Chapter 2: Discussion Questions and Problems
1. Differentiate the following terms/concepts:
a. Systematic and nonsystematic risk
Nondiversifiable or systematic risk is risk that is common to all risky assets in the system
b. Beta and standard deviation
c. Direct and indirect agency costs
Agency costs arise when managers’ incentives are not consistent with maximizing the
d. Weak, semi-strong, and strong form market efficiency
With weak form market efficiency prices reflect all the information contained in historical
2. A stock has a beta of 1.2 and the standard deviation of its returns is 25%. The
market risk premium is 5% and the risk-free rate is 4%.
a. What is the expected return for the stock?
b. What are the expected return and standard deviation for a portfolio that
is equally invested in the stock and the risk-free asset?
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c. A financial analyst forecasts a return of 12% for the stock. Would you
buy it? Why or why not?
3. What is the joint hypothesis problem? Why is it important?
If when testing one hypothesis another must be assumed to hold, a joint-hypothesis
4. Warren Buffett has been a very successful investor. In 2008 Luisa Kroll
reported that Buffett topped Forbes Magazine’s list of the world’s richest people
with a fortune estimated to be worth $62 billion (March 5, 2008, “The world’s
billionaires,” Forbes). Does this invalidate the EMH?
5. You are considering whether to invest in two stocks, Stock A and Stock B.
Stock A has a beta of 1.15 and the standard deviation of its returns has been
estimated to be 0.28. For Stock B, the beta is 0.84 and standard deviation is 0.48.
a. Which stock is riskier?
b. If the risk-free rate is 4% and the market risk premium is 8%, what is
the expected return for a portfolio that is composed of 60% A and 40%
B?
c. If the correlation between the returns of A and B is 0.50, what is the
standard deviation for the portfolio that includes 60% A and 40% B?
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