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Exam 6: Risk and Return

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Question 1

Multiple Choice

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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 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.

F) A) and D)
G) All of the above

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Question 2

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Nystrand Corporation's stock has an expected return of 12.25%,a beta of 1.25,and is in equilibrium.If the risk-free rate is 5.00%,what is the market risk premium?

A) 5.80%
B) 5.95%
C) 6.09%
D) 6.25%
E) 6.40%

F) A) and B)
G) C) and E)

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Question 3

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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.

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.

If the returns of two firms are negatively correlated,then one of them must have a negative beta.

Diversification will normally reduce the riskiness of a portfolio of stocks.

Stock A has a beta = 0.8,while Stock B has a beta = 1.6.Which of the following statements is CORRECT?

Assume that your cousin holds just one stock,Eastman Chemical Bonding (ECB) ,which he thinks has very little risk.You agree that the stock is relatively safe,but you want to demonstrate that his risk would be even lower if he were more diversified.You obtain the following returns data for Wilder's Creations and Buildings (WCB) .Both companies have had less variability than most other stocks over the past 5 years.Measured by the standard deviation of returns,by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula. ) Year ECB WCB 2011 40) 00% 40) 00% 2012 −10) 00% 15) 00% 2013 35) 00% −5) 00% 2014 −5) 00% −10) 00% 2015 15) 00% 35) 00% Average return = 15) 00% 15) 00% Standard deviation = 22) 64% 22) 64%

Stuart Company's manager believes that economic conditions during the next year will be strong,normal,or weak,and she thinks that the firm's returns will have the probability distribution shown below.What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population,not a sample. ) Economic Conditions Prob. Return Strong 30% 32) 0% Normal 40% 10) 0% Weak 30% −16) 0%

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.

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?

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. )

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.

Which of the following statements is CORRECT?

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.

Donald Gilmore has $100,000 invested in a 2-stock portfolio.$35,000 is invested in Stock X and the remainder is invested in Stock Y.X's beta is 1.50 and Y's beta is 0.70.What is the portfolio's beta?

Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8.The risk-free rate is 6% and the market risk premium is 5%.Which of the following statements is CORRECT?

Megan Ross holds the following portfolio: Stock Investment Beta A $150,000 1) 40 B 50,000 0) 80 C 100,000 1) 00 D 75,000 1) 20 Total $375,000 What is the portfolio's beta?

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.

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?