CHAPTER 8: ANALYSIS OF RISK AND RETURN
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 is an absolute measure of risk, and the is a relative measure of risk.
a. systematic risk, unsystematic risk
b. standard deviation, coefficient of variation
c. correlation, covariance
d. security market line, characteristic line
4. When comparing two equal-sized investments, the is an appropriate measure of total risk.
a. standard deviation
b. coefficient of variation
c. correlation
d. covariance
5. 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
Chapter 8: Analysis of Risk and Return
6. The is the ratio of to the .
a. standard deviation, covariance, expected value
b. covariance, expected value, standard deviation
c. coefficient of variation, standard deviation, expected value
d. coefficient of variation, systematic risk, expected value
7. The coefficient of variation is a(n) measure of risk.
a. relative
b. absolute
c. systematic
d. unsystematic
8. Values of the can range from +1.0 to -1.0.
a. coefficient of variation
b. correlation coefficient
c. standard deviation
d. covariance
9. 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. standard deviation, risk
10. The primary difference between the standard deviation and the coefficient of variation as measures of risk is:
a. the coefficient of variation is easier to compute.
b. the standard deviation is a measure of relative risk whereas the coefficient of variation is a measure of
absolute risk.
c. the coefficient of variation is a measure of relative risk whereas the standard deviation is a measure of
absolute risk.
d. the standard deviation is rarely used in practice whereas the coefficient of variation is widely used.
Chapter 8: Analysis of Risk and Return
11. 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.
12. 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
13. 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. is determined by the prevailing level of risk-free interest rates minus a risk premium
14. 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
15. 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
Chapter 8: Analysis of Risk and Return
16. 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
17. 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
18. Users of the CAPM should be aware of some of the problems in its practical application. These problems
include which of the following?
a. estimating expected future market returns
b. determining the most appropriate measure of the risk- free rate
c. determining an asset’s future beta
d. all of these are problems in application of the CAPM
19. Recalling the meaning and calculation of beta, a security that is completely uncorrelated (ρj,m = 0) with the
market portfolio would have a beta of
a. –1
b. 0
c. +1
d. -100
20. 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. changes in purchasing power
Chapter 8: Analysis of Risk and Return
21. 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
22. The correlated the returns from two securities are, the will be the portfolio effects of risk reduction.
a. more positively, greater
b. greater, greater
c. less positively, greater
d. lower, lower
23. The risk remaining after extensive diversification is primarily:
a. unsystematic risk
b. systematic risk
c. coefficient of variation risk
d. standard deviation risk
24. 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
25. 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.
Chapter 8: Analysis of Risk and Return
26. 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
27. The risk-free rate of return can be thought of as consisting of the following two components:
a. a real rate of return, a default premium
b. unanticipated inflation, bond default premium
c. a real rate of return, an inflation premium
d. a zero beta component, an expectation premium
28. What will happen to the Security Market Line if: (1) inflation expectations increase, and (2) investors become
more risk averse?
a. shift up and have a steeper slope
b. shift down and have the same slope
c. shift down and have a steeper slope
d. shift up but have less slope
29. 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
30. Which of the following is not an approach for managing risk:
a. hedging
b. gaining control over the operating environment
c. limited use of firm-specific assets
d. ignoring systematic risk
Chapter 8: Analysis of Risk and Return
31. Which of the following (if any) is a relative (rather than absolute) measure of risk?
a. standard deviation
b. standard normal probability distribution
c. expected value
d. coefficient of variation
32. In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset portfolio,
the correlation coefficient between the securities must be .
a. less than +1.0
b. equal to 0.0
c. less than 0.0
d. equal to -1.0
33. A portfolio is efficient if .
a. for a given standard deviation, there is no other portfolio with a higher expected return
b. for a given expected return, there is no other portfolio with a lower standard deviation
c. its standard deviation is equal to -1.0
d. for a given standard deviation, there is no other portfolio with a higher expected return and if, for a given
expected return, there is no other portfolio with a lower standard deviation
34. In general, when the correlation coefficient between the returns on two securities is , the risk of a
portfolio is
the weighted average of the total risk of the two individual securities.
a. equal to +1.0; equal to
b. less than +1.0; less than
c. a and b
d. none of these
35. An increase in the expected future inflation rate has the effect of .
a. increasing the slope of the security market line
b. shifting the security market line upward by the amount of the expected increase in inflation
c. increasing systematic risk
d. none of these
Chapter 8: Analysis of Risk and Return
36. An increase in uncertainty regarding the future economic outlook has the effect of .
a. increasing the slope of the security market line
b. shifting the security market line upward
c. reducing risk
d. none of the above
37. 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
38. The is a relative measure of variability because it measures the risk per unit of expected return.
a. coefficient of variation
b. correlation coefficient
c. covariance
d. standard deviation
39. The security returns from multinational companies tend to have systematic risk than domestic companies.
a. more
b. less options with
c. less
d. more hedging of
40. Investors generally are considered to be risk because they expect to be compensated for assuming risk.
a. inverse
b. seekers
c. averse
d. takers
Chapter 8: Analysis of Risk and Return
41. Investors can obtain high returns in their investments if:
a. they use hedging techniques
b. they assume high risks
c. they invest only international securities
d. they invest in legal Ponzi type securities
42. The term structure of interest rates is the pattern of interest rate yields for securities that differ only in
a. default risk
b. liquidity premiums
c. the yield to maturity
d. the length of time to maturity
43. The term structure of interest rates is the pattern of interest rate yields for debt securities that are similar in all
respects except for differences in
a. tax status
b. liquidity
c. risk of default
d. maturity
44. The maturity premium reflects a preference by many lenders for
a. shorter maturities
b. reducing yields
c. high yield securities
d. longer maturities
45. The default risk premium reflects the fact that
a. the premium remains constant over time
b. there is a positive relationship between risk and maturity
c. there is a positive relationship between default risk and required returns
d. the premium varies depending on the time to maturity
Chapter 8: Analysis of Risk and Return
46. The business risk of a firm refers to the
a. results from using fixed-cost sources of funds
b. variability in the price of a firm’s securities
c. variability in the firm’s operating earnings over time
d. influence of government regulations on business earnings
47. The following yields on 20 year bonds prevailed in January for the three securities shown:
Aa-rated corporate bond 9.98%
Baa-rated corporate bond 10.34%
B-rated corporate bond 11.12%
The difference in yields is due primarily to
a. maturity risk premium
b. default risk premium
c. seniority risk premium
d. financial risk premium
48. The ability of an investor to buy and sell a company’s securities quickly and without a significant loss of
value is known as the
a. financial risk
b. marketability risk
c. business risk
d. security risk
49. According to the , long-term interest rates are a function of expected short-term interest rates.
a. Maturity theory
b. Expectations theory
c. Market segmentation theory
d. Preferred habitat theory
50. The term structure of interest rates is related to the .
a. default risk premium
b. seniority risk premium
c. marketability risk premium
d. maturity risk premium
Chapter 8: Analysis of Risk and Return
51. refers to the ability of an investor to buy and sell a company’s securities quickly and without a
significant loss of value.
a. Default risk
b. Business and financial risk
c. Maturity risk
d. Marketability risk
52. The risk-free rate of return is composed of which of the following elements:
a. risk premium and inflation
b. cost of capital and risk premium
c. real rate of return and risk premium
d. real rate of return and inflation
53. The two elements that make up the risk-free rate of return are
a. the supply of funds and the demand for funds
b. the yield on 90-day Treasury bills plus an inflation premium
c. the real rate of return plus an inflation premium
d. the required return plus a risk premium
54. The theory of the yield curve holds that required returns on long-term securities tend to be greater the
longer the time to maturity.
a. expectations
b. market segmentation
c. preferred habitat
d. liquidity premium
55. 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
Chapter 8: Analysis of Risk and Return
56. can be achieved by investing in a set of securities that have different risk-return characteristics.
a. Indexing
b. Capital Asset pricing
c. Diversification
d. Asset allocation
57. On the capital market line (CML), any risk-return combination beyond the Market Portfolio (m) is obtained
by ____.
a. lending money
b. borrowing money
c. reducing risk
d. investing in index funds
58. 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
Probability
$16
0.25
20
0.30
24
0.25
28
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%
Chapter 8: Analysis of Risk and Return
59. 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
Probabilit
$16
0.25
20
0.30
24
0.25
28
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%
60. 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
Probability
$16
0.25
20
0.30
24
0.25
28
0.20
Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the coefficient
of variation for the rate of return on Phoenix stock.
a. 0.0
b. 2.68
c. 2.61
d. 0.275
Chapter 8: Analysis of Risk and Return
61. The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of
14% and a standard deviation of 7%. Determine the probability of earning more than 21% on FTC common
stock. (Note: Table V is required to work this problem.)
a. 1.00
b. 0.8413
c. 0.0013
d. 0.1587
62. The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of
14% and a standard deviation of 7%. Determine the probability of earning a negative rate of return (i.e. less
than 0%) on FTC common stock. (Note: Table V is required to work this problem.)
a. 0.0228
b. 2.00
c. 0.5000
d. 0.9772
63. Elephant Company 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%
64. 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%
Chapter 8: Analysis of Risk and Return
65. 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 standard deviation of returns
for this investor’s portfolio.
a. 73.8%
b. 6.71%
c. 3.00%
d. 8.59%
66. 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%
67. The return expected from a risky investment is 24 percent, and the standard deviation of this return is 17
percent. If returns from this investment are normally distributed, what is the probability that the investment
may earn a negative rate of return? (Note: Table V is required to work this problem.)
a. 8.33%
b. 7.93%
c. 6.88%
d. 5.44%
68. The expected rate of return for 3COM is 18 percent, with a standard deviation of 10.98 percent. The expected
rate of return for Just the Fax is 26 percent with a standard deviation of 15.86%. Which firm would be
considered the riskier from a total risk perspective?
a. 3COM
b. Just the Fax
c. Neither, both have the same risk
d. Cannot be determined