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CHAPTER 2

RISK AND RETURN: PART I


(Difficulty: E = Easy, M = Mediu, a!d T = T"u#$%
T&ue'(alse
Easy:
(2.2) Payoff matrix Answer: a Diff: E
1
. If we develop a weighted average of the possible return outcomes,
multiplying each outcome or "state" by its respective probability of
occurrence for a particular stock, we can construct a payoff matrix of
expected returns.
a. True
b. False
(2.2) Standard deviation Answer: a Diff: E

. The tighter the probability distribution of expected future returns, the


smaller the risk of a given investment as measured by the standard
deviation.
a. True
b. False
(2.2) Coefficient of variation Answer: a Diff: E
!
. The coefficient of variation, calculated as the standard deviation
divided by the expected return, is a standardi"ed measure of the risk
per unit of expected return.
a. True
b. False
(2.2) Risk comparisons Answer: a Diff: E
#
. The coefficient of variation is a better measure of risk than the
standard deviation if the expected returns of the securities being
compared differ significantly.
a. True
b. False
(2.) Risk and expected ret!rn Answer: a Diff: E
$
. %ompanies should deliberately increase their risk relative to the market
only if the actions that increase the risk also increase the expected
rate of return on the firm&s assets by enough to completely compensate
for the higher risk.
a. True
b. False
Chapter 2: Risk and Return: Part I Page 1
(2.2) Risk aversion Answer: a Diff: E
'
. (hen investors re)uire higher rates of return for investments that
demonstrate higher variability of returns, this is evidence of risk
aversion.
a. True
b. False
(2.) CAP" and risk Answer: a Diff: E
*
. +ne key result of applying the %apital ,sset -ricing .odel is that the
risk and return of an individual security should be analy"ed by how that
security affects the risk and return of the portfolio in which it is
held.
a. True
b. False
(2.) CAP" and risk Answer: a Diff: E
/
. ,ccording to the %apital ,sset -ricing .odel, investors are primarily
concerned with portfolio risk, not the isolated risks of individual
stocks. Thus, the relevant risk is an individual stock&s contribution
to the overall riskiness of the portfolio.
a. True
b. False
(2.) Portfo#io risk Answer: $ Diff: E
0
. (hen adding new securities to an existing portfolio, the higher or more
positive the degree of correlation between the new securities and those
already in the portfolio, the greater the benefits of the additional
portfolio diversification.
a. True
b. False
(2.) Portfo#io risk Answer: $ Diff: E
11
. -ortfolio diversification reduces the variability of the returns on each
security held in the portfolio.
a. True
b. False
(2.) Portfo#io ret!rn Answer: $ Diff: E
11
. The reali"ed portfolio return is the weighted average of the relative
weights of securities in the portfolio multiplied by their respective
expected returns.
a. True
b. False
Page 2 Chapter 2: Risk and Return: Part 1
(2.) "arket risk Answer: a Diff: E
1
. .arket risk refers to the tendency of a stock to move with the general
stock market. , stock with above2average market risk will tend to be
more volatile than an average stock, and it will definitely have a beta
which is greater than 1.1.
a. True
b. False
(2.) "arket risk Answer: $ Diff: E
1!
. 3iversifiable risk, which is measured by beta, can be lowered by adding
more stocks to a portfolio.
a. True
b. False
(2.) %eta coefficient Answer: a Diff: E
1#
. , security&s beta measures its nondiversifiable 4or market5 risk
relative to that of most other securities.
a. True
b. False
(2.) %eta coefficient Answer: a Diff: E
1$
. , stock&s beta is more relevant as a measure of risk to an investor with
a well2diversified portfolio than to an investor who holds only one
stock.
a. True
b. False
(2.) C&an'es in $eta Answer: $ Diff: E
1'
. , firm cannot change its beta through any managerial decision because
betas are completely market determined.
a. True
b. False
(2.() Re)!ired ret!rn Answer: $ Diff: E
1*
. The re)uired return on a firm&s common stock is determined by the firm&s
market risk. If its market risk is known, and if it is expected to
remain constant, the analyst has sufficient information to specify the
firm&s re)uired return.
a. True
b. False
(2.() S"* Answer: $ Diff: E
1/
. The slope of the 6.7 is determined by the value of beta.
a. True
b. False
Chapter 2: Risk and Return: Part I Page 3
(2.() S"* and risk aversion Answer: a Diff: E
10
. If investors become more averse to risk, the slope of the 6ecurity
.arket 7ine 46.75 will increase.
a. True
b. False
(Comp: 2.+ 2.() P&ysica# assets Answer: a Diff: E
1
. 8usinesses earn returns for security holders by purchasing and operating
physical assets. The relevant risk of any physical asset must be
measured in terms of its effect on the risk of the firm&s securities.
a. True
b. False
Medium:
(2.2) ,ariance Answer: $ Diff: "
1
. 9ariance is a measure of the variability of returns and since it
involves s)uaring each deviation of the re)uired return from the
expected return, it is always larger than its s)uare root, the standard
deviation.
a. True
b. False
(2.2) Expected ret!rn Answer: a Diff: "

. If the expected rate of return for a particular investment, as seen by


the marginal investor, exceeds its re)uired rate of return, we should
soon observe an increase in demand for the investment, and the price
will likely increase until a price is established that e)uates the
expected return with the re)uired return.
a. True
b. False
(2.2) Coefficient of variation Answer: $ Diff: "
!
. 8ecause of differences in the expected returns of different securities,
the standard deviation is not always an ade)uate measure of risk.
:owever, the coefficient of variation will always allow an investor to
properly compare the relative risks of any two securities.
a. True
b. False
(2.2) Risk aversion Answer: $ Diff: "
#
. ;isk aversion implies that some securities will go unpurchased in the
market even if a large risk premium is paid to investors.
a. True
b. False
Page 4 Chapter 2: Risk and Return: Part 1
(2.2) Risk premi!m and risk aversion Answer: a Diff: "
$
. ;isk aversion is a general dislike for risk and a preference for
certainty. That is, investors would be willing to give up a risk
premium of return in order to obtain a lower return with certainty.
a. True
b. False
(2.) Portfo#io risk Answer: a Diff: "
'
. -ortfolio , has but one security, while -ortfolio 8 has 111 securities.
8ecause of diversification effects, we would expect -ortfolio 8 to have
the lower relevant risk, but it is possible for -ortfolio , to be less
risky.
a. True
b. False
(2.) Portfo#io risk Answer: $ Diff: "
*
. -ortfolio , has but one security, while -ortfolio 8 has 111 securities.
8ecause of diversification, we know that -ortfolio 8 will have the lower
market risk< that is, -ortfolio 8 will have the lower beta.
a. True
b. False
(2.) Red!cin' portfo#io risk Answer: a Diff: "
/
. (hile the portfolio return is a weighted average of reali"ed security
returns, portfolio risk is not necessarily a 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
actually reduce the riskiness of a portfolio.
a. True
b. False
(2.) Portfo#io risk and ret!rn Answer: $ Diff: "
0
. The distributions of rates of return for %ompanies ,, and 88 are given
below=
6tate of -robability of
>conomy 6tate +ccurring ,, 88
8oom 1. !1? 211?
@ormal 1.' 11 $
;ecession 1. 2$ $1
(e can conclude from the above information that any rational risk2averse
investor will add 6ecurity ,, to a well2diversified portfolio over
6ecurity 88.
a. True
b. False
Chapter 2: Risk and Return: Part I Page 5
(2.) Corre#ation coefficient and risk Answer: $ Diff: "
!1
. >ven if the correlation between the returns on two different securities
is perfectly positive, if the securities are combined in the correct
unequal proportions, the resulting portfolio can have less risk than
either security held alone.
a. True
b. False
(2.) Company-specific risk Answer: $ Diff: "
!1
. (hen a firm makes bad managerial Audgements or has unforeseen negative
events happen to it that affect its returns, these random events are
unpredictable and therefore cannot be diversified away by the investor.
a. True
b. False
(2.) Portfo#io risk and $eta Answer: $ Diff: "
!
. If I know for sure that the market will have a positive return over the
next year, to maximi"e my rate of return, I should increase the beta of
my portfolio.
a. True
b. False
(2.) %eta coefficient Answer: a Diff: "
!!
. , portfolio with a beta of minus has the same degree of risk to its
holder, relative to the market, as a portfolio with a beta of plus .
:owever, the holder of either portfolio could lower his or her risk
exposure by buying some "normal" stocks.
a. True
b. False
(2.) Portfo#io $eta Answer: a Diff: "
!#
. (e will generally find that the beta of a diversified portfolio is more
stable over time than the beta of a single security.
a. True
b. False
(2.) C&an'es in $eta Answer: a Diff: "
!$
. ,ny change in beta is likely to affect the re)uired rate of return on a
security, which implies that a change in beta will likely have an impact
on the security&s price.
a. True
b. False
Page 6 Chapter 2: Risk and Return: Part 1
(2.) Diversification effects Answer: a Diff: "
!'
. If an investor buys enough stocks, he or she can, through diversifica2
tion, eliminate all of the non2market risk inherent in owning stocks,
but as a general rule it will not be possible to eliminate all market
risk.
a. True
b. False
(2.()CAP" Answer: a Diff: "
!*
. The %,-. is built on expected conditions, although we are limited in
most cases to using past data in applying it. 8etas used in the %,-.,
calculated using historical data, are always subAect to changes in
future volatility and this is a limitation on the use of the %,-..
a. True
b. False
(2.() CAP" and inf#ation Answer: $ Diff: "
!/
. If the price of money increases due to greater anticipated inflation,
the risk2free rate will reflect this fact. ,lthough r
;F
will increase,
it is possible that the 6.7 re)uired rate of return for a stock will
decrease because the market risk premium 4r
.
2 r
;F
5 will decrease.
4,ssume that beta remains constant.5
a. True
b. False
(2.() "arket risk premi!m Answer: a Diff: "
!0
. 6ince the market return represents the return on an average stock, that
return carries risk with it. ,s a result, there exists a market risk
premium which is the amount over and above the risk2free rate that is
re)uired to compensate an investor for assuming an average amount of
risk.
a. True
b. False
(2.() S"* Answer: a Diff: "
#1
. If you plotted the returns of a given stock against those of the market,
and if you found that the slope of the regression line was negative, the
%,-. would indicate that the re)uired rate of return on the stock should
be less than the risk2free rate for a well2diversified investor,
assuming that the observed relationship is expected to continue into the
future.
a. True
b. False
Chapter 2: Risk and Return: Part I Page 7
(2.() S"* Answer: $ Diff: "
#1
. The B2axis intercept of the 6.7 indicates the return on the individual
asset when the reali"ed return on an average stock 4beta C 1.15 is "ero.
a. True
b. False
Multi)le C$"ice: C"!ce)tual
Easy:
(2..) Risk concepts Answer: e Diff: E
#
. (hich of the following statements is most correctD
a. ;isk refers to the chance that some unfavorable event will occur, and
a probability distribution is completely described by a listing of
the likelihood of unfavorable events.
b. -ortfolio diversification reduces the variability of returns on an
individual stock.
c. (hen company2specific risk has been diversified, the inherent risk
that remains is market risk which is constant for all securities in
the market.
d. , stock with a beta of 21.1 has "ero market risk.
e. The 6.7 relates re)uired returns to firms& market risk. The slope
and intercept of this line cannot be controlled by the financial
manager.
(2.2) Risk meas!res Answer: a Diff: E
#!
. Bou observe the following information regarding %ompany E and %ompany B=
%ompany E has a higher expected mean return than %ompany B.
%ompany E has a lower standard deviation than %ompany B.
%ompany E has a higher beta than %ompany B.
Fiven this information, which of the following statements is most
correctD
a. %ompany E has a lower coefficient of variation.
b. %ompany E has more company2specific risk.
c. %ompany E is a better stock to buy.
d. 6tatements a and b are correct.
e. 6tatements a, b, and c are correct.
Page 8 Chapter 2: Risk and Return: Part 1
(2.) Portfo#io risk and ret!rn Answer: a Diff: E
##
. 6tock , and 6tock 8 each have an expected return of 1$ percent, a
standard deviation of 1 percent, and a beta of 1.. The returns of the
two stocks are not perfectly correlated< the correlation coefficient is
1.'. Bou have put together a portfolio which is $1 percent 6tock , and
$1 percent 6tock 8. (hich of the following statements is most correctD
a. The portfolioGs expected return is 1$ percent.
b. The portfolioGs beta is less than 1..
c. The portfolioGs standard deviation is 1 percent.
d. 6tatements a and b are correct.
e. ,ll of the statements above are correct.
(Comp: 2.+ 2.() %eta coefficient Answer: d Diff: E
#$
. 6tock , has a beta of 1.$ and 6tock 8 has a beta of 1.$. (hich of the
following statements must be true about these securitiesD 4,ssume the
market is in e)uilibrium.5
a. (hen held in isolation, 6tock , has greater risk than 6tock 8.
b. 6tock 8 would be a more desirable addition to a portfolio than 6tock
,.
c. 6tock , would be a more desirable addition to a portfolio than 6tock
8.
d. The expected return on 6tock , will be greater than that on 6tock 8.
e. The expected return on 6tock 8 will be greater than that on 6tock ,.
(2.() S"* Answer: a Diff: E
#'
. (hich of the following statements is incorrectD
a. The slope of the security market line is measured by beta.
b. Two securities with the same stand2alone risk can have different
betas.
c. %ompany2specific risk can be diversified away.
d. The market risk premium is affected by attitudes about risk.
e. :igher beta stocks have a higher re)uired return.
(2.() S"*
Answer: $ Diff: E
#*
. (hich of the following statements is most correctD
a. The slope of the security market line is beta.
b. The slope of the security market line is the market risk premium,
4r
.
H r
;F
5.
c. If you double a companyGs beta its re)uired return more than doubles.
d. 6tatements a and c are correct.
e. 6tatements b and c are correct.
Chapter 2: Risk and Return: Part I Page 9
(2.() S"* Answer: c Diff: E
#/
. 6tock , has a beta of 1. and a standard deviation of 1 percent. 6tock
8 has a beta of 1./ and a standard deviation of $ percent. -ortfolio -
is a I11,111 portfolio consisting of I111,111 invested in 6tock , and
I111,111 invested in 6tock 8. (hich of the following statements is most
correctD 4,ssume that the re)uired return is determined by the 6ecurity
.arket 7ine.5
a. 6tock 8 has a higher re)uired rate of return than stock ,.
b. -ortfolio - has a standard deviation of .$ percent.
c. -ortfolio - has a beta e)ual to 1.1.
d. 6tatements a and b are correct.
e. 6tatements a and c are correct.
(2.() S"*+ CAP"+ and $eta Answer: e Diff: E
#0
. (hich of the following statements is most correctD
a. The slope of the security market line is beta.
b. , stock with a negative beta must have a negative re)uired rate of
return.
c. If a stockGs beta doubles its re)uired rate of return must double.
d. If a stock has a beta e)ual to 1.1, its re)uired rate of return will
be unaffected by changes in the market risk premium.
e. @one of the above statements is correct.
(2.() Risk ana#ysis and portfo#io diversification Answer: d Diff: E
$1
. (hich of the following statements is most correctD
a. -ortfolio diversification reduces the variability of the returns on
the individual stocks held in the portfolio.
b. If an investor buys enough stocks, he or she can, through
diversification, eliminate virtually all of the nonmarket 4or
company2specific5 risk inherent in owning stocks. Indeed, if the
portfolio contained all publicly traded stocks, it would be riskless.
c. The re)uired return on a firm&s common stock is determined by its
systematic 4or market5 risk. If the systematic risk is known, and if
that risk is expected to remain constant, then no other information
is re)uired to specify the firm&s re)uired return.
d. , security&s beta measures its nondiversifiable 4systematic, or
market5 risk relative to that of an average stock.
e. , stock&s beta is less relevant as a measure of risk to an investor
with a well2diversified portfolio than to an investor who holds only
that one stock.
Page 10 Chapter 2: Risk and Return: Part 1
Medium:
(2.2) "arket e)!i#i$ri!m Answer: a Diff: "
$1
. For markets to be in e)uilibrium, that is, for there to be no strong
pressure for prices to depart from their current levels,
a. The expected rate of return must be e)ual to the re)uired rate of
return< that is,
r
C r.
b. The past reali"ed rate of return must be e)ual to the expected rate
of return< that is, r C
r
.
c. The re)uired rate of return must e)ual the reali"ed rate of return<
that is, r C
r
.
d. ,ll three of the statements above must hold for e)uilibrium to exist<
that is,
r
C r C
r
.
e. @one of the statements above is correct.
(2.) Risk aversion Answer: $ Diff: "
$
. Bou have developed the following data on three stocks=
6tock 6tandard 3eviation 8eta
, 1.1$ 1.*0
8 1.$ 1.'1
% 1.1 1.0
If you are a risk minimi"er, you should choose 6tock JJJJJ if it is to
be held in isolation and 6tock JJJJJ if it is to be held as part of a
well2diversified portfolio.
a. ,< ,
b. ,< 8
c. 8< ,
d. %< ,
e. %< 8
(2.) Portfo#io risk and ret!rn Answer: c Diff: "
$!
. In a portfolio of three different stocks, which of the following could
not be trueD
a. The riskiness of the portfolio is less than the riskiness of each of
the stocks if they were held in isolation.
b. The riskiness of the portfolio is greater than the riskiness of one
or two of the stocks.
c. The beta of the portfolio is less than the beta of each of the
individual stocks.
d. The beta of the portfolio is greater than the beta of one or two of
the individual stocks& betas.
e. @one of the above 4that is, they all could be true, but not
necessarily at the same time5.
Chapter 2: Risk and Return: Part I Page 11
(2.) Portfo#io risk Answer: e Diff: "
$#
. (hich of the following statements is most correctD
a. .arket participants are able to eliminate virtually all market risk
if they hold a large diversified portfolio of stocks.
b. .arket participants are able to eliminate virtually all company2
specific risk if they hold a large diversified portfolio of stocks.
c. It is possible to have a situation where the market risk of a single
stock is less than that of a well diversified portfolio.
d. ,nswers a and c are correct.
e. ,nswers b and c are correct.
(2.) Portfo#io risk and $eta Answer: e Diff: "
$$
. (hich of the following statements is most correctD
a. If you add enough randomly selected stocks to a portfolio, you can
completely eliminate all the market risk from the portfolio.
b. If you formed a portfolio which included a large number of low beta
stocks 4stocks with betas less than 1.1 but greater than 21.15, the
portfolio would itself have a beta coefficient that is e)ual to the
weighted average beta of the stocks in the portfolio, so the
portfolio would have a relatively low degree of risk.
c. If you were restricted to investing in publicly traded common stocks,
yet you wanted to minimi"e the riskiness of your portfolio as
measured by its beta, then, according to the %,-. theory, you should
invest some of your money in each stock in the market, i.e., if there
were 11,111 traded stocks in the world, the least risky portfolio
would include some shares in each of them.
d. 3iversifiable risk can be eliminated by forming a large portfolio,
but normally even highly diversified portfolios are subAect to market
risk.
e. 6tatements b and d are correct.
(2.) Portfo#io diversification Answer: c Diff: "
$'
. Kane holds a large diversified portfolio of 111 randomly selected stocks
and the portfolioGs beta C 1.. >ach of the individual stocks in her
portfolio has a standard deviation of 1 percent. Kack has the same
amount of money invested in a single stock with a beta e)ual to 1.' and
a standard deviation of 1 percent. (hich of the following statements
is most correctD
a. KaneGs portfolio has a larger amount of company2specific risk since
she is holding more stocks in her portfolio.
b. Kane has a higher re)uired rate of return, since she is more
diversified.
c. KaneGs portfolio has less market risk since it has a lower beta.
d. 6tatements b and c are correct.
e. @one of the statements above is correct.
Page 12 Chapter 2: Risk and Return: Part 1
(2.) "arket risk Answer: $ Diff: "
$*
. Inflation, recession, and high interest rates are economic events which
are characteri"ed as
a. %ompany2specific risk that can be diversified away.
b. .arket risk.
c. 6ystematic risk that can be diversified away.
d. 3iversifiable risk.
e. Lnsystematic risk that can be diversified away.
(2.) Risk ana#ysis and portfo#io diversification Answer: e Diff: "
$/
. (hich of the following statements is most correctD
a. If you add enough randomly selected stocks to a portfolio, you can
completely eliminate all the market risk from the portfolio.
b. If you form a large portfolio of stocks each with a beta greater
than 1.1, this portfolio will have more market risk than a single
stock with a beta C 1./.
c. %ompany2specific 4or unsystematic5 risk can be reduced by forming a
large portfolio, but normally even highly diversified portfolios are
subAect to market 4or systematic5 risk.
d. ,nswers a, b, and c are correct.
e. ,nswers b and c are correct.
(2./) %eta coefficient Answer: a Diff: "
$0
. (hich of the following statements is most correctD
a. The beta coefficient of a stock is normally found by running a
regression of past returns on the stock against past returns on a
stock market index. +ne 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.
b. It is theoretically possible for a stock to have a beta of 1.1. If a
stock did have a beta of 1.1, then, at least in theory, its re)uired
rate of return would be e)ual to the riskless 4default2free5 rate of
return, r
;F
.
c. If you found a stock with a "ero beta and held it as the only stock
in your portfolio, you would by definition have a riskless portfolio.
Bour 12stock portfolio would be even less risky if the stock had a
negative beta.
d. The beta of a portfolio of stocks is always larger than the betas of
any of the individual stocks.
e. ,ll of the statements above are true.
Chapter 2: Risk and Return: Part I Page 13
(2./) %eta coefficient Answer: a Diff: "
'1
. (hich of the following statements is most correctD
a. 6uppose the returns on two stocks are negatively correlated. +ne has
a beta of 1. as determined in a regression analysis, while the other
has a beta of 21.'. The returns on the stock with the negative beta
will be negatively correlated with returns on most other stocks in
the market.
b. 6uppose you are managing a stock portfolio, and you have information
which leads you to believe that the stock market is likely to be very
strong in the immediate future, i.e., you are confident that the
market is about to rise sharply. Bou should sell your high beta
stocks and buy low beta stocks in order to take advantage of the
expected market move.
c. %ollections Inc. is in the business of collecting past2due accounts
for other companies, i.e., it is a collection agency. %ollections&
revenues, profits, and stock price tend to rise during recessions.
This suggests that %ollections Inc.&s beta should be )uite high, say
.1, because it does so much better than most other companies when
the economy is weak.
d. 6tatements a and b are true.
e. 6tatements a and c are true.
(2./) %eta coefficient Answer: d Diff: "
'1
. Bou have developed data which give 415 the average annual returns on the
market for the past five years, and 45 similar information on 6tocks ,
and 8. If these data are as follows, which of the possible answers best
describes the historical betas for , and 8D
Bears .arket 6tock , 6tock 8
1 1.1! 1.1' 1.1$
21.1$ 1.1 1.1$
! 1.11 1.1/ 1.1$
# 21.11 1.$ 1.1$
$ 1.1' 1.1# 1.1$
a. b
,
M 1< b
8
C 1
b. b
,
M N1< b
8
C 1
c. b
,
C 1< b
8
C 21
d. b
,
O 1< b
8
C 1
e. b
,
O 21< b
8
C 1
Page 14 Chapter 2: Risk and Return: Part 1
(2./) %eta coefficient Answer: c Diff: "
'
. (hich of the following is not a difficulty concerning beta and its
estimationD
a. 6ometimes a security or proAect does not have a past history which
can be used as a basis for calculating beta.
b. 6ometimes, 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 than the "true" or "expected future"
beta.
c. The beta of an "average stock," or "the market," can change over
time, sometimes drastically.
d. 6ometimes the past data used to calculate beta do not reflect the
likely risk of the firm for the future because conditions have
changed.
(2.() Portfo#io risk and $eta Answer: c Diff: "
'!
. 6tock , has a beta C 1./, while 6tock 8 has a beta C 1.'. (hich of the
following statements is most correctD
a. 6tock 8Gs re)uired return is double that of 6tock ,Gs.
b. ,n e)ually weighted portfolio of 6tock , and 6tock 8 will have a beta
less than 1..
c. If market participants become more risk averse, the re)uired return
on 6tock 8 will increase more than the re)uired return for 6tock ,.
d. ,ll of the answers above are correct.
e. ,nswers a and c are correct.
(2.() S"* and risk aversion Answer: e Diff: "
'#
. ,ssume that investors become increasingly risk averse, so that the
market risk premium increases. ,lso, assume that the risk2free rate and
expected inflation remain the same. (hich of the following is most
likely to occurD
a. The re)uired rate of return will decline for stocks that have betas
less than 1.1.
b. The re)uired rate of return on the market, r
.
will remain the same.
c. The re)uired rate of return for each stock in the market will
increase by an amount e)ual to the increase in the market risk
premium.
d. ,nswers a and b are correct.
e. @one of the statements above is correct.
Chapter 2: Risk and Return: Part I Page 15
(2.() Portfo#io ret!rn Answer: $ Diff: "
'$
. The risk2free rate, r
;F
, is ' percent and the market risk premium, 4r
.
H
r
;F
5, is $ percent. ,ssume that re)uired returns are based on the %,-..
Bour I1 million portfolio consists of I*11,111 invested in a stock that
has a beta of 1. and I!11,111 invested in a stock that has a beta of
1./. (hich of the following statements is most correctD
a. The portfolioGs re)uired return is less than 11 percent.
b. If the risk2free rate remains unchanged but the market risk premium
increases by percentage points, the re)uired return on your
portfolio will increase by more than percentage points.
c. If the market risk premium remains unchanged but expected inflation
increases by percentage points, the re)uired return on your
portfolio will increase by more than percentage points.
d. If the stock market is efficient, your portfolioGs expected return
should e)ual the expected return on the market, which is 11 percent.
e. @one of the above answers is correct.
(2.() S"* Answer: e Diff: "
''
. (hich of the following statements is most correctD
a. The 6.7 relates re)uired returns to firms& market risk. The slope
and intercept of this line cannot be controlled by the financial
manager.
b. The slope of the 6.7 is determined by the value of beta.
c. If you plotted the returns of a given stock against those of the
market, and you found that the slope of the regression line was
negative, the %,-. would indicate that the re)uired rate of return
on the stock should be less than the risk2free rate for a well2
diversified investor, assuming that the observed relationship is
expected to continue on into the future.
d. If investors become less risk averse, the slope of the 6ecurity
.arket 7ine will increase.
e. 6tatements a and c are true.
(2.() S"* Answer: a Diff: "
'*
. +ther things held constant, 415 if the expected inflation rate
decreases, and 45 investors become more risk averse, the 6ecurity
.arket 7ine would shift
a. 3own and have steeper slope.
b. Lp and have less steep slope.
c. Lp and keep same slope.
d. 3own and keep same slope.
e. 3own and have less steep slope.
Page 16 Chapter 2: Risk and Return: Part 1
(2.() S"* Answer: $ Diff: "
'/
. (hich of the following statements is most correct about a stock which
has a beta C 1.D
a. If the stock&s beta doubles its expected return will double.
b. If expected inflation increases ! percent, the stock&s expected
return will increase by ! percent.
c. If the market risk premium increases by ! percent the stock&s
expected return will increase by less than ! percent.
d. ,nswers a, b, and c are correct.
e. ,nswers b and c are correct.
(2.() S"*+ CAP"+ and portfo#io risk Answer: a Diff: "
'0
. (hich of the following statements is most correctD
a. ,n increase in expected inflation could be expected to increase the
re)uired return on a riskless asset and on an average stock by the
same amount, other things held constant.
b. , graph of the 6.7 would show re)uired rates of return on the
vertical axis and standard deviations of returns on the hori"ontal
axis.
c. If two "normal" or "typical" stocks were combined to form a 2stock
portfolio, the portfolio&s expected return would be a weighted
average of the stocks& expected returns, but the portfolio&s
standard deviation would probably be greater than the average of the
stocks& standard deviations.
d. If investors became more averse to risk, then 415 the slope of the
6.7 would increase and 45 the re)uired rate of return on low2beta
stocks would increase by more than the re)uired return on high2beta
stocks.
e. The %,-. has been thoroughly tested, and the theory has been
confirmed beyond any reasonable doubt.
4.$5 Portfo#io ret!rn+ CAP"+ and $eta Answer: e Diff: "
*1
. (hich of the following statements is most correctD
a. If the returns from two stocks are perfectly positively correlated
4i.e., the correlation coefficient is N15 and the two stocks have
e)ual variance, an e)ually weighted portfolio of the two stocks will
have a variance which is less than that of the individual stocks.
b. If a stock has a negative beta, its expected return must be
negative.
c. ,ccording to the %,-., stocks with higher standard deviations of
returns will have higher expected returns.
d. , portfolio with a large number of randomly selected stocks will
have less market risk than a single stock which has a beta e)ual to
1.$.
e. @one of the statements above is correct.
Chapter 2: Risk and Return: Part I Page 17
(2.() CAP" and re)!ired ret!rns Answer: d Diff: "
*1
. (hich of the following statements is most correctD
a. (e would observe a downward shift in the re)uired returns of all
stocks if investors believed that there would be deflation in the
economy.
b. If investors became more risk averse, then the new security market
line would have a steeper slope.
c. If the beta of a company doubles, then the re)uired rate of return
will also double.
d. 8oth statements a and b are correct.
e. ,ll of the statements above are correct.
(2.() Portfo#io risk and S"* Answer: e Diff: "
*
. (hich of the following statements is most correctD
a. It is possible to have a situation where the market risk of a single
stock is less than the market risk of a portfolio of stocks.
b. The market risk premium will increase if, on average, market
participants become more risk averse.
c. If you selected a group of stocks whose returns are perfectly
positively correlated, then you could end up with a portfolio for
which none of the unsystematic risk is diversified away.
d. 6tatements a and b are correct.
e. ,ll of the statements above are correct.
Page 18 Chapter 2: Risk and Return: Part 1
Tough:
(2.() CAP" Answer: c Diff: 0
*!
. (hich of the following statements is most correctD
a. ,ccording to %,-. theory, the re)uired rate of return on a given
stock can be found by use of the 6.7 e)uation=
r
i
C r
;F
N 4r
.
2 r
;F
5b
i
.
>xpectations for inflation are not reflected anywhere in this
e)uation, even indirectly, and because of that the text notes that
the %,-. may not be strictly correct.
b. If the re)uired rate of return is given by the 6.7 e)uation as set
forth in Statement a, there is nothing a financial manager can do to
change his or her company&s cost of capital, because each of the
elements in the e)uation is determined exclusively by the market,
not by the type of actions a company&s management can take, even in
the long run.
c. ,ssume that the re)uired rate of return on the market is currently
r
.
C 1$?, and that r
.
remains fixed at that level. If the yield
curve has a steep upward slope, the calculated market risk premium
would be larger if the !12day T2bill rate were used as the risk2free
rate than if the !12year T2bond rate were used as r
;F
.
d. 6tatements a and b are true.
e. 6tatements a and c are true.
(2.() S"* Answer: d Diff: 0
*#
. (hich of the following statements is most correctD
a. If investors become more risk averse, but r
;F
remains constant, the
re)uired rate of return on high beta stocks will rise, the re)uired
return on low beta stocks will decline, but the re)uired return on
an average risk stock will not change.
b. If .utual Fund , held e)ual amounts of 111 stocks, each of which had
a beta of 1.1, and .utual Fund 8 held e)ual amounts of 11 stocks
with betas of 1.1, then the two mutual funds would both have betas
of 1.1 and thus would be e)ually risky from an investor&s
standpoint.
c. ,n investor who holds Aust one stock will be exposed to more risk
than an investor who holds a portfolio of stocks, assuming the
stocks are all e)ually risky. 6ince the holder of the 12stock
portfolio is exposed to more risk, he or she can expect to earn a
higher rate of return to compensate for the greater risk.
d. ,ssume that the re)uired rate of return on the market, r
.
, is given
and fixed. If the yield curve were upward2sloping, then the
6ecurity .arket 7ine 46.75 would have a steeper slope if 12year
Treasury securities were used as the risk2free rate than if !12year
Treasury bonds were used for r
;F
.
e. 6tatements a, b, c, and d are false.
Chapter 2: Risk and Return: Part I Page 19
Multi)le C$"ice: P&"*les
Easy:
(2.) Portfo#io $eta Answer: $ Diff: E
*$
. Bou hold a diversified portfolio consisting of a I11,111 investment in
each of 1 different common stocks 4i.e., your total investment is
I11,1115. The portfolio beta is e)ual to 1.. Bou have decided to
sell one of your stocks which has a beta e)ual to 1.* for I11,111. Bou
plan to use the proceeds to purchase another stock which has a beta
e)ual to 1.#. (hat will be the beta of the new portfolioD
a. 1.1'$
b. 1.!$
c. 1.$1
d. 1./#
e. 1.!!!
(2.) Portfo#io ret!rn Answer: $ Diff: E
*'
. Bou are an investor in common stock, and you currently hold a well2
diversified portfolio which has an expected return of 1 percent, a beta
of 1., and a total value of I0,111. Bou plan to increase your
portfolio by buying 111 shares of ,TP> at I11 a share. ,TP> has an
expected return of 1 percent with a beta of .1. (hat will be the
expected return and the beta of your portfolio after you purchase the
new stockD
a.
P
r C 1.1?< b
p
C .11
b.
P
r C 1./?< b
p
C 1./
c.
P
r C 1.1?< b
p
C 1.1
d.
P
r C 1!.?< b
p
C 1.#1
e.
P
r C 1#.1?< b
p
C 1.!
(2.() Re)!ired ret!rn Answer: a Diff: E
**
. %alculate the re)uired rate of return for .ars Inc.Gs stock. The .arsGs
beta is 1., the rate on a T2bill is # percent, the rate on a long2term
T2bond is ' percent, the expected return on the market is 11.$ percent,
the market has averaged a 1# percent annual return over the last six
years, and .ars has averaged a 1#.# return over the last six years.
a. 1.'?
b. 1!.?
c. 1#.1?
d. 1$.'?
e. 1'.?
Page 20 Chapter 2: Risk and Return: Part 1
(2.() Re)!ired ret!rn Answer: d Diff: E
*/
. %alculate the re)uired rate of return for .ercury Inc., assuming that
investors expect a $ percent rate of inflation in the future. The real
risk2free rate is e)ual to ! percent and the market risk premium is $
percent. .ercury has a beta of .1, and its reali"ed rate of return has
averaged 1$ percent over the last $ years.
a. 1$?
b. 1'?
c. 1*?
d. 1/?
e. 1?
(2.() CAP" and re)!ired ret!rn Answer: e Diff: E
*0
. :; %orporation has a beta of .1, while 7; %orporation&s beta is 1.$.
The risk2free rate is 11 percent, and the re)uired rate of return on an
average stock is 1$ percent. @ow the expected rate of inflation built
into r
;F
falls by ! percentage points, the real risk2free rate remains
constant, the re)uired return on the market falls to 11 percent, and the
betas remain constant. (hen all of these changes are made, what will be
the difference in the re)uired returns on :;&s and 7;&s stocksD
a. 1.1?
b. .$?
c. #.$?
d. $.#?
e. '.1?
(2.() %eta coefficient Answer: $ Diff: E
/1
. Fiven the following information, determine which beta coefficient for
6tock , is consistent with e)uilibrium=
r
,
C 11.!?< r
;F
C $?< r
.
C 11?
a. 1./'
b. 1.'
c. 1.11
d. 1./1
e. 1.!$
(2.() %eta coefficient Answer: a Diff: E
/1
. ,ssume that the risk2free rate is $ percent, and that the market risk
premium is * percent. If a stock has a re)uired rate of return of 1!.*$
percent, what is its betaD
a. 1.$
b. 1.!$
c. 1.!*
d. 1.'1
e. 1.0'
Chapter 2: Risk and Return: Part I Page 21
(2.() "arket risk premi!m Answer: d Diff: E
/
. , stock has an expected return of 1.$ percent. The beta of the stock
is 1.1$ and the risk2free rate is $ percent. (hat is the market risk
premiumD
a. 1.!1?
b. '.$1?
c. 1$.11?
d. '.!1?
e. *.$?
Medium:
(2.2) Expected ret!rn Answer: e Diff: "
/!
. ,ssume that a new law is passed which restricts investors to holding
only one asset. , risk2averse investor is considering two possible
assets as the asset to be held in isolation. The assets& possible
returns and related probabilities 4i.e., the probability distributions5
are as follows=
,sset E ,sset B
- r - r
1.11 2!? 1.1$ 2!?
1.11 1.11
1.$ $ 1.!1 $
1.$ / 1.!1 /
1.!1 11 1.$ 11
(hich asset should be preferredD
a. ,sset E, since its expected return is higher.
b. ,sset B, since its beta is probably lower.
c. >ither one, since the expected returns are the same.
d. ,sset E, since its standard deviation is lower.
e. ,sset B, since its coefficient of variation is lower and its expected
return is higher.
(2.2) Expected ret!rn Answer: c Diff: "
/#
. Fiven the following probability distribution, what is the expected
return and the standard deviation of returns for 6ecurity KD
6tate -
i
r
K
JJJJJ JJJJ JJJJ
1 1. 11?
1.' 1$
! 1. 1
a. 1$?< '.$1?
b. 1?< $.1/?
c. 1$?< !.1'?
d. 1$?< 11.11?
Page 22 Chapter 2: Risk and Return: Part 1
e. 1?< $.11?
(2.2) Coefficient of variation Answer: $ Diff: "
/$
. ;ipken Iron (orks faces the following probability distribution=
6tate of -robability of 6tockGs >xpected ;eturn
the >conomy 6tate +ccurring if this 6tate +ccurs
8oom 1.$ $?
@ormal 1.$1 1$
;ecession 1.$ $
(hat is the coefficient of variation on the company&s stockD 4,ssume
that the standard deviation is calculated using the probability
statistic.5
a. 1.1'
b. 1.#*
c. 1.$#
d. 1.'*
e. 1.*1
(2.2) Coefficient of variation Answer: c Diff: "
/'
. ,n analyst has estimated how a particular stockGs return will vary
depending on what will happen to the economy=
6tate of -robability of 6tockGs >xpected ;eturn
the >conomy 6tate +ccurring if this 6tate +ccurs
;ecession 1.11 2'1?
8elow ,verage 1.1 211
,verage 1.#1 1$
,bove ,verage 1.1 #1
8oom 1.11 01
(hat is the coefficient of variation on the companyGs stockD 4Lse the
population standard deviation to calculate the coefficient of
variation.5
a. .11
b. .11
c. .#*
d. !.!!#
e. !.**
Chapter 2: Risk and Return: Part I Page 23
(2.2) Coefficient of variation Answer: c Diff: "
/*
. The following probability distributions of returns for two stocks have
been estimated=
-robability 6tock , 6tock 8
1.! 1? $?
1.# / #
1.! ' !
(hat is the coefficient of variation for the stock that is less risky
4assuming you use the coefficient of variation to rank riskiness5.
a. !.'
b. 1./
c. 1.10
d. 1.''
e. $.1'
(2.) Portfo#io $eta Answer: $ Diff: "
//
. Bou hold a diversified portfolio consisting of a I$,111 investment in
each of 1 different common stocks. The portfolio beta is e)ual to
1.1$. Bou have decided to sell one of your stocks, a lead mining stock
whose b is e)ual to 1.1, for I$,111 net and to use the proceeds to buy
I$,111 of stock in a steel company whose b is e)ual to .1. (hat will
be the new beta of the portfolioD
a. 1.1
b. 1.1
c. 1.
d. 1.11
e. 1.1$
(2./) "arket ret!rn Answer: d Diff: "
/0
. The returns of Lnited ;ailroad Inc. 4L;I5 are listed below, along with
the returns on "the market"=
Bear L;I .arket
1 21#? 20?
1' 11
! 1$
# * $
$ 2 21
If the risk2free rate is 0 percent and the re)uired return on L;I&s
stock is 1$ percent, what is the re)uired return on the marketD ,ssume
the market is in e)uilibrium. 4:int= Think rise over run.5
a. #?
b. 0?
c. 11?
d. 1!?
Page 24 Chapter 2: Risk and Return: Part 1
e. 1'?
(2.() Re)!ired ret!rn Answer: c Diff: "
01
. Bou are holding a stock which has a beta of .1 and is currently in
e)uilibrium. The re)uired return on the stock is 1$ percent, and the
return on an average stock is 11 percent. (hat would be the percentage
change in the return on the stock, if the return on an average stock
increased by !1 percent while the risk2free rate remained unchangedD
a. N1?
b. N!1?
c. N#1?
d. N$1?
e. N'1?
(2.() Re)!ired ret!rn Answer: c Diff: "
01
. +akdale Furniture Inc. has a beta coefficient of 1.* and a re)uired rate
of return of 1$ percent. The market risk premium is currently $
percent. If the inflation premium increases by percentage points, and
+akdale ac)uires new assets which increase its beta by $1 percent, what
will be +akdale&s new re)uired rate of returnD
a. 1!.$1?
b. ./1?
c. 1/.*$?
d. 1$.$?
e. 1*.11?
(2.() CAP" and re)!ired ret!rn Answer: d Diff: "
0
. Bour portfolio consists of I111,111 invested in a stock which has a beta
C 1./, I1$1,111 invested in a stock which has a beta C 1., and I$1,111
invested in a stock which has a beta C 1./. The risk2free rate is *
percent. 7ast year this portfolio had a re)uired rate of return of 1!
percent. This year nothing has changed except for the fact that the
market risk premium has increased by percent 4two percentage points5.
(hat is the portfolio&s current re)uired rate of returnD
a. $.1#?
b. *.1#?
c. 11.#$?
d. 1$.!!?
e. 1'.$?
Chapter 2: Risk and Return: Part I Page 25
4%omp= .!, .$5 Portfo#io $eta Answer: c Diff: "
0!
. , mutual fund manager has a I11,111,111 portfolio with a beta C 1..
,ssume that the risk2free rate is ' percent and that the market risk
premium is also ' percent. The manager expects to receive an additional
I$1,111,111 in funds soon. 6he wants to invest these funds in a variety
of stocks. ,fter making these additional investments, she wants the
fund&s expected return to be 1!.$ percent. (hat should be the average
beta of the new stocks added to the portfolioD
a. 1.11
b. 1.!!
c. 1.#$
d. 1.'#
e. 1./*
4%omp= .!, .$5 Portfo#io $eta Answer: e Diff: "
0#
. (alter Kasper currently manages a I$11,111 portfolio. :e is expecting
to receive an additional I$1,111 from a new client. The existing
portfolio has a re)uired return of 11.*$ percent. The risk2free rate is
# percent and the return on the market is 0 percent. If (alter wants
the re)uired return on the new portfolio to be 11.$ percent, what should
be the average beta for the new stocks added to the portfolioD
a. 1.$1
b. .11
c. 1.'*
d. 1.!$
e. 1./1
4%omp= .!, .$5 Portfo#io ret!rn Answer: a Diff: "
0$
. ,n investor is forming a portfolio by investing I$1,111 in stock , which
has a beta of 1.$1, and I$,111 in stock 8 which has a beta of 1.01. The
return on the market is e)ual to ' percent and Treasury bonds have a
yield of # percent. (hat is the re)uired rate of return on the
investor&s portfolioD
a. '.'?
b. './?
c. $./?
d. *.1?
e. @one of the answers above is correct.
(2.() %eta coefficient Answer: a Diff: "
0'
. ,n investor has I$,111 invested in a stock which has an estimated beta
of 1., and another I1$,111 invested in the stock of the company for
which she works. The risk2free rate is ' percent and the market risk
premium is also ' percent. The investor calculates that the re)uired
rate of return on her total 4I1,1115 portfolio is 1$ percent. (hat is
the beta of the company for which she worksD
a. 1.'
Page 26 Chapter 2: Risk and Return: Part 1
b. 1.*
c. 1./
d. 1.0
e. .1
(2.() CAP" and re)!ired ret!rn Answer: d Diff: "
0*
. %ompany E has a beta of 1.', while %ompany B&s beta is 1.*. The risk2
free rate is * percent, and the re)uired rate of return on an average
stock is 1 percent. @ow the expected rate of inflation built into r
;F
rises by 1 percentage point, the real risk2free rate remains constant,
the re)uired return on the market rises to 1# percent, and betas remain
constant. ,fter all of these changes have been reflected in the data,
by how much will the re)uired return on 6tock E exceed that on 6tock BD
a. !.*$?
b. #.1?
c. #./?
d. $.#1?
e. $.*$?
(2.() Expected and re)!ired ret!rns Answer: $ Diff: "
0/
. Bou have been scouring The Wall Street Journal looking for stocks that
are "good values" and have calculated the expected returns for five
stocks. ,ssume the risk2free rate 4r
;F
5 is * percent and the market risk
premium 4
rM
2
rRF
5 is percent. (hich security would be the best
investmentD 4,ssume you must choose Aust one.5
>xpected ;eturn 8eta
a. 0.11? 1.*1
b. *.1'? 1.11
c. $.1#? 21.'*
d. /.*#? 1./*
e. 11.$1? .$1
(Comp: 2.+ 2.() CAP" and $eta coefficient Answer: d Diff: "
00
. , money manager is managing the account of a large investor. The
investor holds the following stocks=
6tock ,mount Invested >stimated 8eta
, I,111,111 1./1
8 $,111,111 1.11
% !,111,111 1.#1
3 $,111,111 DDD

The portfolioGs re)uired rate of return is 1* percent. The risk2free
rate, r
;F
, is * percent and the return on the market, r
.
, is 1# percent.
(hat is 6tock 3Gs estimated betaD
a. 1.$'
b. 1.!/0
c. 1.#0
d. .1'
e. .1$#
Chapter 2: Risk and Return: Part I Page 27
Page 28 Chapter 2: Risk and Return: Part 1
Tough:
(Comp: 2.+ 2.() Portfo#io re)!ired ret!rn Answer: a Diff: 0
111
. , money manager is holding the following portfolio=
6tock ,mount Invested 8eta
1 I!11,111 1.'
!11,111 1.1
! $11,111 1.#
# $11,111 1./
The risk2free rate is ' percent and the portfolioGs re)uired rate of
return is 1.$ percent. The manager would like to sell all of her
holdings of 6tock 1 and use the proceeds to purchase more shares of
6tock #. (hat would be the portfolioGs re)uired rate of return
following this changeD
a. 1!.'!?
b. 11.0?
c. 11.1$?
d. 1.$?
e. 1#.!!?
Chapter 2: Risk and Return: Part I Page 29
(i!a!cial Calculat"& Secti"!
Multi)le C$"ice: P&"*les
Easy:
(2.2) Coefficient of variation Answer: $ Diff: E
111
. 8elow are the stock returns for the past five years for ,gnew
Industries=
Bear 6tock ;eturn
1 ?
!!
! 1
# 21
$ 11
(hat was the stockGs coefficient of variation during this five2year
periodD 4Lse the population standard deviation to calculate the
coefficient of variation.5
a. 11./1
b. 1.#'
c. 1$.*
d. 1.'0
e. #.
Medium:
(2.) Portfo#io standard deviation Answer: a Diff: "
11
. :ere are the expected returns on two stocks=
;eturns
-robability E B
1.1 21? 11?
1./ 1 1$
1.1 #1 1
If you form a $12$1 portfolio of the two stocks, what is the portfolio&s
standard deviationD
a. /.1?
b. 11.$?
c. 1!.#?
d. 1'.$?
e. 1.1?
Page 30 Chapter 2: Risk and Return: Part 1
(2.() CAP" and re)!ired ret!rn Answer: e Diff: "
11!
. :istorical rates of return for the market and for 6tock , are given
below=
Bear .arket 6tock ,
1 '.1? /.1?
2/.1 !.1
! 2/.1 2.1
# 1/.1 1.1
If the re)uired return on the market is 11 percent and the risk2free
rate is ' percent, what is the re)uired return on 6tock ,, according to
%,-.Q6.7 theoryD
a. '.11?
b. '.$*?
c. *.$?
d. *.*0?
e. /.*?
(2.() CAP" and re)!ired ret!rn Answer: a Diff: "
11#
. 6ome returns data for the market and for %ountercyclical %orp. are given
below=
Bear .arket %ountercyclical
Bear 1 2.1? /.1?
Bear 1.1 !.1
Bear ! 2/.1 1/.1
Bear # 1.1 2*.1
The re)uired return on the market is 1# percent, and the risk2free rate
is / percent. (hat is the re)uired return on %ountercyclical %orp.,
according to %,-.Q6.7 theoryD
a. !.#?
b. #.$/?
c. /.11?
d. 11.*'?
e. 1#.11?
Chapter 2: Risk and Return: Part I Page 31
(Comp: 2./+ 2.() Expected and re)!ired ret!rns Answer: c Diff: "
11$
. The reali"ed returns for the market and 6tock K for the last # years are
given below=
Bear .arket 6tock K
1 11? $?
1$ 1
! 2$ 1#
# 1 11
,n average stock has an expected return of 1 percent, and the market
risk premium is # percent. If 6tock K&s expected rate of return as
viewed by a marginal investor is / percent, what is the difference
between K&s expected and re)uired rates of returnD
a. 1.''?
b. 1.$?
c. .'#?
d. !.*?
e. $.!'?
(Comp: 2.+ 2./+ 2.() Portfo#io ret!rn Answer: c Diff: "
11'
. 6tock E, 6tock B, and the market have had the following returns over the
past four years.
Bear .arket E B
1 11? 11? 1?
* # 2!
! 1* 1 1
# 2! 2 2$
The risk2free rate is * percent. The market risk premium is $ percent.
(hat is the re)uired rate of return for a portfolio which consists of
I1#,111 invested in 6tock E and I',111 invested in 6tock BD
a. 0.0#?
b. 11.'/?
c. 11.$/?
d. 1.#1?
e. 1!.'*?
Page 32 Chapter 2: Risk and Return: Part 1
N"!ulti)le C$"ice P&"*les
Tough:
(Comp: 2.+ 2./+ 2.() Re)!ired ret!rn on stock Diff: 0
11*
. ,ssume that the following returns were earned on 6tock B and the market
during the last eight years=
Bear

r
B


r
.
Bear r
B
r
.
110 1#? 1?

11$ ' 11
11/ 0 11

11# 21 2$
11* 1 2$

11! 11 1
11' 11 1$

11 0 1$


,verage return *.$? 11?


6tandard deviation $.1/? 11?
a. (hat is 6tock BGs beta coefficientD 4:int= Lse a calculator with
statistical functions to determine the least s)uares line.5
b. If the expected value of r
.
is 11 percent and r
;F
is ' percent, what is
the re)uired rate of return on 6tock BD
c. 6uppose that in Kanuary, 111, investors learn that Firm B will, in
the future, face much greater competition, and investors conclude that
6tock B will, in the future, be exposed to much higher
nondiversifiable risk. >xpected future profits and dividends,
however, are unchanged 4although the uncertainty about profits and
dividends does increase5. (hat effect is this knowledge likely to
have on 6tock BGs market price, on the reali"ed rate of return on
6tock B during 110, on the re)uired rate of return on the stock, and
on the expected rate of return on the stock in the futureD
d. 6uppose that during 111 6tock B had a return of minus $ percent,
while the market return was 1 percent. (hat would this do to the
calculated beta coefficient for 6tock BD 4:int= ,dd the new data
point and recalculate beta.5
e. Lse the %,-. to calculate the re)uired rate of return for 6tock B.
,ssume r
.
C 11 percent and r
;F
C ' percent.
f. :ow does this new estimate of r
B
compare with the estimate based on
data through 110D 3oes this seem reasonableD
Chapter 2: Risk and Return: Part I Page 33
CHAPTER 2
ANS+ERS AND S,-UTI,NS
Page 34 Chapter 2: Risk and Return: Part 1
1
. (2.2) Payoff matrix Answer: a Diff: E
. (2.2)Standard deviation Answer: a Diff: E
!. (2.2) Coefficient of variation Answer: a Diff: E
#. (2.2) Risk comparisons Answer: a Diff: E
$. (2.) Risk and expected ret!rn Answer: a Diff: E
'. (2.2) Risk aversion Answer: a Diff: E
*. (2.) CAP" and risk Answer: a Diff: E
/. (2.) CAP" and risk Answer: a Diff: E
0. (2.) Portfo#io risk Answer: $ Diff: E
11. (2.) Portfo#io risk Answer: $ Diff: E
11. (2.) Portfo#io ret!rn Answer: $ Diff: E
1. (2.) "arket risk Answer: a Diff: E
1!. (2.) "arket risk Answer: $ Diff: E
1#. (2.) %eta coefficient Answer: a Diff: E
1$. (2.) %eta coefficient Answer: a Diff: E
1'. (2.) C&an'es in $eta Answer: $ Diff: E
1*. (2.() Re)!ired ret!rn Answer: $ Diff: E
1/. (2.() S"* Answer: $ Diff: E
10. (2.() S"* and risk aversion Answer: a Diff: E
1. (Comp: 2.+ 2.() P&ysica# assets Answer: a Diff: E
1. (2.2) ,ariance Answer: $ Diff: "
. (2.2) Expected ret!rn Answer: a Diff: "
!. (2.2) Coefficient of variation Answer: $ Diff: "
#. (2.2) Risk aversion Answer: $ Diff: "
$. (2.2) Risk premi!m and risk aversion Answer: a Diff: "
'. (2.) Portfo#io risk Answer: a Diff: "
*. (2.) Portfo#io risk Answer: $ Diff: "
/. (2.) Red!cin' portfo#io risk Answer: a Diff: "
0. (2.) Portfo#io risk and ret!rn Answer: $ Diff: "
!1. (2.) Corre#ation coefficient and risk Answer: $ Diff: "
!1. (2.) Company-specific risk Answer: $ Diff: "
!. (2.) Portfo#io risk and $eta Answer: $ Diff: "
!!. (2.) %eta coefficient Answer: a Diff: "
!#. (2.) Portfo#io $eta Answer: a Diff: "
!$. (2.) C&an'es in $eta Answer: a Diff: "
!'. (2.) Diversification effects Answer: a Diff: "
!*. (2.() CAP" Answer: a Diff: "
!/. (2.() CAP" and inf#ation Answer: $ Diff: "
!0. (2.() "arket risk premi!m Answer: a Diff: "
#1. (2.() S"* Answer: a Diff: "
#1. (2.() S"* Answer: $ Diff: "
#. (2..) Risk concepts Answer: e Diff: E
#!. (2.2) Risk meas!res Answer: a Diff: E
6tatement a is true, since the coefficient of variation is e)ual to the
standard deviation divided by the mean. The remaining statements are false.
##. (2.) Portfo#io risk and ret!rn Answer: a Diff: E
6tatement a is true< the others are false. 6ince both stocksG betas are
e)ual to 1., the beta of the portfolio will e)ual 1.. 8ecause the stocksG
correlation coefficient is less than one, the portfolioGs standard deviation
will be lower than 1 percent.
#$. (Comp: 2.+ 2.() %eta coefficient Answer: d Diff: E
#'. (2.() S"* Answer: a Diff: E
The slope of the 6.7 is determined by the si"e of the market risk premium, r
.
2 r
;F
, which depends on investor risk aversion.
#*. (2.() S"* Answer: $ Diff: E
6tatement b is true. 6tatement a is false, since the slope of the 6.7 is r
.
H r
;F
. 6tatement c is false, since r
s
C r
;F
N 4r
.
H r
;F
5b. The remaining
statements are false.
#/. (2.() S"* Answer: c Diff: E
6tatement c is correct< the others are false. 6tock , will have a higher
re)uired rate of return than 8 because , has the higher beta.
The standard deviation of a portfolio is not the average of the standard
deviations of the component stocks. The portfolio beta is a weighted average
of the component stocksG betas< therefore, b
-
C 1.1.
#0. (2.() S"*+ CAP"+ and $eta Answer: e Diff: E
6tatement e is correct< the others are false. The market risk premium is the
slope of the 6.7. If a stock has a negative beta, this does not mean its
re)uired return is negative. , doubling of a stock&s beta doesn&t mean that
its re)uired return will double. The re)uired return is a function of r
;F
,
r
.
, and beta. The re)uired return is affected by the market risk premium.
$1. (2.() Risk ana#ysis and portfo#io diversification Answer: d Diff: E
, security&s beta does indeed measure market risk relative to that of an
average stock. 3iversification reduces the variability of the portfolio&s
return. ,n investor, through diversification, can eliminate company2specific
risk< however, a portfolio containing all publicly2traded stocks would still
be exposed to market risk. The %,-. specifies a stock&s re)uired return as=
r
s
C r
;F
N 4r
.
2 r
;F
5b. Thus, the risk2free rate and the market risk premium
are needed along with a stock&s beta to determine its re)uired return. ,
stock&s beta is more relevant as a measure of risk to an investor with a
well2diversified portfolio than to an investor who holds only that one stock.
$1. (2.2) "arket e)!i#i$ri!m Answer: a Diff: "
$. (2.) Risk aversion Answer: $ Diff: "
$!. (2.) Portfo#io risk and ret!rn Answer: c Diff: "
$#. (2.) Portfo#io risk Answer: e Diff: "
$$. (2.) Portfo#io risk and $eta Answer: e Diff: "
$'. (2.) Portfo#io diversification Answer: c Diff: "
6tatement c is correct< the others are false. :olding a portfolio of stocks
reduces company2specific risk. 3iversification lowers risk< conse)uently, it
reduces the re)uired rate of return. 8eta measures market risk, the lower
the beta the lower the market risk.
$*. (2.) "arket risk Answer: $ Diff: "
$/. (2.) Risk ana#ysis and portfo#io diversification Answer: e Diff: "
$0. (2./) %eta coefficient Answer: a Diff: "
'1. (2./) %eta coefficient Answer: a Diff: "
'1. (2./) %eta coefficient Answer: d Diff: "
'. (2./) %eta coefficient Answer: c Diff: "
'!. (2.() Portfo#io risk and $eta Answer: c Diff: "
'#. (2.() S"* and risk aversion Answer: e Diff: "
'$. (2.() Portfo#io ret!rn Answer: $ Diff: "
6tatement b is correct< all the other statements are false. If the market
risk premium increases by percent and r
;F
remains unchanged, then the
portfolioGs return will increase by ?41.1/5 C .1'?. 6tatement a is false,
since r
p
C '? N 4$?5b
p
. The portfolioGs beta is calculated as 1.*41.5 N
1.!41./5 C 1.1/. Therefore, r
p
C '? N $?41.1/5 C 11.#?. 6tatement c is
false. If r
;F
increases by percent, but ;-
.
remains unchanged, the
portfolioGs return will increase by percent. 6tatement d is false. .arket
efficiency states that the expected return should e)ual the re)uired return<
therefore,
p r

C r
p
C 11.#?.
''. (2.() S"* Answer: e Diff: "
'*. (2.() S"* Answer: a Diff: "
'/. (2.() S"* Answer: $ Diff: "
'0. (2.() S"*+ CAP"+ and portfo#io risk Answer: a Diff: "
,n increase in expected inflation would lead to an increase in r
;F
, the
intercept of the 6.7. If risk aversion were unchanged, then the slope of the
6.7 would remain constant. Therefore, there would be a parallel upward shift
in the 6.7, which would result in an increase in r
.
that is e)ual to the
expected increase in inflation.
*1. (2.() Portfo#io ret!rn+ CAP"+ and $eta Answer: e Diff: "
6tatement e is correct because none of the statements are correct. 6tatement
a is false because if the returns of stocks were perfectly positively
correlated the portfolio&s variance would e)ual the variance of each of the
stocks. 6tatement b is false. , stock can have a negative beta and still
have a positive return because
rs
C
rRF
N 4
rM
2
rRF
5b. 6tatement c is
false. ,ccording to the %,-., stocks with higher betas have higher expected
returns. 8etas are a measure of market risk, while standard deviation is a
measure of stand2alone risk22but not a good measure. The coefficient of
variation is a better measure of stand2alone risk. The portfolio&s beta 4the
measure of market risk5 will be dependent on the beta of each of the randomly
selected stocks in the portfolio. :owever, the portfolio&s beta would
probably approach b
.
C 1, which would indicate higher market risk than a
stock with a beta e)ual to 1.$.
*1. (2.() CAP" and re)!ired ret!rns Answer: d Diff: "
*. (2.() Portfo#io risk and S"* Answer: e Diff: "
*!. (2.() CAP" Answer: c Diff: 0
*#. (2.() S"* Answer: d Diff: 0
*$. (2.) Portfo#io $eta Answer: $ Diff: E
1. C 1Q141.*5 N 40Q15b
b is average beta for other 10 stocks.
1.1'$ C 410Q15b.
@ew 8eta C 1.1'$ N 1Q141.#5 C 1.!$.
*'
. (2.) Portfo#io ret!rn Answer: $ Diff: E
p
r
C 1.041?5 N 1.141?5 C 1./?.
b
-
C 1.041.5 N 1.14.15 C 1./.
**. (2.() Re)!ired ret!rn Answer: a Diff: E
r
s
C '? N 411.$?2'?51. C 1.'?.
*/. (2.() Re)!ired ret!rn Answer: d Diff: E
r
;F
C rR N I- C !? N $? C /?.
r
s
C /? N 4$?5.1 C 1/?.
*0. (2.() CAP" and re)!ired ret!rn Answer: e Diff: E
b
:;
C .1< b
7;
C 1.$. @o changes occur.
r
;F
C 11?. 3ecreases by !? to *?.
r
.
C 1$?. Falls to 11?.
@ow 6.7= r
i
C r
;F
N 4r
.
2 r
;F
5b
i
.
r
:;
C *? N 411? 2 *?5 C *? N #?45 C 1$?
r
7;
C *? N 411? 2 *?51.$ C *? N #?41.$5 C 0
3ifference

'?
/1
. (2.() %eta coefficient Answer: $ Diff: E
In e)uilibrium
r
,
C
r
C 11.!?.
r
,
C r
;F
N 4r
.
2 r
;F
5b
11.!? C $? N 411? 2 $?5b
b C 1.'.
/1
. (2.() %eta coefficient Answer: a Diff: E
1!.*$? C $? N 4*?5b
/.*$? C *?b
b C 1.$.
/
. (2.() "arket risk premi!m Answer: d Diff: E
1.$? C $? N 4;-
.
51.1$
*.$? C 4;-
.
51.1$
;-
.
C '.!1?.
/!
. (2.2) Expected ret!rn Answer: e Diff: "
r
C 1.1142!?5 N 1.114?5 N 1.$4$?5 N 1.$4/?5 N 1.!1411?5 C '.1$?.
Y
r C 1.1$42!?5 N 1.114?5 N 1.!14$?5 N 1.!14/?5 N 1.$411?5 C '.#$?.

E
C 1.1142!? 2 '.1$?5

N 1.114? 2 '.1$?5

N 1.$4$? 2 '.1$?5

N 1.$4/? 2 '.1$?5

N 1.!1411? 2 '.1$?5


C 1$.*!<
E
C !.0*.
%9
E
C !.0*Q'.1$ C 1.'#$.

B
C 1.1$42!? 2 '.#$?5

N 1.114? 2 '.#$?5

N 1.!14$? 2 '.#$?5

N 1.!14/? 2 '.#$?5

N 1.$411? 2 '.#$?5

C 11.0$<
B
C !.!1.
%9
B
C !.!1Q'.#$ C 1.$1!.
Therefore, ,sset B has a higher expected return and lower coefficient of
variation and hence it would be preferred.
/#. (2.2) Expected ret!rn Answer: c Diff: "
J
r C 41.541.115 N 41.'541.1$5 N 41.541.15 C 1.1$ C 1$.1?.
>xpected return C 1$.1?.
2
J
C 41.541.11 2 1.1$5

N 1.'41.1$ 2 1.1$5

N 41.541.1 2 1.1$5

C 1.111.
6tandard deviation C 1.111 C 1.1!1' C !.1'?.
/$
. (2.2) Coefficient of variation Answer: $ Diff: "
The expected rate of return will e)ual 1.$4$?5 N 1.$41$?5 N 1.$4$?5 C 1$?.
The variance of the expected return is 1.$4$? 2 1$?5

N 1.$41$? 21$?5

N
1.$4$? 2 1$?5

C 1.11$1. The standard deviation is the s)uare root of


1.11$1 C 1.1*1*. ,nd, %9 C 1.1*1*Q1.1$ C 1.#*.
/'. (2.2) Coefficient of variation Answer: c Diff: "
%9 C 6tandard deviationQ>xpected return.
>xpected return C 1.142'1?5 N 1.4211?5 N 1.#41$?5 N 1.4#1?5 N 1.1401?5
C 1$?.
deviation
6tandard
C S1.142'1? 2 1$?5

N 1.4211? 2 1$?5

N 1.#41$? 21$?5

N 1.4#1? 2 1$?5

N 1.1401? 2 1$?5

T
1Q


C 1,!*$
1Q


C !*.1/1?.
%9 C !*.1/1?Q1$? C .#*1.
/*
. (2.2) Coefficient of variation Answer: c Diff: "
>xpected return for stock , is 1.!41?5 N 1.#4/?5 N 1.!4'?5 C /.'?.
>xpected return for stock 8 is 1.!4$?5 N 1.#4#?5 N 1.!4!?5 C #?.
6tandard deviation for stock , is=
S1.!41? 2 /.'?5

N 1.#4/? 2 /.'?5

N 1.!4'? 2 /.'?5

T
1Q
C .!*#0?. 6imilarly,
the standard deviation for stock 8 is 1.**#'?.
%9
,
C .!*#0?Q/.'? C 1./.
%9
8
C 1.**#'?Q#? C 1.10.
//
. (2.) Portfo#io $eta Answer: $ Diff: "
8efore=

1.1$ C 1.0$4b
;
5 N 1.1$41.15
1.0$4b
;
5 C 1.11
b
;
C 1.1$/.
,fter= b
-
C 1.0$4b
;
5 N 1.1$4.15 C 1.11 N 1.11 C 1.1.
/0
. (2./) "arket ret!rn Answer: d Diff: "
b C
;ise
;un
C

B
E
C
2 1'
1$ 2 11
C
#
'
C 1.$.
r
s
C 1$? C 0? N 4r
.
2 0?51.$


'? C 4r
.
2 0?51.$


#? C r
.
2 0?
r
.
C 1!?.
01
. (2.() Re)!ired ret!rn Answer: c Diff: "
6tep 1 6olve for risk2free rate
r
s
C 1$? C r
;F
N 411? 2 r
;F
5.1 C r
;F
N 1? 2 r
;F
r
;F
C $?.
6tep %alculate new market return
r
.
increases by !1?, so r
.
C 1.!411?5 C 1!?.
6tep ! %alculate new re)uired return on stock
r
s
C $? N 41!? 2 $?5 C 1?.
6tep # %alculate percentage change in return on stock
1$?
1$? 2 1?
C #1?.
01. (2.() Re)!ired ret!rn Answer: c Diff: "
8efore= r
s
C 1$? C r
;F
N 4$?51.*< r
;F
C 1$? 2 !.$?< r
;F
C 11.$?.
@ew r
;F
C 11.$? N .1? C 1!.$?.
@ew beta C 1.* 1.$ C 1.1$.
,fter= @ew re)uired rate of return=
r
s
C 1!.$? N 4$?51.1$ C 1/.*$?.
0
. (2.() CAP" and re)!ired ret!rn Answer: d Diff: "
b
p
C
111 , !11 I
111 , 111 I
41./5 N
111 , !11 I
111 , 1$1 I
41.5 N
111 , !11 I
111 , $1 I
41./5
b
p
C 1.1'*.
7ast year= r C 1!?
1!? C *? N ;-
.
41.1'*5
'? C ;-
.
41.1'*5
;-
.
C $.1#0?.
This year=
r C *? N4$.1#0? N ?51.1'*
r C 1$.!!?.
0!
. (Comp: 2.+ 2.() Portfo#io $eta Answer: c Diff: "
,fter additional investments are made, for the entire fund to have an
expected return of 1!.$?,the portfolio must have a beta of 1.$ as shown by
1!.$? C '? N 4'?5b. 6ince the fundGs beta is a weighted average of the betas
of all the individual investments, we can calculate the re)uired beta on the
additional investment as follows=
1.$ C
11 I$1,111,1
1.5 111 4I11,111,
N
11 I$1,111,1
E5 11 4I$1,111,1
1.$ C 1.0' N 1.E
1.0 C 1.E
E C 1.#$.
0#. (Comp: 2.+ 2.() Portfo#io $eta Answer: e Diff: "
Find the beta of the original portfolio 4b
+ld
5 as 11.*$? C #? N 40? 2 #?5b
+ld
or b
+ld
C 1.!$. To achieve an expected return of 11.$?, the new portfolio
must have a beta 4b
@ew
5 of 11.$? C #? N 40? 2 #?5
@ew b
or
@ew b
C 1.$. To
construct a portfolio with a b
@ew
C 1.$, the added stocks must have an average
beta 4b
,vg
5 such that=
1.$ C 4I$1,111QI*$1,1115b
,vg
N 4I$11,111QI*$1,11151.!$
1.$ C 1.!!!b
,vg
N 1.01
1.' C 1.!!!b
,vg
b
,vg
C 1./.
0$
. (Comp: 2.+ 2.() Portfo#io ret!rn Answer: a Diff: "
The portfolioGs beta is a weighted average of the individual security betas
as follows=
4I$1,111QI*$,11151.$ N 4I$,111QI*$,11151.0 C 1.!. The re)uired rate of
return is then simply= #? N 4'? 2 #?51.! C '.'?.
0'
. (2.() %eta coefficient Answer: a Diff: "
First find the portfolioGs beta=
1$? C '? N 4'?5b
p
0? C '?b
p
b
p
C 1.$.
7et b
c
be the beta of the company for which she works. The portfolioGs beta
is a weighted average of the individual betas of the stocks in the portfolio.
Therefore, 1.$ C 4I$,111QI1,11151. N 4I1$,111QI1,1115b
%.
1.$ C 1.! N 1.*$b
c
1. C 1.*$b
c
b
c
C 1.'.
0*. (2.() CAP" and re)!ired ret!rn Answer: d Diff: "
b
E
C 1.'< b
B
C 1.*< r
;F
C *?< r
.
C 1?.
Inflation increases by 1?, but rR remains constant. r
;F
increases by 1?< r
.
rises to 1#?.
8efore inflation change=
r
E
C *? N $?41.'5 C 1$?.
r
B
C *? N $?41.*5 C 11.$?.
,fter inflation change=
r
E
C /? N 41#? 2 /?51.' C 1*.'?.
r
B
C /? N 41#? 2 /?51.* C 1.?.
r
E
2 r
B
C 1*.'? 2 1.? C $.#?.
0/
. (2.() Expected and re)!ired ret!rns Answer: $ Diff: "
8y calculating the re)uired returns on each of the securities and comparing
re)uired and expected returns, we can identify which security is the best
investment alternative, i.e., the security for which the expected return
exceeds the re)uired return by the largest amount. The expected and re)uired
returns and the differences between them are shown below=
6ecurity >xpected ;eturn ;e)uired ;eturn >xpected2;e)uired
, 0.11? *? N ?41.*5 C 11.#1? 21.!0?
8 *.1'? *? N ?41.15 C *.11? 1.1'?
% $.1#? *? N ?421.'*5 C $.''? 21.'?
3 /.*#? *? N ?41./*5 C /.*#? 1.11?
> 11.$1? *? N ?4.$15 C 1.11? 21.$1?
%learly, security 8 is the best alternative.
00. (Comp: 2.+ 2.() CAP" and $eta coefficient Answer: d Diff: "
-ortfolio beta is found from the %,-.=
1*? C *? N 41#? 2 *?5b
p


b
p
C 1.#/'.
The portfolio beta is a weighted average of the betas of the stocks within
the portfolio.
1.#/' C 4Q1$541./5 N 4$Q1$541.15 N 4!Q1$541.#5 N 4$Q1$5b
3
1.#/' C 1.11'* N 1.!''* N 1./11 N 4$Q1$5b
3
1.'*$ C $Q1$b
3

b
3
C .1'.
111. (Comp: 2.+ 2.() Portfo#io re)!ired ret!rn Answer: a Diff: 0
6tep 1 Find the beta of the original portfolio by taking a weighted average
of the individual stocksG betas. (e calculate a beta of 1.!.
1
]
1

,
_

,
_

,
_

,
_

+ + + 41./5
I1,'11,111
I$11,111
41.#5
I1,'11,111
I$11,111
415
I1,'11,111
I!11,111
41.'5
I1,'11,111
I!11,111
6tep Find the market risk premium using the original portfolio.
r
s
C 1.1$ C 1.1' N 4r
.
2 r
;F
51.!. If you substitute for all the
values you know, you calculate a market risk premium of 1.1$.
6tep ! %alculate the new portfolio&s beta.
The )uestion asks for the new portfolioGs re)uired rate of return.
(e have all of the necessary information except the new portfolioGs
beta. @ow, 6tock 1 has 1 weight 4we sold it5 and 6tock # has a
weight of
,
_

I1,'11,111
I/11,111
1.$. The portfolioGs new beta is=
+
,
_

415
I1,'11,111
I!11,111
+
,
_

41.#5
I1,'11,111
I$11,111

,
_

41./5
I1,'11,111
I/11,111
1.$$.
6tep # Find the portfolio&s re)uired return.
Thus, r
s
C 1.1' N 41.1$51.$$ C 1!.'$? 1!.'!?.
111. (2.2) Coefficient of variation Answer: $ Diff: E
Lsing your financial calculator you find the mean to be 11./ and the
population standard deviation to be 1$.*1$. The coefficient of variation is
Aust the standard deviation divided by the mean, or 1$.*1$Q11./ C 1.#$$1
1.#'.
11
. (2.) Portfo#io standard deviation Answer: a Diff: "
Fill in the columns for "EB" and "product," and then use the formula to
calculate the standard deviation. (e did each 4r 2

r
5

- calculation with a
calculator, stored the value, did the next calculation and added it to the
first one, and so forth. (hen all three calculations had been done, we
recalled the stored memory value, took its s)uare root, and had
EB
C /.1?.
-robability -ortfolio EB -roduct
1.1 2$.1? 21.$?
1./ 1*.$ 1#.1
1.1 !1.1 !.1

^
r
C 1'.$?
EB
C 44r 2

r
5

-5
U
C /.1*? /.1?.
11!. (2.() CAP" and re)!ired ret!rn Answer: e Diff: "
r
,
C '? N 411? 2 '?5b
,
.
%alculate b
,
as follows using a financial calculator=
' Input / N
2/ Input ! N
2/ Input 2 N
1/ Input 1 N
1
y ,m
swap b
,
C 1.#$!#.
r
,
C '? N $?41.#$!#5 C /.''0? /.*?.
11#. (2.() CAP" and re)!ired ret!rn Answer: a Diff: "
(ith your financial calculator input the following=
2 Input / N
1 Input ! N
2/ Input 1/ N
1 Input 2* N
1
y,m
swap b
%
C 21.*'.
r
%
C /? N 41#? 2 /?5421.*'5 C /? 2 #.$/? C !.#?.
11$. (Comp: 2./+ 2.() Expected and re)!ired ret!rns Answer: c Diff: "
Lse the calculator&s regression function to find beta
A
. It is 21.''11.
Find r
;F
. @ote that ;-
.
C r
.
2 r
;F
, so
#? C 1? 2 r
;F
r
;F
C /?.
Find r
K
C /? 2 #?41.''5 C $.!'?.
C /.11? 2 $.!'? C .'#?.
11'
. (Comp: 2.+ 2./+ 2.() Portfo#io ret!rn Answer: c Diff: "
%alculate
E b
and
B b
for the stocks using the regression function of a
calculator.
b
E
C 1.*!$/< b
B
C 1.!!#0.
r
E
C *? N $?41.*!$/5 C 11.'*0?.
r
B
C *? N $?41.!!#05 C 1!.'*#$?.
r
p
C 1#Q1411.'*0?5 N 'Q141!.'*#$?5 C 11.$/?.
11*. (Comp: 2.+ 2./+ 2.() Re)!ired ret!rn on stock Diff: 0

rB
21
.2
.2
3
/
r
.

-3 -/ / 3 .2 .2 21 2/
a. The least s)uares procedure yields the following e)uation for predicting
the rate of return on 6tock B= r
B
C a N br
.
C .$ N 1.$r
.
. Therefore, the
beta for 6tock B is 1.$1. The regression line is plotted in the graph.
b. r
B
C r
;F
N 4r
.
2 r
;F
5b
B
C '? N 4#?51.$ C /?.
c. The stock is now riskier. (ith greater risk and the same expected earnings
and dividends, the price of the stock would fall. Thus, capital losses
would be incurred, and they would offset if not overwhelm the dividend
return, with the net result being a low or even negative reali"ed rate of
return during 111. The re)uired rate of return would rise. (ith the same
expected dividends and dividend growth rate, but a lower market price, the
expected rate of return on the now lower priced stock would rise to e)ual
the now higher re)uired rate of return.
d. ,dding the point 2$, 1 for 111 to the data set produces this regression
e)uation=
r
B
C .*$ N 1.!r
.
. beta C 1.!.
Thus, the historical beta declines when the 110 data is added.
e. r
B
C '? N 4#?51.! C *.?.
f. This is down from /? in 110. 6ince we know that investors regard 6tock B
as being riskier, the true re)uired rate of return must be higher than /?,
not lower. This demonstrates one of the problems with using the %,-.. In
this case, rising risk caused a decline in the price of the stock, which
caused a low rate of return, which in turn caused the calculated beta to
decline. In this example, historical betas do not reflect risk well at
all.