Chapter 06: Risk and 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
2. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most
investors are risk averse.
a. True
b. False
3. 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
Chapter 06: Risk and Return
4. Diversification will normally reduce the riskiness of a portfolio of stocks.
a. True
b. False
5. 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
6. 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
Chapter 06: Risk and Return
7. 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
8. 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
9. 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
Chapter 06: Risk and Return
10. 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
11. 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
12. If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.
a. True
b. False
Chapter 06: Risk and Return
13. If a stock’s expected return as seen by the marginal investor exceeds this investor’s required return, then the investor
will buy the stock until its price has risen enough to bring the expected return down to equal the required return.
a. True
b. False
14. If a stock’s market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the
stock until its price has fallen down to the level of the investor’s estimate of the intrinsic value.
a. True
b. False
15. For a stock to be in equilibrium, two conditions are necessary: (1) The stock’s market price must equal its intrinsic
value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this
investor’s required return.
a. True
Chapter 06: Risk and Return
b. False
16. Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock’s market price equal
its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal
investor equal this investor’s required return? If either of these conditions, but not necessarily both, holds, then the stock is
said to be in equilibrium.
a. True
b. False
17. 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, its standard deviation.
a. True
b. False
Chapter 06: Risk and Return
18. “Risk aversion” implies that investors require higher expected returns on riskier than on less risky securities.
a. True
b. False
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 low standard
deviation.
a. True
b. False
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
Chapter 06: Risk and Return
21. A stock’s beta measures its diversifiable risk relative to the diversifiable risks of other firms.
a. True
b. False
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
23. If the returns of two firms are negatively correlated, then one of them must have a negative beta.
a. True
b. False
Chapter 06: Risk and Return
24. A stock with a beta equal to −1.0 has zero systematic (or market) risk.
a. True
b. False
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
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 06: Risk and Return
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
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
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
Chapter 06: Risk and Return
Boom 0.2 30% −10%
Normal 0.6 10% 5%
Recession 0.2 −5% 50%
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
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
Chapter 06: Risk and Return
32. We would generally find that the beta of a single security is more stable over time than the beta of a diversified
portfolio.
a. True
b. False
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
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
Chapter 06: Risk and Return
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
b. False
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
37. A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.
a. True
Chapter 06: Risk and Return
b. False
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
39. The slope of the SML is determined by the value of beta.
a. True
b. False
Chapter 06: Risk and Return
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
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
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
Chapter 06: Risk and Return
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
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
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
Chapter 06: Risk and Return
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
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
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
Chapter 06: Risk and Return
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
50. If markets are in equilibrium, which of the following conditions will exist?
a. Each stock’s expected return should equal its required return as seen by the marginal investor.
b. All stocks should have the same expected return as seen by the marginal investor.
c. The expected and required returns on stocks and bonds should be equal.
d. All stocks should have the same realized return during the coming year.
e. Each stock’s expected return should equal its realized return as seen by the marginal investor.
Chapter 06: Risk and Return
51. You are considering investing in one of the these three stocks:
Stock Standard Deviation Beta
A 20% 0.59
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; B.
b. B; A.
c. C; A.
d. C; B.
e. A; A.
52. Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly
risk averse and has asked for your advice. 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. Stock A.
b. Stock B.
c. Neither A nor B, as neither has a return sufficient to compensate for risk.
d. Add A, since its beta must be lower.
e. Either A or B, i.e., the investor should be indifferent between the two.
Chapter 06: Risk and Return
53. Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?
a. 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.
b. The beta of an “average stock,” or “the market,” can change over time, sometimes drastically.
c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because
conditions have changed.
d. All of the statements above are true.
e. The fact that a security or project may not have a past history that can be used as the basis for calculating beta.
54. Stock A’s beta is 1.7 and Stock B’s beta is 0.7. Which of the following statements must be true about these securities?
(Assume market equilibrium.)
a. Stock B must be a more desirable addition to a portfolio than A.
b. Stock A must be a more desirable addition to a portfolio than B.
c. The expected return on Stock A should be greater than that on B.
d. The expected return on Stock B should be greater than that on A.
e. When held in isolation, Stock A has more risk than Stock B.