CHAPTER 08—RISK AND RATES OF RETURN
1. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as
measured by its standard deviation.
a.
True
b.
False
False
EASY
2. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a
standardized measure of the risk per unit of expected return.
a.
True
b.
False
True
EASY
3. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the
securities being compared differ significantly.
a.
True
b.
False
False
EASY
4. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most
investors are risk averse.
a.
True
CHAPTER 08—RISK AND RATES OF RETURN
b.
False
True
EASY
5. When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of
correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the
portfolio’s risk.
a.
True
b.
False
True
EASY
6. Diversification will normally reduce the riskiness of a portfolio of stocks.
a.
True
b.
False
True
EASY
7. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really
interested in ex ante (future) data.
a.
True
b.
False
True
CHAPTER 08—RISK AND RATES OF RETURN
8. The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.
a.
True
b.
False
False
EASY
9. 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 its beta will be greater than 1.0.
a.
True
b.
False
True
EASY
10. An individual stock’s diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the
portfolio in which the stock is held.
a.
True
b.
False
False
EASY
EASY
CHAPTER 08—RISK AND RATES OF RETURN
11. Managers should under no conditions take actions that increase their firm’s risk relative to the market, regardless of
how much those actions would increase the firm’s expected rate of return.
a.
True
b.
False
False
EASY
12. One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering
both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of
the asset held in isolation is not relevant under the CAPM.
a.
True
b.
False
True
EASY
13. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of
individual stocks held in isolation. Thus, the relevant risk of a stock is the stock’s contribution to the riskiness of a well-
diversified portfolio.
a.
True
b.
False
True
EASY
CHAPTER 08—RISK AND RATES OF RETURN
14. If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.
a.
True
b.
False
False
EASY
15. Most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets. The
relevant risk of each asset should be measured in terms of its effect on the risk of the firm’s stockholders.
a.
True
b.
False
16. Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return
from the expected return, it is always larger than its square root, the standard deviation.
a.
True
b.
False
True
MODERATE
CHAPTER 08—RISK AND RATES OF RETURN
17. Because of differences in the expected returns on different investments, the standard deviation is not always an
adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows
investors to make better comparisons of investments’ stand-alone risk.
a.
True
b.
False
True
MODERATE
18.
a.
True
b.
False
True
MODERATE
19. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose
standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if
stocks are held in portfolios, it is possible that the required return could be higher on the stock with the lower standard
deviation.
a.
True
b.
False
True
MODERATE
Variance
CHAPTER 08—RISK AND RATES OF RETURN
20. Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the
market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors
have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities
with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.
a.
True
b.
False
True
MODERATE
21. A stock’s beta measures its diversifiable risk relative to the diversifiable risks of other firms.
a.
True
b.
False
False
MODERATE
22. A stock’s beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who
holds a well-diversified portfolio.
a.
True
b.
False
False
MODERATE
CHAPTER 08—RISK AND RATES OF RETURN
23. If the returns of two firms are negatively correlated, then one of them must have a negative beta.
a.
True
b.
False
True
MODERATE
24. A stock with a beta equal to −1.0 has zero systematic (or market) risk.
a.
True
b.
False
False
MODERATE
25. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is
negative.
a.
True
b.
False
True
MODERATE
26. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would
expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky.
a.
True
b.
False
CHAPTER 08—RISK AND RATES OF RETURN
True
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
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Portfolio risk
Bloom’s: Comprehension
27. Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion
to its market value. Because of its diversification, Portfolio B will by definition be riskless.
a.
True
b.
False
False
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
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Portfolio risk
Bloom’s: Comprehension
28. A portfolio’s risk is measured by the 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 thus reduce the riskiness of their portfolios.
a.
True
b.
False
False
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
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Portfolio risk
29. The distributions of rates of return for Companies AA and BB are given below:
State of the
Probability of
Economy
This State Occurring
AA
BB
Boom
0.2
30%
−10%
Normal
0.6
10%
5%
Recession
0.2
−5%
50%
CHAPTER 08—RISK AND RATES OF RETURN
We can conclude from the above information that any rational, risk-averse investor would be better off adding Security
AA to a well-diversified portfolio over Security BB.
a.
True
b.
False
30. Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct
proportions, the resulting 2-asset portfolio will have less risk than either security held alone.
a.
True
b.
False
False
MODERATE
31. Bad managerial judgments or unforeseen negative events that happen to a firm are defined as “company-specific,” or
“unsystematic,” events, and their effects on investment risk can in theory be diversified away.
a.
True
b.
False
True
MODERATE
32. We would generally find that the beta of a single security is more stable over time than the beta of a diversified
CHAPTER 08—RISK AND RATES OF RETURN
portfolio.
a.
True
b.
False
False
MODERATE
33. We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single
security.
a.
True
b.
False
False
MODERATE
34. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in
owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.
a.
True
b.
False
False
MODERATE
35. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because
betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This
is one of the strengths of the CAPM.
a.
True
CHAPTER 08—RISK AND RATES OF RETURN
b.
False
False
MODERATE
CAPM
36. Under the CAPM, the required rate of return on a firm’s common stock is determined only by the firm’s market risk. If
its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to
calculate the firm’s required rate of return.
a.
True
b.
False
False
MODERATE
37. A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.
a.
True
b.
False
True
MODERATE
38. Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will
likely have an impact on the stock’s price, other things held constant.
a.
True
b.
False
True
CHAPTER 08—RISK AND RATES OF RETURN
39. The slope of the SML is determined by the value of beta.
a.
True
b.
False
False
MODERATE
40. The slope of the SML is determined by investors’ aversion to risk. The greater the average investor’s risk aversion, the
steeper the SML.
a.
True
b.
False
True
MODERATE
41. If you plotted the returns of a company against those of the market and found that the slope of your line was negative,
the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-
diversified investor, assuming that the observed relationship is expected to continue in the future.
a.
True
b.
False
True
MODERATE
MODERATE
CHAPTER 08—RISK AND RATES OF RETURN
42. If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression
line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the risk–
free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.
a.
True
b.
False
False
MODERATE
43. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free
rate.
a.
True
b.
False
True
MODERATE
44. The SML relates required returns to firms’ systematic (or market) risk. The slope and intercept of this line can be
influenced by a manager’s actions.
a.
True
b.
False
CHAPTER 08—RISK AND RATES OF RETURN
45. The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on
an average (b = 1) stock is zero.
a.
True
b.
False
False
MODERATE
46. If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation,
the risk-free rate will also increase. If there is no change in investors’ risk aversion, then the market risk premium (rM −
rRF) will remain constant. Also, if there is no change in stocks’ betas, then the required rate of return on each stock as
measured by the CAPM will increase by the same amount as the increase in expected inflation.
a.
True
b.
False
True
MODERATE
47. Since the market return represents the expected return on an average stock, the market return reflects a certain amount
of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate that is
required to compensate stock investors for assuming an average amount of risk.
a.
True
b.
False
True
MODERATE
CHAPTER 08—RISK AND RATES OF RETURN
48. Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A’s portfolio has a beta
of minus 2.0, while Investor B’s portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the
two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio
could lower their risks, and by exactly the same amount, by adding some “normal” stocks with beta = 1.0.
a.
True
b.
False
49. The CAPM is a multi-period model that takes account of differences in securities’ maturities, and it can be used to
determine the required rate of return for any given level of systematic risk.
a.
True
b.
False
False
The CAPM is a single-period model, and it does not take account of securities’ maturities.
CHALLENGING
8-5 Some Concerns About Beta and the CAPM
FOFM.BRIG.16.08.05 – Some Concerns About Beta and the CAPM
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CAPM
50. You have the following data on three stocks:
Stock
Standard Deviation
Beta
A
20%
0.59
MODERATE
8-4 The Relationship Between Risk and Rates of Return
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Market risk premium
CHAPTER 08—RISK AND RATES OF RETURN
B
10%
0.61
C
12%
1.29
If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be
held as part of a well-diversified portfolio.
a.
A; A.
b.
A; B.
c.
B; A.
d.
C; A.
e.
C; B.
c
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
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Risk aversion
Bloom’s: Application
Multiple Choice: Conceptual
51. Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in
a diversified portfolio?
a.
Variance; correlation coefficient.
b.
Standard deviation; correlation coefficient.
c.
Beta; variance.
d.
Coefficient of variation; beta.
e.
Beta; beta.
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
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Risk measures
Bloom’s: Comprehension
Multiple Choice: Conceptual
52. A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock
portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market.
Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the
market, with r = 0.75. However, Stock A’s standard deviation of returns is 12% versus 8% for Stock B. Which stock
should this investor add to his or her portfolio, or does the choice not matter?
a.
Either A or B, i.e., the investor should be indifferent between the two.
b.
Stock A.
CHAPTER 08—RISK AND RATES OF RETURN
c.
Stock B.
d.
Neither A nor B, as neither has a return sufficient to compensate for risk.
e.
Add A, since its beta must be lower.
With only 4 stocks in the portfolio, unsystematic risk matters, and B has less.
8-3 Risk in a Portfolio Context: The CAPM
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Stock selection in portfolio
Bloom’s: Application
Multiple Choice: Conceptual
53. Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?
a.
The fact that a security or project may not have a past history that can be used as the 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 from 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.
The beta coefficient of a stock is normally found by regressing past returns on a stock against past market
returns. This calculated historical beta may differ from the beta that exists in the future.
8-3 Risk in a Portfolio Context: The CAPM
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Multiple Choice: Conceptual
54. Which of the following statements is CORRECT?
a.
The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.
b.
If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by
definition have a riskless portfolio.
c.
The beta coefficient of a stock is normally found by regressing past returns on a stock against past market
returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate
the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that
exists in the future.
d.
The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
e.
It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in
CHAPTER 08—RISK AND RATES OF RETURN
theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.
8-3 Risk in a Portfolio Context: The CAPM
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Beta coefficient
Bloom’s: Comprehension
Multiple Choice: Conceptual
55. Which of the following statements is CORRECT?
a.
Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection
agency. Collections’ revenues, profits, and stock price tend to rise during recessions. This suggests that
Collections Inc.’s beta should be quite high, say 2.0, because it does so much better than most other companies
when the economy is weak.
b.
Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a
regression analysis using data for the last 5 years, while the other has a beta of −0.6. The returns on the stock
with the negative beta must have been negatively correlated with returns on most other stocks during that 5-
year period.
c.
Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock
market is likely to be very strong in the immediate future. That is, you are convinced 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.
d.
You think that investor sentiment is about to change, and investors are about to become more risk averse. This
suggests that you should rebalance your portfolio to include more high-beta stocks.
e.
If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-
beta stocks will rise while those on high-beta stocks will decline.
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Beta coefficient
Bloom’s: Analysis
Multiple Choice: Conceptual
56. Which of the following statements is CORRECT?
a.
If a company with a high beta merges with a low-beta company, the best estimate of the new merged
company’s beta is 1.0.
b.
Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated
with stocks, especially if the projects are closely associated with research and development activities.
c.
The beta of an “average stock,” which is also “the market beta,” can change over time, sometimes drastically.
CHAPTER 08—RISK AND RATES OF RETURN
d.
If a newly issued stock does not have a past history that can be used for calculating beta, then we should
always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more
debt than the average firm.
e.
During a period when a company is undergoing a change such as increasing its use of leverage or taking on
riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the
future.
8-3 Risk in a Portfolio Context: The CAPM
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Beta coefficient
Bloom’s: Comprehension
Multiple Choice: Conceptual
57. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true, assuming the CAPM is
correct.
a.
Stock A would be a more desirable addition to a portfolio then Stock B.
b.
In equilibrium, the expected return on Stock B will be greater than that on Stock A.
c.
When held in isolation, Stock A has more risk than Stock B.
d.
Stock B would be a more desirable addition to a portfolio than A.
e.
In equilibrium, the expected return on Stock A will be greater than that on B.
8-3 Risk in a Portfolio Context: The CAPM
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Beta coefficient
Bloom’s: Analysis
Multiple Choice: Conceptual
58. Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to
the CAPM?
a.
If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta
significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.
b.
Stock Y’s realized return during the coming year will be higher than Stock X’s return.
c.
If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on
the two stocks should increase by the same amount.
d.
Stock Y’s return has a higher standard deviation than Stock X.
e.
If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in
its required return than will Stock Y.