Finance Chapter 29 Adding More Such Stocks Will Have Effect The Portfolios Risk Adding More

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subject Authors Eugene F. Brigham, Phillip R. Daves

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Chapter 29: Basic Financial Tools: A review
HAS VARIABLES:
False
81. Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
d.
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
theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.
e.
The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.
ANSWER:
b
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82. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true, assuming the CAPM is
correct?
a.
In equilibrium, the expected return on Stock B will be greater than that on Stock A.
b.
When held in isolation, Stock A has more risk than Stock B.
c.
Stock B would be a more desirable addition to a portfolio than A.
d.
In equilibrium, the expected return on Stock A will be greater than that on B.
e.
Stock A would be a more desirable addition to a portfolio then Stock B.
ANSWER:
d
83. Stock X has a beta of 0.7 and Stock Y has a beta of 1.7. Which of the following statements must be true, according to
the CAPM?
a.
Stock Y's realized return during the coming year will be higher than Stock X's return.
b.
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.
c.
Stock Y's return has a higher standard deviation than Stock X.
d.
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.
e.
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.
ANSWER:
b
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84. Which of the following statements is CORRECT?
a.
The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
b.
It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that
includes the stock.
c.
Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.
d.
An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified
portfolio of stocks.
e.
An investor can eliminate virtually all market risk if he or she holds a very large and well-diversified portfolio
of stocks.
ANSWER:
d
85. Recession, inflation, and high interest rates are economic events that are best characterized as being
a.
company-specific risk factors that can be diversified away.
b.
among the factors that are responsible for market risk.
c.
risks that are beyond the control of investors and thus should not be considered by security analysts or
portfolio managers.
d.
irrelevant except to governmental authorities like the Federal Reserve.
e.
systematic risk factors that can be diversified away.
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Chapter 29: Basic Financial Tools: A review
ANSWER:
b
86. Which of the following statements is CORRECT?
a.
Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios
are subject to market (or systematic) risk.
b.
A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the
standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0.
c.
A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with
a beta = 0.8.
d.
If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk
from the portfolio.
e.
A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than
the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are
selected.
ANSWER:
a
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87. Which of the following statements is CORRECT?
a.
A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less
risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the
same standard deviations.
b.
A two-stock portfolio will always have a lower beta than a one-stock portfolio.
c.
If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than
a one-stock portfolio.
d.
A stock with an above-average standard deviation must also have an above-average beta.
e.
A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.
ANSWER:
a
88. Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly
positively correlated with one another, i.e., the correlations are all between 0 and 1.
Expected
Standard
Return
Deviation
10%
20%
10%
10%
12%
12%
Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds
invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal
expected returns. Which of the following statements is CORRECT?
a.
Portfolio AB's coefficient of variation is greater than 2.0.
b.
Portfolio AB's required return is greater than the required return on Stock A.
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Chapter 29: Basic Financial Tools: A review
c.
Portfolio ABC's expected return is 10.66667%.
d.
Portfolio ABC has a standard deviation of 20%.
e.
Portfolio AB has a standard deviation of 20%.
ANSWER:
c
89. Which of the following statements is CORRECT?
a.
A portfolio with a large number of randomly selected stocks would have more market risk than a single stock
that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.
b.
If a stock has a negative beta, its expected return must be negative.
c.
A portfolio with a large number of randomly selected stocks would have less market risk than a single stock
that has a beta of 0.5.
d.
According to the CAPM, stocks with higher standard deviations of returns must also have higher expected
returns.
e.
If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and
these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a
standard deviation that is less than that of the individual stocks.
ANSWER:
a
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90. Which of the following is most likely to be true for a portfolio of 40 randomly selected stocks?
a.
The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
b.
The beta of the portfolio is less than the average of the betas of the individual stocks.
c.
The beta of the portfolio is equal to the average of the betas of the individual stocks.
d.
The beta of the portfolio is larger than the average of the betas of the individual stocks.
e.
The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.
ANSWER:
c
91. If you randomly select stocks and add them to your portfolio, which of the following statements best describes what
you should expect?
a.
Adding more such stocks will increase the portfolio's expected rate of return.
b.
Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk.
c.
Adding more such stocks will have no effect on the portfolio's risk.
d.
Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.
e.
Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.
ANSWER:
e
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92. Charlie and Lucinda each have $50,000 invested in stock portfolios. Charlie's has a beta of 1.2, an expected return of
10.8%, and a standard deviation of 25%. Lucinda's has a beta of 0.8, an expected return of 9.2%, and a standard deviation
that is also 25%. The correlation coefficient, r, between Charlie's and Lucinda's portfolios is zero. If Charlie and Lucinda
marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio?
a.
The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual
portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the
two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two
portfolios' standard deviations, 25%.
b.
The combined portfolio's expected return will be greater than the simple weighted average of the expected
returns of the two individual portfolios, 10.0%.
c.
The combined portfolio's standard deviation will be greater than the simple average of the two portfolios'
standard deviations, 25%.
d.
The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard
deviations, 25%.
e.
The combined portfolio's expected return will be less than the simple weighted average of the expected returns
of the two individual portfolios, 10.0%.
ANSWER:
a
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93. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently
consists of 3 average stocks?
a.
The expected return of your portfolio is likely to decline.
b.
The diversifiable risk will remain the same, but the market risk will likely decline.
c.
Both the diversifiable risk and the market risk of your portfolio are likely to decline.
d.
The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio
should also decline.
e.
The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
ANSWER:
e
94. Stocks A and B are quite similar: Each has an expected return of 12%, a beta of 1.2, and a standard deviation of 25%.
The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the
following statements is CORRECT?
a.
Portfolio P has a standard deviation that is greater than 25%.
b.
Portfolio P has an expected return that is less than 12%.
c.
Portfolio P has a standard deviation that is less than 25%.
d.
Portfolio P has a beta that is less than 1.2.
e.
Portfolio P has a beta that is greater than 1.2.
ANSWER:
c
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95. Stocks A, B, and C are similar in some respects: Each has an expected return of 10% and a standard deviation of 25%.
Stocks A and B have returns that are independent of one another; i.e., their correlation coefficient, r, equals zero. Stocks A
and C have returns that are negatively correlated with one another; i.e., r is less than 0. Portfolio AB is a portfolio with
half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in
Stock A and half invested in Stock C. Which of the following statements is CORRECT?
a.
Portfolio AC has an expected return that is greater than 25%.
b.
Portfolio AB has a standard deviation that is greater than 25%.
c.
Portfolio AB has a standard deviation that is equal to 25%.
d.
Portfolio AC has a standard deviation that is less than 25%.
e.
Portfolio AC has an expected return that is less than 10%.
ANSWER:
d
96. Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on
the two stocks have a correlation coefficient of +0.6. Your portfolio consists of 50% A and 50% B. Which of the
following statements is CORRECT?
a.
The portfolio's expected return is 15%.
b.
The portfolio's standard deviation is greater than 20%.
c.
The portfolio's beta is greater than 1.2.
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Chapter 29: Basic Financial Tools: A review
d.
The portfolio's standard deviation is 20%.
e.
The portfolio's beta is less than 1.2.
ANSWER:
a
97. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value
invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e.,
the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the
following statements is CORRECT?
a.
Portfolio P's expected return is equal to the expected return on Stock A.
b.
Portfolio P's expected return is less than the expected return on Stock B.
c.
Portfolio P's expected return is equal to the expected return on Stock B.
d.
Portfolio P's expected return is greater than the expected return on Stock C.
e.
Portfolio P's expected return is greater than the expected return on Stock B.
ANSWER:
c
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98. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2,
but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $300,000 invested in Stock A and
$100,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the
following statements is CORRECT?
a.
The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
b.
The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued.
c.
Portfolio AB's expected return is 11.0%.
d.
Portfolio AB's beta is less than 1.2.
e.
Portfolio AB's standard deviation is 17.5%.
ANSWER:
a
99. You have a portfolio P that consists of 50% Stock X and 50% Stock Y. Stock X has a beta of 0.7 and Stock Y has a
beta of 1.3. The standard deviation of each stock's returns is 20%. The stocks' returns are independent of each other, i.e.,
the correlation coefficient, r, between them is zero. Given this information, which of the following statements is
CORRECT?
a.
The required return on Portfolio P is equal to the market risk premium (rM rRF).
b.
Portfolio P has a beta of 0.7.
c.
Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
d.
Portfolio P has the same required return as the market (rM).
e.
Portfolio P has a standard deviation of 20%.
ANSWER:
d
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100. The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM rRF,
is positive. Which of the following statements is CORRECT?
a.
Stock B's required rate of return is twice that of Stock A.
b.
If Stock A's required return is 11%, then the market risk premium is 5%.
c.
If Stock B's required return is 11%, then the market risk premium is 5%.
d.
If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will
increase by more than Stock B's.
e.
If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will
increase by more than Stock A's.
ANSWER:
b
101. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
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Chapter 29: Basic Financial Tools: A review
a.
If a stock's beta doubled, its required return under the CAPM would also double.
b.
If a stock's beta doubled, its required return under the CAPM would more than double.
c.
If a stock's beta were 1.0, its required return under the CAPM would be 5%.
d.
If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%.
e.
If a stock has a negative beta, its required return under the CAPM would be less than 5%.
ANSWER:
e
102. Portfolio P has equal amounts invested in each of the three stocks, A, B, and C. Stock A has a beta of 0.8, Stock B
has a beta of 1.0, and Stock C has a beta of 1.2. Each of the stocks has a standard deviation of 25%. The returns on the
three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an
increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is
CORRECT?
a.
The required return on Stock A will increase by less than the increase in the market risk premium, while the
required return on Stock C will increase by more than the increase in the market risk premium.
b.
The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as
Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease.
c.
The required returns on all three stocks will increase by the amount of the increase in the market risk premium.
d.
The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as
Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.
e.
The required return of all stocks will remain unchanged since there was no change in their betas.
ANSWER:
a
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Chapter 29: Basic Financial Tools: A review
103. Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the
following statements is CORRECT?
a.
If a stock has a negative beta, its required return must also be negative.
b.
An index fund with beta = 1.0 should have a required return less than 11%.
c.
If a stock's beta doubles, its required return must also double.
d.
An index fund with beta = 1.0 should have a required return greater than 11%.
e.
An index fund with beta = 1.0 should have a required return of 11%.
ANSWER:
e
104. Which of the following statements is CORRECT?
a.
If the risk-free rate rises, then the market risk premium must also rise.
b.
If a company's beta is halved, then its required return will also be halved.
c.
If a company's beta doubles, then its required return will also double.
d.
The slope of the security market line is equal to the market risk premium, (rM rRF).
e.
Beta is measured by the slope of the security market line.
ANSWER:
d
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105. Dixon Food's stock has a beta of 1.4, while Clark Café's stock has a beta of 0.7. Assume that the risk-free rate, rRF, is
5.5% and the market risk premium, (rM rRF), equals 4%. Which of the following statements is CORRECT?
a.
If the market risk premium increases but the risk-free rate remains unchanged, Dixon's required return will
increase because it has a beta greater than 1.0 but Clark's required return will decline because it has a beta less
than 1.0.
b.
Since Dixon's beta is twice that of Clark's, its required rate of return will also be twice that of Clark's.
c.
If the risk-free rate increases while the market risk premium remains constant, then the required return on an
average stock will increase.
d.
If the market risk premium decreases but the risk-free rate remains unchanged, Dixon's required return will
decrease because it has a beta greater than 1.0 and Clark's will also decrease, but by more than Dixon's
because it has a beta less than 1.0.
e.
If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase
for both stocks but the increase will be larger for Dixon since it has a higher beta.
ANSWER:
c
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106. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is
invested in Stock B. If the market risk premium (rM rRF) were to increase but the risk-free rate (rRF) remained constant,
which of the following would occur?
a.
The required return would decrease by the same amount for both Stock A and Stock B.
b.
The required return would increase for Stock A but decrease for Stock B.
c.
The required return on Portfolio P would remain unchanged.
d.
The required return would increase for Stock B but decrease for Stock A.
e.
The required return would increase for both stocks but the increase would be greater for Stock B than for
Stock A.
ANSWER:
e
107. Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is
most likely to occur?
a.
The required return on a stock with beta > 1.0 will increase.
b.
The return on "the market" will remain constant.
c.
The return on "the market" will increase.
d.
The required return on a stock with beta < 1.0 will decline.
e.
The required return on a stock with beta = 1.0 will not change.
ANSWER:
d
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108. Assume that the risk-free rate, rRF, increases but the market risk premium, (rM rRF), declines, with the net effect
being that the overall required return on the market, rM, remains constant. Which of the following statements is
CORRECT?
a.
The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a
beta greater than 1.0.
b.
Since the overall return on the market stays constant, the required return on each individual stock will also
remain constant.
c.
The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta
greater than 1.0.
d.
The required return of all stocks will fall by the amount of the decline in the market risk premium.
e.
The required return of all stocks will increase by the amount of the increase in the risk-free rate.
ANSWER:
c
109. Which of the following statements is CORRECT?
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Chapter 29: Basic Financial Tools: A review
a.
The slope of the Security Market Line is beta.
b.
Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive.
c.
If a stock's beta doubles, its required rate of return must also double.
d.
If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be
negative.
e.
If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk
premium.
ANSWER:
d
110. Which of the following statements is CORRECT?
a.
Portfolio diversification reduces the variability of returns on an individual stock.
b.
Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely
described by a listing of the likelihoods of unfavorable events.
c.
The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be
controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions
as changing the firm's capital structure or the type of assets it employs.
d.
A stock with a beta of 1.0 has zero market risk if held in a 1-stock portfolio.
e.
When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is
constant for all stocks in the market.
ANSWER:
c
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111. Which of the following statements is CORRECT?
a.
Two firms with the same expected dividend and growth rates must also have the same stock price.
b.
It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never
expected to become constant.
c.
If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of
5%, this implies that the stock's dividend yield is also 5%.
d.
The price of a stock is the present value of all expected future dividends, discounted at the dividend growth
rate.
e.
The constant growth model takes into consideration the capital gains investors expect to earn on a stock.
ANSWER:
e
112. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate
of 5% a year forever (g = 5%). If the company is in equilibrium and its expected and required rate of return is 15%,
which of the following statements is CORRECT?
a.
The company's dividend yield 5 years from now is expected to be 10%.
b.
The constant growth model cannot be used because the growth rate is negative.

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