11
18) You must add one of two investments to an already well– diversified portfolio.
Security A
Security B
Expected Return = 14%
Expected Return = 12%
Standard Deviation of
Standard Deviation of
Returns = 15.0%
Returns = 11%
Beta = 1.5
Beta = 1.5
If you are a risk-averse investor, which one is the better choice?
A) Security A
B) Security B
C) Either security would be acceptable.
D) Cannot be determined with information given
Keywords: Well-diversified Portfolio, Risk-Return Trade-off, Beta
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
12
19) You are given the following probability distribution for XYZ common stock’s returns during the next
year, which are assumed to be normally distributed. Show all work below, and complete the following:
Return
Probability
12%
20%
16%
60%
20%
20%
a. Calculate the standard deviation of the returns, and round to the nearest one-half percent.
b. Draw a graphical representation of XYZ’s normal distribution below (ye old bell-shaped curve).
LABEL THE AXES OF THE GRAPH OR THE FOLLOWING RESULTS WILL BE MEANINGLESS. Using
your result in part A for the standard deviation (rounded to the nearest one-half percent) explain and
indicate on the graph, the probability that XYZ will return more than 13.5%, assuming a normal
distribution.
Keywords: Expected Return, Standard Deviation, Normal Deviation
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
13
20) Bay Land, Inc. has the following distribution of returns:
State
Return
Probability
Boom
0.3
0.25
Normal
0.4
0.15
Bust
0.3
0.30
Assuming that these returns are normally distributed, what is the probability that Bay Land, Inc. will
return less than 7.25%? Show all work, and clearly explain and state your answer.
Keywords: Expected Return, Standard Deviation, Normal Distribution
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
21) How is risk defined?
Keywords: Risk, Return
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
14
22) You are considering a security with the following possible rates of return:
Return (%)
9.5
13.6
14.9
25.3
a. Calculate the expected rate of return.
b. Calculate the standard deviation of the returns.
Keywords: Expected Rate of Return, Standard Deviation of Returns
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
15
23) You are considering the three securities listed below.
Returns
Stock A
Stock B
Stock C
2%
-3%
5%
10%
8%
8%
15%
20%
12%
a. Calculate the expected return for each security.
b. Calculate the standard deviation of returns for each security.
c. Compare Stock A with Stocks B and C. Is Stock A preferred over the others?
Keywords: Expected Return, Standard Deviation, Risk-Return Trade-off
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
Learning Objective 6.3
1) Historically, investments with the highest returns have the lowest standard deviations because
investors do not like risk.
Keywords: Risk-Return Trade-off
Learning Obj.: L.O. 6.3
AACSB: Reflective Thinking
16
2) Small company stocks have historically had higher average annual returns than large company stocks,
and also a higher risk premium.
Keywords: Small Company Stocks, Risk Premium
Learning Obj.: L.O. 6.3
AACSB: Reflective Thinking
3) Investment A and Investment B both have the same expected return, but Investment A is more risky
than Investment B. In the technical jargon of modern portfolio theory, Investment A is said to “dominate”
Investment B.
Keywords: Risk-Return Trade-off
Learning Obj.: L.O. 6.3
AACSB: Analytical Thinking
4) Negative historical returns are not possible during periods of high volatility (high standard deviations
of returns) due to the risk-return trade-off.
Keywords: Risk-Return Trade-off, Historical Returns, Standard Deviation
Learning Obj.: L.O. 6.3
AACSB: Reflective Thinking
5) Investment A has an expected return of 15% per year, while Investment B has an expected return of
12% per year. A rational investor will choose
A) Investment A because of the higher expected return.
B) Investment B because a lower return means lower risk.
C) Investment A if A and B are of equal risk.
D) Investment A only if the standard deviation of returns for A is higher than the standard deviation of
returns for B.
Keywords: Expected Rate of Return, Standard Deviation, Risk-Return Trade-off
Learning Obj.: L.O. 6.3
AACSB: Analytical Thinking
6) Of the following different types of securities, which is typically considered most risky?
A) long-term corporate bonds
B) long-term government bonds
C) common stocks of large companies
D) common stocks of small companies
Keywords: Risk, Stocks, Bonds
Learning Obj.: L.O. 6.3
AACSB: Reflective Thinking
17
7) The category of securities with the highest historical risk premium is
A) large company stocks.
B) small company stocks.
C) government bonds.
D) small company corporate bonds.
Keywords: Risk Premium
Learning Obj.: L.O. 6.3
AACSB: Reflective Thinking
8) If you were to use the standard deviation as a measure of investment risk, which of the following has
historically been the least risky investment?
A) common stock of large firms
B) U.S. Treasury bills
C) common stock of small firms
D) long-term government bonds
Keywords: Standard Deviation, Risk, U.S. Treasury Bills
Learning Obj.: L.O. 6.3
AACSB: Reflective Thinking
9) If you were to use the standard deviation as a measure of investment risk, which of the following has
historically been the highest risk investment?
A) common stock of large firms
B) U.S. Treasury bills
C) common stock of small firms
D) long-term government bonds
Keywords: Standard Deviation, Risk, Small Cap Common Stocks
Learning Obj.: L.O. 6.3
AACSB: Reflective Thinking
Learning Objective 6.4
1) The benefits of diversification occur as long as the investments in a portfolio are not perfectly
positively correlated.
Keywords: Diversification, Correlation
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
18
2) Proper diversification generally results in the elimination of risk.
Keywords: Diversification, Risk
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
3) A stock with a beta of 1 has systematic or market risk equal to the “typical” stock in the marketplace.
Keywords: Beta, Systematic Risk
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
4) Diversifying among different kinds of assets is called asset allocation.
Keywords: Asset Allocation, Diversification
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
5) Asset allocation is not recommended by financial planners because mixing different types of assets,
such as stocks with bonds, makes it more difficult to track performance and adjust portfolios to changing
market conditions.
Keywords: Asset Allocation
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
6) A stock with a beta of 1.4 has 40% more variability in returns than the average stock.
Keywords: Beta, Variability
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
7) Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks have higher
standard deviations of returns than bonds.
Keywords: Diversification, Portfolio Risk
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
8) An all-stock portfolio is more risky than a portfolio consisting of all bonds.
Keywords: Diversification, Portfolio Risk
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
19
9) Company unique risk can be virtually eliminated with a portfolio consisting of approximately 20
securities.
Keywords: Company Unique Risk, Diversification
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
10) Total risk equals systematic risk plus unsystematic risk.
Keywords: Systematic Risk, Unsystematic Risk, Total Risk
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
11) A well-diversified portfolio typically has systematic risk equal to about 40% of the portfolio’s total
risk.
Keywords: Systematic Risk, Diversification
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
12) A security with a beta of one has a required rate of return equal to the overall market rate of return.
Keywords: Beta
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
13) Unique security risk can be eliminated from an investor’s portfolio through diversification.
Keywords: Diversification, Portfolio
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
14) The beta of a T-bill is zero.
Keywords: Beta, T-bill
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
15) The beta of a T-bill is one.
Keywords: Beta, T-bill
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
20
16) Portfolio performance is determined mainly by stock selection and market timing, with less emphasis
on asset allocation.
Keywords: Asset Allocation, Portfolio Performance
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
17) Beta is a measurement of the relationship between a security‘s returns and the general market’s
returns.
Keywords: Beta
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
18) The relevant risk to an investor is that portion of the variability of returns that cannot be diversified
away.
Keywords: Relevant Risk, Non-diversifiable Risk
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
19) The characteristic line for any well-diversified portfolio is horizontal.
Keywords: Characteristic Line, Well-diversified Portfolio
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
20) The slope of the characteristic line of a security is that security‘s beta.
Keywords: Characteristic Line, Beta
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
21) Beta represents the average movement of a company’s stock returns in response to a movement in the
market’s returns.
Keywords: Beta
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking