Chapter 7—ANALYSIS OF RISK AND RETURN
MULTIPLE CHOICE
1. The ____ is a statistical measure of the mean or average value of the possible outcomes.
a.
probability distribution
b.
standard deviation
c.
expected value
d.
coefficient of variation
2. The ____ the standard deviation, the ____ the investment.
a.
smaller, larger the expected return on
b.
larger, riskier
c.
smaller, riskier
d.
larger, smaller the expected return on
3. The slope of the characteristic line for a specific security is an estimate of ____ for that security.
a.
beta
b.
systematic risk
c.
total risk
d.
both beta and systematic risk
4. The returns from most common stocks are
a.
positively correlated with each other
b.
negatively correlated with each other
c.
uncorrelated with each other
d.
none of these are correct
5. The ____ of a portfolio of two or more securities is equal to the weighted average of the ____ of each
of the individual securities in the portfolio.
a.
standard deviation, standard deviation
b.
risk, risk
c.
expected return, expected return
d.
all of these answers apply
6. Security A’s expected return is 10 percent while the expected return of B is 14 percent. The standard
deviation of A’s returns is 5 percent, and it is 9 percent for B. An investor plans to invest equal
amounts in A and B. Which of the following statements is true about this portfolio consisting of stock
A and stock B.
a.
The risk of the portfolio is equal to 7 percent.
b.
The lower the correlation of returns between the two stocks, the higher the portfolio’s risk.
c.
The risk of the portfolio is primarily dependent on the utility function of the investor.
d.
The higher the correlation of returns between the two stocks, the higher the portfolio’s risk.
7. Which of the following is not an example of a source of systematic risk?
a.
interest rate changes
b.
foreign competition with an industry’s products
c.
changes in the overall economic outlook
d.
changes in the inflation rate
8. The security market line
a.
is defined as the slope of a line relating an individual security’s return to the returns of
other securities in that firm’s primary industry.
b.
provides a picture of the risk-return tradeoff required by diversified investors considering
various risky assets.
c.
has as its slope the beta of the security
d.
none of these answers are correct.
9. All other things being equal, what is the major impact that an increase in the expected inflation rate
would be expected to have on the security market line?
a.
reduce its slope
b.
shift it down and to the right
c.
shift it up and to the left
d.
reduce required returns for investors in any individual asset
10. Beta is defined as:
a.
a measure of volatility of a security’s returns relative to the returns of a broad-based
market portfolio of securities.
b.
the ratio of the variance of market returns to the covariance of returns on a security with
the market
c.
the inverse of the slope of the security regression line
d.
all of these answers are correct
11. A beta value of 0.5 for a security indicates
a.
the security has average systematic risk
b.
the security has above-average systematic risk
c.
the security has no unsystematic risk
d.
the security has below-average systematic risk
12. The security market line can be thought of as expressing relationships between required rates of return
and
a.
the time value of money
b.
beta
c.
total risk
d.
portfolio diversification
13. All of the following are primary sources of systematic risk except
a.
changes in the amount of foreign competition facing an industry
b.
changes in investor expectations about the economy
c.
interest rate changes
d.
interest rate changes and investor expectations
14. All of the following factors have their primary impact on unsystematic risk except
a.
availability of raw materials
b.
effects of foreign competition
c.
changes in inflation
d.
strikes
15. The risk remaining after extensive diversification is primarily:
a.
unsystematic risk
b.
systematic risk
c.
coefficient of variation risk
d.
standard deviation risk
16. The most relevant risk that must be considered for any widely traded individual security is its ____.
a.
unsystematic risk
b.
standard deviation
c.
covariance risk
d.
systematic risk
17. Texas Computers (TC) stock has a beta of 1.5 and American Water (AW) stock has a beta of 0.5.
Which of the following statements will be true about these securities?
a.
The addition of TC would reduce portfolio risk more than the addition of AW.
b.
The addition of AW would reduce total portfolio risk more than the addition of TC.
c.
The required return for TC is greater than the required return for AW.
d.
The required return for AW is greater than the required return of TC.
18. The risk premium for an individual security is equal to the
a.
beta times the market return
b.
difference between the required return and the risk free rate
c.
weighted average of the individual security betas in a portfolio
d.
the security’s covariance divided by the variance of the market
19. Arbitrage pricing theory is a model that relates expected returns on securities to
a.
security risk and yield spreads
b.
yield spreads and yield curve slope
c.
anticipated economic factors
d.
multiple risk factors
20. In the ____, the expected return on a security is equal to the risk-free rate plus a single risk premium
that is equal to the product of the expected rate of return on the market portfolio less the risk-free rate
times the sensitivity of the security’s returns to the market return.
a.
Arbitrage Pricing Theory
b.
Capital Asset Pricing Model
c.
Dividend Valuation Model
d.
Risk premium on debt model
21. Investors generally are considered to be risk ____ because they expect to be compensated for assuming
risk.
a.
adverse
b.
seekers
c.
averse
d.
takers
22. Business risk is influenced by all the following factors except:
a.
variability in interest expenses
b.
variability in sales
c.
diversity of its product line
d.
choice of production technology
23. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith
Blarney have assigned the following probability distribution to the price of (and rate of return on)
Phoenix stock one year from now:
Price
Rate of Return
Probability
$16
-20%
0.25
20
0%
0.30
24
+20%
0.25
28
+40%
0.20
Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the
expected rate of return on Phoenix Stock.
a.
8%
b.
0%
c.
10%
d.
40%
24. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith
Blarney have assigned the following probability distribution to the price of (and rate of return on)
Phoenix stock one year from now:
Price
Rate of Return
Probability
$16
-20%
0.25
20
0%
0.30
24
+20%
0.25
28
+40%
0.20
Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the
standard deviation of possible rates of return on Phoenix stock (to the nearest tenth of a percent).
a.
456%
b.
20.9%
c.
2.2%
d.
21.4%
25. Energetic Elephant Company’s common stock has a beta of 1.2. The risk-free rate is 6 percent and the
expected market rate of return is 12 percent. Determine the required rate of return on the security.
a.
7.2%
b.
14.4%
c.
19.2%
d.
13.2%
26. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25
percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on
Epsilon is 16 percent. The standard deviation of returns for Gamma is 8 percent and for Epsilon is 12
percent. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the expected
return on the investor’s portfolio.
a.
14%
b.
12%
c.
13%
d.
9%
27. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25
percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on
Epsilon is 16 percent. The standard deviation of returns on Gamma is 8 percent and on Epsilon is 12
percent. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the standard
deviation of returns for this investor’s portfolio.
a.
73.8%
b.
6.71%
c.
3.00%
d.
8.59%
28. Compute the risk premium for the stock of Omega Tools if the risk-free rate is 6%, the expected
market return is 12%, and Omega’s stock has a beta of .8.
a.
10.8%
b.
4.8%
c.
48.0%
d.
16.8%
29. Don has $3,000 invested in AT&T with an expected return of 11.6 percent; $10,000 in IBM with an
expected return of 12.8 percent; and $6,000 in GM with an expected return of 12.2 percent. What is
Don’s expected return on his portfolio?
a.
12.42%
b.
12.20%
c.
11.81%
d.
Cannot be determined
30. Sally’s broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities
have an expected return of 10.3 percent and 20% have an expected return of 12.8 percent, what is the
expected return of the remaining portion of her portfolio?
a.
20.9%
b.
18.8%
c.
12.5%
d.
cannot be determined
31. Assume you want to construct a portfolio with a 14 percent return from the following two securities:
Security
Expected Return
Beta
1
16%
1.12
2
12.5%
0.94
What percentage of your portfolio should be invested in Security 1?
a.
57%
b.
47%
c.
43%
d.
53%
32. Determine the beta of a portfolio consisting of equal investments in the following common stocks:
Security
Apple Computer
Coca-Cola
Harley-Davidson
Homestake Mining
a.
1.05
b.
1.00
c.
1.10
d.
0.95
33. An investor, who believes the economy is slowing down, wishes to reduce the risk of her portfolio.
She currently owns 12 securities, each with a market value of $3,000. The current beta of the portfolio
is 1.21 and the beta of the riskiest security is 1.62. What will the portfolio beta be if the riskiest
security is replaced with a security of equal market value but a beta of 0.80?
a.
1.14
b.
1.18
c.
1.05
d.
1.17
34. Determine the beta of a portfolio consisting of the following common stocks:
Security
Market Value
Beta
Boeing
$5,000
1.2
Exxon
$4,000
0.8
Duke Power
$2,500
0.6
Blockbuster Video
$2,000
1.4
Coca-Cola
$7,500
1.0
a.
0.93
b.
0.85
c.
1.00
d.
cannot be determined
35. Jim Bowles is an investor who believes the economy is gaining strength and, therefore, wishes to
increase the risk of his 14 security portfolio. Each security has a current market value of $5,000 and
the current beta of the portfolio is 1.02. The beta of the least risky security is .76. If Jim replaces the
least risky security with another security with the same market value but a beta of 1.45, what will the
portfolio beta be then?
a.
1.03
b.
1.07
c.
1.08
d.
1.04
36. Determine the beta of a portfolio consisting of the following common stocks:
Security
Market Value
Beta
Glaxo
$2,600
1.24
SCANA
3,700
.88
BancOne
2,900
.95
Pepsi
3,400
1.05
AFLAC
3,000
1.09
Votec
4,400
1.41
a.
1.00
b.
1.12
c.
1.09
d.
1.11
37. The beta of Sanafil is 1.2. Sanafil is evaluating a merger with Matra, a firm that has a beta of 0.95.
Sanafil’s stock sells for $40 per share and there are 10 million shares outstanding. Matra’s stock sells
for $60, but there are only 2 million shares outstanding. If these two firms merge, what will be the
merged firm’s beta?
a.
1.00
b.
1.14
c.
1.05
d.
1.16
38. Security A offers an expected return of 14% with a standard deviation of 8%. Security B offers an
expected return of 11% with a standard deviation of 6%. If you wish to construct a portfolio with a
12.8% expected return, what percentage of the portfolio will consist of security A?
a.
55%
b.
60%
c.
65%
d.
45%
39. What is the beta for Always Good Corporation if the past market returns are as listed?
Past Market
Returns
Returns for
Always Good Corp.
-10
-15
10
12
19
17
4
-3
-4
4
a.
1.07
b.
2.1
c.
.5
d.
.98
40. What is the beta of this corporation’s stock?
Past Returns in
the Market
Returns on this
Corporation’s Stock
4
3
9
1
15
22
7
18
-1
-9
a.
2.6
b.
1.01
c.
1.76
d.
.85
41. Using the beta of Mucho Macho Tuxedo Shop, what would be an investor’s required rate of return if
he/she had bought a share of Mucho Macho stock? The market return is 12% and the risk-free rate is
2.5%.
Past Returns in
the Market
Returns on Mucho
Macho’s Stock
4
3
9
1
15
22
7
18
-1
-9
a.
22.6%
b.
15.7%
c.
19.2%
d.
13.7%
42. Comfy Camelback Travel Agencies has a beta of 1.2. The return in the market is 14% and the risk-free
rate is 3.5%. What is the risk premium?
a.
16.1%
b.
15.7%
c.
12.6%
d.
18.2%
43. What is the risk premium of a stock if the risk-free rate is 3%, the return in the market is 12% and beta
is 1.1?
a.
12.9%
b.
13.2%
c.
9.9%
d.
15.1%
44. What is the required rate of return on a stock that has a beta of 2.3, the market risk premium is 12%
and the risk-free rate is 3%?
a.
15.7%
b.
12.8%
c.
21.9%
d.
30.6%
45. Systematic risk is also referred to as:
a.
diversifiable risk
b.
economic risk
c.
nondiversifiable risk
d.
not relevant
46. Which of the following statements is/are correct?
I. Valuation is the process that links risk and return to determine the worth of an asset.
II. Any action taken by the financial manager that increases risk will also increase the required return.
a.
I only
b.
II only
c.
Both I and II
d.
Neither I nor II
47. Which of the following measures the variation from an expected value?
a.
standard deviation
b.
probability distribution
c.
mean
d.
chi square
ESSAY
1. What is the Security Market Line?
2. How does the Security Market Line identify undervalued and overvalued stocks?
3. Why is systematic risk considered the relevant risk and how is it measured?