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Chapter 08: Analysis of Risk and Return
Multiple Choice
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
c
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
a
5. The slope of the characteristic line for a specific security is an estimate of ____ for that security.
a.
alpha
b.
beta
c.
total risk
d.
relative risk
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
c
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Chapter 08: Analysis of Risk and Return
7. The possibility that actual returns will deviate from expected returns is known as ____.
a.
risk
b.
interest
c.
beta
d.
standard deviation
a
8. Values of the ____ can range from +1.0 to –1.0.
a.
coefficient of variation
b.
correlation coefficient
c.
standard deviation
d.
covariance
b
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
c
10. The expected value of one roll of a standard six-sided die is ____.
a.
6
b.
3
c.
3.5
d.
4
c
11. Security A’s expected return is 10%, while the expected return of B is 14%. The standard deviation of A’s returns is
5%, and it is 9% 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%.
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.
d
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
b
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Chapter 08: Analysis of Risk and Return
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
anticipated 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
c
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 are correct
a
16. A beta value of 0.5 for a security indicates that the security has ____.
a.
average systematic risk
b.
above-average systematic risk
c.
no unsystematic risk
d.
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 the best estimate of an asset’s future beta
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Chapter 08: Analysis of Risk and Return
d.
All of these are correct
d
19. 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
b
20. Systematic risk ____.
a.
cannot be mitigated via diversification
b.
can be mitigated via diversification
c.
is unique to each firm
d.
is affected by factors such as strikes
a
21. 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
c
22. 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
c
23. The risk remaining after extensive diversification is primarily ____.
a.
unsystematic risk
b.
systematic risk
c.
coefficient of variation risk
d.
standard deviation risk
b
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
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Chapter 08: Analysis of Risk and Return
d
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.
c
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.
security’s covariance divided by the variance of the market
b
27. The risk-free rate of return can be thought of as consisting of ____ and ____.
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.
It will shift up and have a steeper slope.
b.
It will shift down and have the same slope.
c.
It will shift down and have a steeper slope.
d.
It will shift up but have less slope.
a
29. Unsystematic risk ____.
a.
is caused by factors affecting the market as a whole
b.
is the predominant determinant of individual security risk premium
c.
cannot be mitigated via diversification
d.
can be mitigated via diversification
d
30. What is the standard deviation of {5, 5, 5, 5, 5}?
a.
2.5
b.
5
c.
1
d.
0
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Chapter 08: Analysis of Risk and Return
31. A set of numbers that is ____ will have a ____ standard deviation.
a.
perfectly consistent; nonzero
b.
inconsistent; low
c.
consistent; high
d.
consistent; low
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 which of the following is true?
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.
For a given expected return, the correlation coefficient is equal to +1.0.
d.
All of these are correct.
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; greater than
c.
greater than –1.0; less than
d.
None of these are correct
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 are correct
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 these are correct
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Chapter 08: Analysis of Risk and Return
a
37. Empirical studies of the Capital Asset Pricing Model have produced ____ results.
a.
universally adoring
b.
mixed
c.
mostly negative
d.
mostly positive
38. A ____ probability distribution assigns probabilities to a limited number of outcomes.
a.
discrete
b.
continuous
c.
lazy
d.
systematic
a
39. The security returns from multinational companies tend to have ____ systematic risk than those of domestic
companies.
a.
more
b.
less options with
c.
less
d.
neither more nor less
40. An important risk dimension other than variability of returns that motivates investors is ____.
a.
standard deviation
b.
beta
c.
risk of failure
d.
coefficient of variation
c
41. Investors can obtain high returns in their investments if they ____.
a.
use hedging techniques
b.
assume high risks
c.
invest only international securities
d.
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
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Chapter 08: Analysis of Risk and Return
43. 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.
MacGuffin
b.
market segmentation
c.
expectations
d.
liquidity premium
44. The maturity premium reflects a preference by many lenders for ____.
a.
shorter maturities
b.
reducing yields
c.
high yield securities
d.
longer maturities
a
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
c
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
c
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 ____ risk premium.
a.
maturity
b.
default
c.
seniority
d.
financial
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 ____ risk.
a.
financial
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Chapter 08: Analysis of Risk and Return
b.
marketability
c.
business
d.
security
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 ____ risk premium.
a.
default
b.
seniority
c.
marketability
d.
maturity
51. The ____ theory holds that the securities markets are demarcated by maturity.
a.
boondoggle
b.
liquidity premium
c.
expectations
d.
market segmentation
52. The expectations, liquidity premium, and market segmentation theories all attempt to ____.
a.
account for the differences between systematic and unsystematic risks in the securities market
b.
define investors’ required rates of return
c.
predict the values of effective interest rates
d.
explain the shape of the yield curve
53. Common stockholders require a higher rate of return than do holders of Aaa-rated bonds. This reflects which type of
risk premium?
a.
maturity
b.
default
c.
seniority
d.
marketability
c
54. The ____ theory of the yield curve takes into account the supply and demand interactions between buyers and lenders
of securities.
a.
expectations
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Chapter 08: Analysis of Risk and Return
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
a
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
c
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
Rate of Return
Probability
$16
–20%
0.25
$20
0%
0.30
$24
+20%
0.25
$28
+40%
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%
a
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
Rate of Return
Probability
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Chapter 08: Analysis of Risk and Return
$16
–20%
0.25
$20
0%
0.30
$24
+20%
0.25
$28
+40%
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.
45.6%
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
Rate of Return
Probability
$16
–20%
0.25
$20
0%
0.30
$24
+20%
0.25
$28
+40%
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
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
a
63. Elephant Company common stock has a beta of 1.2. The risk-free rate is 6%, and the expected market rate of return is
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Chapter 08: Analysis of Risk and Return
12%. 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% of her funds in the common stock of Gamma Industries and 25% in Epsilon
Company. The expected return on Gamma is 12%, and the expected return on Epsilon is 16%. The standard deviation of
returns for Gamma is 8% and for Epsilon is 12%. 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%
c
65. An investor plans to invest 75% of her funds in the common stock of Gamma Industries and 25% in Epsilon
Company. The expected return on Gamma is 12%, and the expected return on Epsilon is 16%. The standard deviation of
returns for Gamma is 8% and for Epsilon is 12%. 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 0.8.
a.
10.8%
b.
4.8%
c.
48.0%
d.
16.8%
67. The return expected from a risky investment is 24%, and the standard deviation of this return is 17%. 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%