.25 15% 3% Normal.65 10% 4% Bust.10 4% 9% 20. What is the expected return for asset A? A) 7.35% B) 8.50% C) 9.75% D) 10.65% E) 11.90% 21. What is the standard deviation of returns for asset A? A) 1.3% B) 1.8% C) 2.6% D) 3.1% E) 4.5% Page 5
22. What is the standard deviation of returns for asset B? A) 1.4% B) 2.2% C) 2.9% D) 3.6% E) 5.2% 23. What is the expected return on a portfolio with weights of 40% in asset A and 60% in asset B? A) 3.1% B) 4.5% C) 5.9% D) 8.4% E) 9.3% Page 6