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CFIN4
Chapter 8 – Risk and Rates of Return
1. If we develop a weighted average of the possible return outcomes, multiplying each outcome or "state" by its
respective probability of occurrence for a particular stock, we can construct a payoff matrix of expected returns.
a. True
b. False
2. Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average
market risk will tend to be more volatile than an average stock, and it will have a beta which is greater than 1.0.
a. True
b. False
3. A firm cannot change its beta through any managerial decision because betas are completely market determined.
a. True
b. False
4. In the real world, the type of security that generates a return that is nearest to a risk-free rate of return is a Treasury
bill.
a. True
b. False
CFIN4
Chapter 8 – Risk and Rates of Return
5. Risk is defined as the chance (probability) of actually observing outcomes that are less than expected, or
unfavorable. Outcomes that are greater than expected are not considered when evaluating risk because such
occurrences are desirable.
a. True
b. False
6. Risk is defined as the chance (probability) of actually observing outcomes that are greater than expected, or
favorable. Such outcomes are more desirable than observing less-than-expected events, so the possibility that
positive outcomes will occur must be emphasized when evaluating risk.
a. True
b. False
7. Risk really should not be a significant factor when making financial decision because all business decisions involve
predictions about the future, which is unknown. As a result, all decisions automatically include some consideration of
risk.
a. True
b. False
8. Risk is indicated by variability, whether the variability is considered positive or negative. Both the positive and
negative outcomes must be evaluated when considering risk because all unexpected possibilities should be examined,
even the positive ones.
a. True
b. False
CFIN4
Chapter 8 – Risk and Rates of Return
9. A listing of all possible outcomes, or events, with a probability assigned to each is called a probability distribution.
a. True
b. False
10. The expected rate of return of an asset will always equal one of the possible rates of return for that asset.
a. True
b. False
11. 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.
a. True
b. False
12. Assume Stock A has a standard deviation of 0.21 while Stock B has a standard deviation of 0.10. If both Stock A
and Stock B must be held in isolation, and if investors are risk averse, we can conclude that Stock A will have a
greater required return. However, if the assets could be held in portfolios, it is conceivable that the required return
could be higher on the low standard deviation stock.
a. True
b. False
CFIN4
Chapter 8 – Risk and Rates of Return
13. The only condition under which risk can be reduced to zero is to find securities that are perfectly negatively
correlated (r = −1.0) with each other.
a. True
b. False
14. While the portfolio return is a weighted average of realized security returns, portfolio risk is not necessarily a
weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows
investors to combine stocks and actually reduce the riskiness of a portfolio.
a. True
b. False
15. If I know for sure that the market will have a positive return over the next year, to maximize my rate of return, I
should increase the beta of my portfolio.
a. True
b. False
16. The Y-axis intercept of the SML indicates the return on the individual asset when the realized return on an average
stock (beta = 1.0) is zero.
a. True
b. False
CFIN4
Chapter 8 – Risk and Rates of Return
17. The tighter the probability distribution, the less variability there is and the less likely it is that the actual outcome will
be close to the expected value; consequently the more likely it is that the actual return will be much different from
the expected return.
a. True
b. False
18. The standard deviation is the weighted average of all the deviations from the expected value, and it indicates how far
above or below the expected value the actual value is expected to be.
a. True
b. False
19. Combining stocks with perfectly correlated stock returns into a portfolio is less risky than holding an individual stock
since the portfolio will benefit from diversification.
a. True
b. False
20. Which of the following statements is correct?
a. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely
described by a listing of the likelihood of unfavorable events.
b. Portfolio diversification reduces the variability of returns on an individual stock.
c. When company specific risk has been diversified, the inherent risk that remains is market risk which is
constant for all securities in the market.
d. A stock with a beta of −1.0 has zero systematic (or market) risk.
e. The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line
cannot be controlled by the financial manager.
CFIN4
Chapter 8 – Risk and Rates of Return
21. 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?
a. Variance; correlation coefficient.
b. Standard deviation; correlation coefficient.
c. Beta; variance.
d. Coefficient of variation; beta.
e. Beta; beta.
22. Which of the following statements is correct?
a. If the returns on a stock could vary widely, and its standard deviation is large, then the stock will necessarily
have a large beta coefficient.
b. A stock that is more highly positively correlated with "The Market" than most stocks would not necessarily
have a beta coefficient that is greater than 1.0.
c. A stock's standard deviation of returns is a measure of the stock's "stand-alone" risk, while its coefficient of
variation measures its risk if the stock is held in a portfolio.
d. A portfolio that contained 100 low-beta stocks would be riskier than a portfolio containing 100 high-beta
stocks.
e. Negative betas cannot exist; if you calculate one, you made an error.
CFIN4
Chapter 8 – Risk and Rates of Return
23. Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these
securities? (Assume the market is in equilibrium.)
a. When held in isolation, Stock A has greater risk than Stock B.
b. Stock B would be a more desirable addition to a portfolio than Stock A.
c. Stock A would be a more desirable addition to a portfolio than Stock B.
d. The expected return on Stock A will be greater than that on Stock B.
e. The expected return on Stock B will be greater than that on Stock A.
24. 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?
a. The market risk premium would increase.
b. Beta would increase.
c. The slope of the SML would increase.
d. The required return of an average stock, rA = rM
, would increase.
e. None of the indicated changes would be likely to occur.
25. All else equal, risk averse investors generally require returns to purchase investments with risks.
a. higher; lower
b. lower; higher
c. higher; higher
d. None of the above is correct.
CFIN4
Chapter 8 – Risk and Rates of Return
26. According to the following information, which of the stocks would be considered riskiest in a diversified portfolio of
investments?
Stock
σ
β
ABC
12.5%
1.0
FGH
8.0%
0.5
MNO
20.2%
2.4
TUV
15.3%
3.0
a. Stock MNO, because it has the highest standard deviation.
b. Stock TUV, because it has the highest beta.
c. Stock FGH, because it has the highest s/b ratio
d. Stock ABC, because its beta is the same as the market beta (1.0) and the market is always very, very risky.
27. According to the capital asset pricing model, which of the following stocks should have the highest required rate of
return?
Stock Name
Standard Deviation
Beta
Alpha Automobiles
19.0%
1.8
Beta Electronics
28.0
1.1
Omega Foods
8.0
0.7
a. Beta Electronics because its standard deviation is highest.
b. Alpha Automobiles because its beta coefficient is highest.
c. Omega foods because the ration of standard deviation/beta is the lowest.
d. Not enough information is given to answer this question.
28. Which of the following statements is most correct?
a. The required return on a firm's common stock is determined by the firm's systematic (or market) risk. If its
systematic risk is known, and if it is expected to remain constant, the analyst has sufficient information to
specify the firm's required return.
b. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of most other
securities.
c. If the returns of two firms are negatively correlated, one of them must have a negative beta.
d. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an
investor who holds only one stock.
e. Statements b and c are both correct.
29. You have developed the following data on three stocks:
Stock
Standard Deviation
Beta
A
0.15
0.79
B
0.25
0.61
C
0.20
1.29
If you are a risk minimizer, you should choose Stock
held as part of a well-diversified portfolio.
a. A; A
b. A; B
c. B; A
d. C; A
e. C; B
if it is to be held in isolation and Stock if it is to be
CFIN4
Chapter 8 – Risk and Rates of Return
30. Which of the following statements is false?
a. The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of
the securities being compared differ significantly.
b. Managers cannot act in the best interests of their shareholders unless they know their shareholders' average
time preference for receiving their money and what risks a typical shareholder is prepared to assume.
c. Companies should deliberately increase their risk relative to the market only if the actions that increase the
risk also increase the expected rate of return on the firm's assets by enough to completely compensate for the
higher risk.
d. If the expected rate of return for a particular investment, as seen by the marginal investor, exceeds its
required rate of return, we should soon observe an increase in demand for the investment, and the price will
likely increase until a price is established that equates the expected return with the required return.
e. All of the above statements are correct.
31. Which of the following statements is most correct?
a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all the market risk
from the portfolio
b. If you formed a portfolio which included a large number of low beta stocks (stocks with betas less than 1.0
but greater than −1.0), the portfolio would itself have a beta coefficient that is equal to the weighted average
beta of the stocks in the portfolio, so the portfolio would have a relatively low degree of risk.
c. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness
of your portfolio as measure by its beta, then, according to the CAPM theory, you should invest some of your
money in each stock in the market, i.e., if there were 10,000 traded stocks in the world, the least risky
portfolio would include some shares in each of them.
d. Company specific (or unsystematic) risk can be eliminated by forming a large portfolio, but normally even
highly diversified portfolios are subject to market (or systematic) risk.
e. Statements b and d are both correct.
CFIN4
Chapter 8 – Risk and Rates of Return
32. In a portfolio of three different stocks, which of the following could not be true?
a. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.
b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
c. The beta of the portfolio is less than the beta of each of the individual stocks.
d. The beta of the portfolio is greater than the beta of one or two of the individual stock's betas.
e. None of the above (i.e., they all could be true, but not necessarily at the same time).
33. Which of the following statements is most correct?
a. A portfolio with a beta of minus 2 has the same degree of risk to the 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 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.
34. For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current
levels,
a. The expected rate of return must be equal to the required rate of return; that is,
b. The past realized rate of return must be equal to the expected rate of return; that is
c. The required rate of return must equal the realized rate of return; that is
d. All three of the above statements must hold for equilibrium to exist; that is,
e. None of the above statements are correct.
CFIN4
Chapter 8 – Risk and Rates of Return
35. Which of the statements is most correct?
a. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a
regression analysis, while the other has a beta of −0.6. The returns on the stock with the negative beta will be
negatively correlated with returns on most other stocks in the market.
b. Suppose you are managing a stock portfolio, and you have information which leads you to believe that the
stock market is likely to be very strong in the immediate future, i.e., you are confident that the market is about
to rise sharply. You should sell your high beta stocks and buy low beta stocks in order to take advantage of
the expected market move.
c. In a recent issue, The Wall Street Journal ran a story on a company named Collections Inc., which is in the
business of collecting past due accounts for other companies, i.e., it is a collections agency. According to the
Journal, Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that
Collection Inc.'s beta should be quite high, say 2.0, because it does so much better than most companies when
the economy is weak.
d. Statements a and b are both true.
e. Statements a and c are both true.
36. Which of the following is not a difficulty concerning beta and its estimation?
a. Sometimes a security or project does not have a past history which can be used as a basis for calculating
beta.
b. Sometimes, during a period when the company is undergoing a change such as toward more leverage or
riskier assets, the calculated beta will be drastically different than the "true" or "expected future" beta.
c. The beta of an "average stock," or "the market," can change over time, sometimes drastically.
d. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because
conditions have changed.
e. All of the above are potentially serious difficulties.
CFIN4
Chapter 8 – Risk and Rates of Return
37. Which of the following statements is correct?
a. If the returns from two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1) 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 with
has a beta equal to 0.5.
e. None of the above statements are correct.
38. Other things held constant, (1) if the expected inflation rate decreases, and (2) investors become more risk averse,
the Security Market Line would shift
a. Down and have steeper slope.
b. Up and have less steep slope.
c. Up and keep same slope.
d. Down and keep same slope.
e. Down and have less steep slope.
CFIN4
Chapter 8 – Risk and Rates of Return
39. Which of the following statements is most correct?
a. An increase in expected inflation could be expected to increase the required return on a riskless asset and on
an average stock by the same amount, other things held constant.
b. A graph of the SML would show required rates of return on the vertical axis and standard deviations of
returns on the horizontal axis.
c. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return
would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would
probably be greater than the average of the stocks' standard deviations.
d. If investors became more averse to risk, then (1) the slope of the SML would increase and (2) the required
rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.
e. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
40. Which of the following statements is most correct?
a. If beta doubles, the required return doubles.
b. If a stock has a negative beta, its required return is negative.
c. Higher beta stocks have more company-specific risk, but do not necessarily have more market risk.
d. If a portfolio's beta increases from 1.2 to 1.5, its required rate of return will increase by an amount equal to its
market risk premium.
e. If two stocks have the same standard deviation and the correlation coefficient between the returns of two
stocks equals zero, an equally weighted portfolio of the two stocks will have a standard deviation lower than
that of individual stocks.
CFIN4
Chapter 8 – Risk and Rates of Return
41. Assume you are considering combining two investments to form a portfolio and you are very concerned with the risk
that will result from the combination. If you want to attain the greatest effect from diversification, you would prefer
that the assets are related.
a. negatively
b. positively
c. not
d. The relationship between the two investments gives no indication of the diversification effect that will result by
combining them to form a portfolio.
e. Diversification is not an important factor in investment decisions.
42. is a measure of total risk, whereas is a measure of systematic risk.
a. Standard deviation; beta
b. Beta; standard deviation
c. Standard deviation; variance
d. Coefficient of variation; standard deviation
e. None of the above is correct.
43. If a stock has a beta coefficient, β, equal to 1.20, the risk premium associated with the market is 9 percent, and the
risk-free rate is 5 percent, application of the capital asset pricing model indicates the appropriate return should be
____.
a. 9.8%
b. 14%
c. 5%
d. 15.8%
e. None of the above is correct.
CFIN4
Chapter 8 – Risk and Rates of Return
44. Stock X has β = 4.0, which means that it is considered four times riskier than the average stock, or the stock market
as a whole. According to the capital asset pricing model, Stock X should earn
a. a total return that is four times greater than the market return, that is, rX = 4 × rM
.
b. a risk premium that is four times greater than the market risk premium, that is, RPX = 4 × RPM
, which
means that rX − rRF = 4 × (rM − rRF).
c. a return that is less than the market return (rM
) because, all else equal, the high risk associated with Stock X
will cause its value to decrease.
d. the risk-free rate of return (rRF).
e. None of the above is correct.
45. Sharon Stonewall currently has an investment portfolio that contains 10 stocks that have a total value equal to
$160,000. The portfolio has a beta (β) equal to 1.0. Sharon wants to invest an additional $40,000 in a stock with β =
2.0. After Sharon adds the new stock to her portfolio, what will be the portfolio's beta?
a. 1.2
b. 1.5
c. 2.0
d. Not enough information is given to compute the portfolio's beta (β).
e. None of the above is correct.
