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8.1 Portfolio Returns and Portfolio Risk

1) Which of the following investments is clearly preferred to the others?

Return

Risk

A

14%

12%

B

22%

20%

C

18%

16%

A) Investment A

B) Investment B

C) Investment C

D) Cannot be determined

Answer: D

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

2) You are considering investing in U.S. Steel. Which of the following is an example of

nondiversifiable risk?

A) Risk resulting from foreign expropriation of U.S. Steel property

B) Risk resulting from oil exploration by Marathon Oil (a U.S. Steel subsidy)

C) Risk resulting from a strike against U.S. Steel

D) None of the above

Answer: D

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

3) You are considering buying some stock in Continental Grain. Which of the following is an

example of nondiversifiable risk?

A) Risk resulting from a general decline in the stock market

B) Risk resulting from a news release that several of Continental's grain silos were tainted

C) Risk resulting from an explosion in a grain elevator owned by Continental

D) Risk resulting from an impending lawsuit against Continental

Answer: A

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

4) If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a

40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what is the

expected rate of return?

A) 12%

B) 13%

C) 14%

D) 15%

Answer: B

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

5) If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a

40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what would be

the standard deviation?

A) 2.24

B) 2.56

C) 2.83

D) 2.98

Answer: A

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

6) You are considering investing in a project with the following possible outcomes:

Probability of Investment

States

Occurrence

Returns

State 1: Economic boom 15%

16%

State 2: Economic growth 45%

12%

State 3: Economic decline 25%

5%

State 4: Depression

15%

-5%

Calculate the expected rate of return and standard deviation of returns for this investment.

A) 9.8%, 7.0%

B) 7.0%, 43.6%

C) 8.3%, 6.6%

D) 8.3%, 16.1%

Answer: C

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

2

Copyright 2011 Pearson Education, Inc.

7) The prices for the Guns and Hoses Corporation for the first quarter of 1992 are given below.

Find the holding period return for February.

Month End

Price

January

$135.28

February

$119.40

March

$141.57

A) 18.56%

B) 13.30%

C) -11.73%

D) 8.83%

Answer: C

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: holding period return

Principles: Principle 3: Cash Flows Are the Source of Value

8) Wilson, Inc. is expecting the following returns on their stock and related probabilities.

Calculate Wilson's expected return.

State

Probability

Return

Boom

30%

30%

Normal

70%

10%

A) 16%

B) 14%

C) 12%

D) 10%

Answer: A

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

Use the following information, which describes the possible outcomes from investing in a

particular asset, to answer the following question(s).

State of the EconomyProbability of the States Percentage Returns

Economic recession

25%

5%

Moderate economic growth

55%

10%

Strong economic growth

20%

13%

9) The expected return from investing in the asset is:

A) 9.00%.

B) 9.35%.

C) 10.00%.

D) 10.55%.

Answer: B

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

10) The standard deviation of returns is:

A) 8.00%.

B) 7.63%.

C) 4.68%.

D) 2.76%.

Answer: D

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

11) What is the expected rate of return for an investment that has the following expected

scenario? If there is an 18% probability of a recession, 2.0% return; if there is a 65% probability

of a moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2%

return.

A) 11.25%

B) 7.33%

C) 8.95%

D) 9.59%

Answer: C

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

4

Copyright 2011 Pearson Education, Inc.

12) What is the expected return on an investment that has the following expected scenario? If

there is a 10% probability of a booming economy, $250 return; if there is a 70% probability of a

moderate economy, $154 return; if there is a 20% probability of a declining economy, $50 return.

A) $154.00

B) $142.80

C) $65.00

D) $15.12

Answer: B

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

Use the following information, which describes the expected return and standard deviation for

three different assets, to answer the following question(s).

Asset X

Expected return 9.5%

Standard deviation

Asset Y

8.8%

4.9%

Asset Z

9.5%

5.5%

5.5%

13) If an investor must choose between investing in either Asset X or Asset Y, then:

A) she will always choose Asset X over Asset Y.

B) she will always choose Asset Y over Asset X.

C) she will be indifferent between investing in Asset X and Asset Y.

D) none of the above.

Answer: A

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

14) If an investor must choose between investing in either Asset X or Asset Z, then:

A) he will always choose Asset X over Asset Z.

B) he will always choose Asset Z over Asset X.

C) he will be indifferent between investing in Asset X and Asset Z.

D) none of the above.

Answer: A

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

5

Copyright 2011 Pearson Education, Inc.

15) Which of the following is NOT an example of factors that affect systematic risk?

A) Changes in general interest rates

B) A firm wins a lawsuit dealing with patent infringement

C) Our country declares war in the Persian Gulf

D) Environmental awareness increases throughout the country

Answer: B

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: systematic risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

16) Which of the following best measures the risk of holding an asset in isolation (i.e., standalone risk)?

A) The mean co-variance

B) The standard deviation

C) The coefficient of optimization

D) The standard asset pricing model

E) The omegatron

Answer: B

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

17) What is a practical measure that is used to quantify the risk of a single investment?

A) The systematic variation

B) The Fisher effect

C) The IRP

D) The standard deviation

Answer: D

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

18) What is the standard deviation of an investment that has the following expected scenario? If

there is an 18% probability of a recession, 2.0% return; if there is a 65% probability of a

moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2% return.

A) 3.68%

B) 1.23%

C) 8.47%

D) 6.66%

Answer: A

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

6

Copyright 2011 Pearson Education, Inc.

19) You are considering investing in a firm that has the following possible outcomes:

Economic boom: probability of 25%; return of 25%

Economic growth: probability of 60%; return of 15%

Economic decline: probability of 15%; return of -5%

What is the expected rate of return on the investment?

A) 15.0%

B) 11.7%

C) 14.5%

D) 25.0%

Answer: C

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

20) Which of the following is an adequate method of achieving portfolio diversification?

A) Invest in various bonds and stocks.

B) Invest in stocks of different industries.

C) Invest internationally.

D) All of the above.

E) None of the above.

Answer: D

Diff: 1

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: systematic risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

21) You have been employed by Telemetry Medical Instruments (TMI) for seven years and

participate in their 401 (k) plan by having 5% of your paycheck invested in the plan. You have

been so impressed with the performance of the company's stock that you currently have all of

your 401 (k) money invested in TMI's common stock. What does prudent investment

management suggest that you do about risk?

A) Close out your 401 (k) and put the money in the bank.

B) Increase your payroll deduction from 5% to 10% but keep all funds invested in TMI.

C) Close out your 401 (k) and invest in T-bills.

D) Take some of your investment out of TMI's common stock and invest it in the stocks and

bonds of other firms.

Answer: D

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

22) You bought Chemtron stock for $45 a year ago. It is selling for $54 today. What is your

holding period return?

A) 9%

B) 11%

C) 6%

D) 20%

Answer: D

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: holding period return

Principles: Principle 3: Cash Flows Are the Source of Value

23) You purchased the stock of Sargent Motors at a price of $75.75 one year ago today. If you

sell the stock today for $89.00, what is your holding period return?

A) 35.00%

B) 12.50%

C) 17.50%

D) 25.00%

Answer: C

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: holding period return

Principles: Principle 3: Cash Flows Are the Source of Value

24) Which of the following statements is correct?

A) Portfolio diversification reduces the variability of the returns on the individual stocks held in

a portfolio.

B) Portfolio A has but one security, while Portfolio B has 100 securities. Because of

diversification, we would expect Portfolio B to have lower risk.

C) If an investor buys enough stocks, he or she can, through diversification, eliminate all market

risk.

D) Diversification can be achieved by purchasing stocks that are perfectly positively correlated.

Answer: B

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

8

Copyright 2011 Pearson Education, Inc.

25) Your broker mailed you your year-end statement. You have $25,000 invested in Dow

Chemical, $18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The

annualized returns for these stocks is 16.5% for Dow, 12.0% for GM, 18.5% for Microsoft, and

15.3% for Nike. What is the return of your entire portfolio?

A) 15.60%

B) 18.55%

C) 16.25%

D) 9.00%

Answer: C

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

26) According to the experts, a model portfolio should consist of a mix of securities that over the

long run should look something like this: cash or money market accounts, 5%; bonds, 25%;

domestic stocks, 35%; international stocks, 35%. What is the determination of the proportions of

various securities within a portfolio referred to as?

A) Risk assessment

B) Capital asset modeling

C) Beta selection

D) Portfolio regression

E) Asset allocation

Answer: E

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: portfolio composition

Principles: Principle 2: There Is a Risk-Return Tradeoff

27) By investing in different securities, an investor can lower his exposure to risk.

Answer: TRUE

Diff: 1

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

28) The greater the dispersion of possible returns, the riskier is the investment.

Answer: TRUE

Diff: 1

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: standard deviation

Principles: Principle 2: There Is a Risk-Return Tradeoff

9

Copyright 2011 Pearson Education, Inc.

29) For the most part, there has been a positive relation between risk and return historically.

Answer: TRUE

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

30) The benefit from diversification is far greater when the diversification occurs across asset

types.

Answer: TRUE

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

31) Investing in foreign stocks is one way to improve diversification of a portfolio.

Answer: TRUE

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

32) You are considering a security with the following possible rates of return:

Probability Return (%)

0.20

9.6

0.30

12.0

0.30

14.4

0.20

16.8

a. Calculate the expected rate of return.

b. Calculate the standard deviation of the returns.

Answer:

a. R = (0.2)(9.6) + (0.3)(12.0) + (0.3)(14.4) + (0.2 )(16.8) = 13.2%

b. s(R) = [(9.6 - 13.2)2 (0.2) + (12 - 13.2)2(0.3)

+ (14.4 - 13.2)2(0.3) + (16.8 - 13.2)2(0.2)]1/2 = 2.459%

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

10

Copyright 2011 Pearson Education, Inc.

33) Using the following information for McDonovan, Inc.'s stock, calculate their expected return

and standard deviation.

State

Probability

Return

Boom

20%

40%

Normal

60%

15%

Recession

20%

(20%)

Answer: Ki = (Ki)(Pi) = (.20)(40%) + (.60)(15%) + (.20)(-20%)

= 8% + 9% - 4% = 13%

2

i = ((Ki K) Pi).5

i = ((40%-13%)2(.2) + (15%-13%)2 (.6) + (-20%-13%)2 (.2)).5 = 19.13%

Diff: 2

Topic: 8.1 Portfolio Returns and Portfolio Risk

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

8.2 Systematic Risk and the Market Portfolio

1) The capital asset pricing model:

A) provides a risk-return trade-off in which risk is measured in terms of the market returns.

B) provides a risk-return trade-off in which risk is measured in terms of beta.

C) measures risk as the coefficient of variation between security and market rates of return.

D) depicts the total risk of a security.

Answer: B

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

2) The appropriate measure for risk according to the capital asset pricing model is:

A) the standard deviation of a firm's cash flows.

B) alpha.

C) beta.

D) probability of correlation.

Answer: C

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

11

Copyright 2011 Pearson Education, Inc.

3) You are considering investing in Ford Motor Company. Which of the following is an example

of diversifiable risk?

A) Risk resulting from the possibility of a stock market crash

B) Risk resulting from uncertainty regarding a possible strike against Ford

C) Risk resulting from an expected recession

D) Risk resulting from interest rates decreasing

Answer: B

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

4) Sterling Incorporated has a beta of 1.0. If the expected return on the market is 12%, what is

the expected return on Sterling Incorporated's stock?

A) 9%

B) 10%

C) 12%

D) Insufficient information is provided

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

5) Which of the following has a beta of zero?

A) A risk-free asset

B) The market

C) A high-risk asset

D) Both A and B

Answer: A

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

6) Beta is a statistical measure of:

A) hyperbolic.

B) total risk.

C) the standard deviation.

D) the relationship between an investment's returns and the market return.

Answer: D

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

12

Copyright 2011 Pearson Education, Inc.

A) systematic risk.

B) unsystematic risk.

C) company-specific risk.

D) diversifiable risk.

Answer: A

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

8) If you hold a portfolio made up of the following stocks:

Investment Value Beta

Stock A

$2,000

1.5

Stock B

$5,000

1.2

Stock C

$3,000

.8

What is the beta of the portfolio?

A) 1.17

B) 1.14

C) 1.32

D) Can't be determined from information given

Answer: B

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

9) Changes in the general economy, such as changes in interest rates or tax laws, represent what

type of risk?

A) Firm-specific risk

B) Market risk

C) Unsystematic risk

D) Diversifiable risk

Answer: B

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

13

Copyright 2011 Pearson Education, Inc.

10) A stock with a beta greater than 1.0 has returns that are ________ volatile than the market,

and a stock with a beta of less than 1.0 exhibits returns which are ________ volatile than those of

the market portfolio.

A) more, more

B) more, less

C) less, more

D) less, less

Answer: B

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

11) You hold a portfolio with the following securities:

Percent

Security

of Portfolio

Beta

Return

X Corporation

20%

1.35

14%

Y Corporation

35%

.95

10%

Z Corporation

45%

.75

8%

Compute the expected return and beta for the portfolio.

A) 10.67%, 1.02

B) 9.9%, 1.02

C) 34.4%, .94

D) 9.9%, .94

Answer: D

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

12) The beta of ABC Co. stock is the slope of:

A) the security market line.

B) the characteristic line for a plot of returns on the S&P 500 versus returns on short-term

Treasury bills.

C) the arbitrage pricing line.

D) the characteristic line for a plot of ABC Co. returns against the returns of the market portfolio

for the same period.

Answer: D

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

14

Copyright 2011 Pearson Education, Inc.

13) You are thinking of adding one of two investments to an already well diversified portfolio.

Security A

Security B

Expected return = 12%

Expected return = 12%

Standard deviation of returns = 20.9% Standard deviation of returns = 10.1%

Beta = .8

Beta = 2

If you are a risk-averse investor:

A) security A is the better choice.

B) security B is the better choice.

C) either security would be acceptable.

D) cannot be determined with information given.

Answer: A

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

14) The market (systematic) risk associated with an individual stock is most closely identified

with the:

A) variance of the returns of the stock.

B) variance of the returns of the market.

C) beta of the stock.

D) standard deviation of the stock.

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

15) Which of the following is NOT an example of systematic risk?

A) Inflation

B) Recession

C) Management risk

D) Interest rate risk

Answer: C

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: systematic risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

16) What type of risk can investors reduce through diversification?

A) All risk

B) Systematic risk only

C) Unsystematic risk only

D) Uncertainty

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: unique risk

15

Copyright 2011 Pearson Education, Inc.

17) Which of the following statements is true?

A) A stock with a beta of zero has a very low level of systematic risk.

B) A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of

1.0.

C) A stock with a beta less than 1.0 has lower nondiversifiable risk than a stock with a beta of

1.0.

D) A stock with a beta less than 1.0 has higher nondiversifiable risk than a stock with a beta of

1.0.

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

18) Currently, the expected return on the market is 12.5% and the required rate of return for

Alpha, Inc. is 12.5%. Therefore, Alpha's beta must be:

A) less than 1.0.

B) greater than 1.0.

C) equal to 1.0.

D) unknown based on the information provided.

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

19) Investment risk is:

A) the probability of achieving a return that is greater than what was expected.

B) the probability of achieving a beta coefficient that is less than what was expected.

C) the probability of achieving a return that is less than what was expected.

D) the probability of achieving a standard deviation that is less than what was expected.

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

16

Copyright 2011 Pearson Education, Inc.

A) Systematic, or market, risk can be reduced through diversification.

B) Both systematic and unsystematic risk can be reduced through diversification.

C) Unsystematic, or company, risk can be reduced through diversification.

D) Neither systematic nor unsystematic risk can be reduced through diversification.

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

21) Which of the following is a good measure of the relationship between an investment's returns

and the market's returns?

A) The beta coefficient

B) The standard variation

C) The CPI

D) The S&P 500 Index

Answer: A

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

22) Which of the following is generally used to measure the market when calculating betas?

A) The Dow Jones Transportations

B) The Standard & Poors 500

C) The Value Line Quantam Index

D) The Lehman Brothers Bond Index

Answer: B

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

23) Your broker mailed you your year-end statement. You have $25,000 invested in Dow

Chemical, $18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The betas

for each of your stocks are 1.55 for Dow, 1.12 for GM, 2.39 for Microsoft, and .76 for Nike.

What is the beta of your portfolio?

A) 1.46

B) 1.70

C) 2.60

D) 0.41

Answer: B

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: portfolio beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

17

Copyright 2011 Pearson Education, Inc.

24) You are considering a portfolio of three stocks with 30% of your money invested in company

X, 45% of your money invested in company Y, and 25% of your money invested in company Z.

If the betas for each stock are 1.22 for company X, 1.46 for company Y, and 1.03 for company Z,

what is the portfolio beta?

A) 1.24

B) 1.00

C) 1.28

D) 1.33

Answer: C

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: portfolio beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

25) Beta is a measurement of the relationship between a security's returns and the general

market's returns.

Answer: TRUE

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

26) Total risk equals unique security risk times systematic risk.

Answer: FALSE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

27) The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in

terms of beta.

Answer: TRUE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

28) The relevant risk to an investor is that portion of the variability of returns that cannot be

diversified away.

Answer: FALSE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

18

Copyright 2011 Pearson Education, Inc.

29) Stocks with higher betas are usually more stable than stocks with lower betas.

Answer: FALSE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

30) A stock with a beta of 1.0 would earn the risk-free rate.

Answer: FALSE

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: market return

Principles: Principle 2: There Is a Risk-Return Tradeoff

31) Unsystematic risk can be eliminated through diversification.

Answer: TRUE

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: unique risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

32) Beta is a measure of systematic risk.

Answer: TRUE

Diff: 1

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

33) The market rewards assuming additional unsystematic risk with additional returns.

Answer: FALSE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: unique risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

34) The market rewards assuming additional systematic risk with additional returns.

Answer: TRUE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: systematic risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

35) Betas for individual stocks tend to be stable.

Answer: FALSE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

19

Copyright 2011 Pearson Education, Inc.

36) A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta

of 1.0.

Answer: FALSE

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

37) Briefly discuss why there is no reason to believe that the market will reward investors with

additional returns for assuming unsystematic risk.

Answer: Through diversification, risk can be lowered without sacrificing returns. The market

rewards investors for the systematic risk that cannot be eliminated through proper asset

allocation in a diversified portfolio.

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

38) Provide an intuitive discussion of beta and its importance for measuring risk.

Answer: Beta is an important measure that indicates the systematic risk of a given investment.

Since systematic risk cannot be diversified away, investors are compensated for taking this risk.

Beta compares the market risk of a particular investment with the market risk of the market, and

the risk premium necessary for a stock is directly proportional to the risk premium for the market

as a whole. When the risk premium is added to the risk free rate, this results in the required

return for the stock.

Diff: 2

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: diversifying risk

Principles: Principle 2: There Is a Risk-Return Tradeoff

39) The stock of the Preston Corporation is expected to pay a dividend of $6 during the coming

year. Dividends are expected to grow far into the future at 8%. Investors have recently evaluated

future market return variance to be 0.0016 and the covariance of returns for Preston and the

market as 0.00352. Assuming a required market return of 14% and a risk-free rate of 6%, at what

price should the stock of Preston sell?

Answer: Beta = 0.00352/0.0016 = 2.2

K = 0.06 + 2.2(0.14 - 0.06)

K = 0.236

P = $6/(0.236 - 0.08) = $6/0.156 = $38.46

Diff: 3

Topic: 8.2 Systematic Risk and the Market Portfolio

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

20

Copyright 2011 Pearson Education, Inc.

1) The risk-return relationship for each financial asset is shown on:

A) the capital market line.

B) the New York Stock Exchange market line.

C) the security market line.

D) none of the above.

Answer: C

Diff: 1

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

2) Siebling Manufacturing Company's common stock has a beta of .8. If the expected risk-free

return is 7% and the market offers a premium of 8% over the risk-free rate, what is the expected

return on Siebling's common stock?

A) 7.8%

B) 13.4%

C) 14.4%

D) 8.7%

Answer: B

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

3) Huit Industries' common stock has an expected return of 14.4% and a beta of 1.2. If the

expected risk-free return is 8%, what is the expected return for the market (round your answer to

the nearest .1%)?

A) 7.7%

B) 9.6%

C) 12.0%

D) 13.3%

Answer: D

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

21

Copyright 2011 Pearson Education, Inc.

4) Tanzlin Manufacturing's common stock has a beta of 1.5. If the expected risk-free return is 9%

and the expected return on the market is 14%, what is the expected return on the stock?

A) 13.5%

B) 21.0%

C) 16.5%

D) 21.5%

Answer: C

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

5) Given the capital asset pricing model, a security with a beta of 1.5 should return ________, if

the risk-free rate is 6% and the market return is 11%.

A) 13.5%

B) 14.0%

C) 14.5%

D) 15.0%

Answer: A

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

6) The security market line (SML) relates risk to return, for a given set of market conditions. If

expected inflation increases, which of the following would most likely occur?

A) The market risk premium would increase.

B) Beta would increase.

C) The slope of the SML would increase.

D) The SML line would shift up.

Answer: D

Diff: 3

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

7) The security market line (SML) relates risk to return, for a given set of market conditions. If

risk aversion increases, which of the following would most likely occur?

A) The market risk premium would increase.

B) Beta would increase.

C) The slope of the SML would increase.

D) The SML line would shift up.

Answer: A

Diff: 3

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

22

Copyright 2011 Pearson Education, Inc.

8) The Elvis Alive Corporation, makers of Elvis memorabilia, has a beta of 2.35. The return on

the market portfolio is 13%, and the risk-free rate is 7%. According to CAPM, what is the risk

premium on a stock with a beta of 1.0?

A) 11.75%

B) 18.75%

C) 6%

D) 13%

Answer: C

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

9) Bell Weather, Inc. has a beta of 1.25. The return on the market portfolio is 12.5%, and the riskfree rate is 5%. According to CAPM, what is the required return on this stock?

A) 20.62%

B) 9.37%

C) 14.37%

D) 15.62%

Answer: C

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

10) The rate on six-month T-bills is currently 5%. Andvark Company stock has a beta of 1.69

and a required rate of return of 15.4%. According to CAPM, determine the return on the market

portfolio.

A) 11.15%

B) 6.15%

C) 17.07%

D) 14.11%

Answer: A

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

23

Copyright 2011 Pearson Education, Inc.

11) You are going to invest all of your funds in one of three projects with the following

distribution of possible returns:

Project 1

Project 2

Standard Deviation 12% Standard Deviation 19.5%

Probability

Return

Probability

Return

50% Chance

20%

30% Chance

30%

50% Chance

-4%

40% Chance

10%

30% Chance

-20%

Project 3

Standard Deviation 12%

Probability

Return

10% Chance

30%

40% Chance

15%

40% Chance

10%

10% Chance

-21%

If you are a risk-averse investor, which one should you choose?

A) Project 1

B) Project 2

C) Project 3

Answer: C

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

12) The return on the market portfolio is currently 13%. Battmobile Corporation stockholders

require a rate of return of 21%, and the stock has a beta of 3.5. According to CAPM, determine

the risk-free rate.

A) 7%

B) 14.7%

C) 9.8%

D) 24.2%

Answer: C

Diff: 3

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

24

Copyright 2011 Pearson Education, Inc.

13) Hefty stock has a beta of 1.2. If the risk-free rate is 7% and the market risk premium is 6.5%,

what is the required rate of return on Hefty?

A) 14.8%

B) 14.4%

C) 12.4%

D) 13.5%

Answer: A

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

14) The market risk premium is measured by:

A) beta.

B) market return less risk-free rate.

C) T-bill rate.

D) standard deviation.

Answer: B

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

15) Marjen stock has a required return of 20%. The expected market return is 15%, and the beta

of Marjen's stock is 1.5. Calculate the risk-free rate.

A) 4%

B) 5%

C) 6%

D) 7%

Answer: B

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

25

Copyright 2011 Pearson Education, Inc.

16) You are thinking about purchasing 1,000 shares of stock in the following firms:

Number of SharesFirm's Beta

Firm A

100

0.75

Firm B

200

1.47

Firm C

200

0.82

Firm D

600

1.60

If you purchase the number of shares specified, then the beta of your portfolio will be:

A) 1.16.

B) 1.35.

C) 1.00.

D) .85.

E) Cannot be determined with information given.

Answer: E

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

Use the following information to answer the following question(s).

Beta

1

1.25

0.6

Market

Firm A

Firm B

Market Return

10%

A) 2%.

B) 4%.

C) 6%.

D) 8%.

Answer: D

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

18) Firm A's risk premium is:

A) 2%.

B) 4%.

C) 6%.

D) 8%.

E) 10%.

Answer: E

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: risk, return

26

Copyright 2011 Pearson Education, Inc.

19) Firm B's risk premium is:

A) 2.66%.

B) 4.8%.

C) 6.3%.

D) 8.1%.

Answer: B

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: risk, return

Principles: Principle 2: There Is a Risk-Return Tradeoff

20) The required rate of return for Firm A is:

A) 4%.

B) 8%.

C) 12%.

D) 16%.

E) Cannot be determined with information given.

Answer: C

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: expected return

Principles: Principle 2: There Is a Risk-Return Tradeoff

21) Calculate the current beta for Mercury, Inc. The rate on 30-year U.S. Treasury bonds is

currently 8%. The market risk premium is 5%. Mercury returned 18% to its stockholders in the

latest year.

A) 1.00

B) 1.75

C) 1.25

D) 2.00

E) 1.50

Answer: D

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

27

Copyright 2011 Pearson Education, Inc.

22) The rate of return on the S&P 500 is 16.2%. Epsilon has a beta of 1.85. If the T-bond rate is

5.9%, what should investors expect as a rate of return on Epsilon's stock?

A) 16.2%

B) 22.1%

C) 18.5%

D) 25.0%

Answer: D

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

23) Which of the following statements is true?

A) An average stock has a beta of 1.0.

B) A stock having a beta of greater than 1.0 is a higher-than-average-risk stock.

C) A stock having a beta of less than 1.0 is a lower-than-average-risk stock.

D) All of the above.

E) None of the above.

Answer: D

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: beta

Principles: Principle 2: There Is a Risk-Return Tradeoff

24) The risk-free rate is currently 6.5%. Acid Battery Company stockholders require a rate of

return of 27.5%, and the stock has a beta of 2.1. What is the current market risk premium?

A) 6.90%

B) 21.00%

C) 13.65%

D) 10.00%

Answer: D

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

25) U.S. Treasury bonds currently yield 6%. Consolidated Industries stock has a beta of 1.5. The

rate of return on the S&P 500 is presently 18%. What is the rate of return that Consolidated

Industries stockholders require?

A) 6%

B) 24%

C) 18%

D) 27%

Answer: B

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

28

Copyright 2011 Pearson Education, Inc.

26) Amalgamated Aluminum stock has a beta of 1.2. Today's market risk premium is 13%.

Amalgamated Aluminum stockholders require a rate of return of 22%. What is the present riskfree rate?

A) 6.40%

B) 22.00%

C) 4.60%

D) 15.60%

Answer: A

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

27) If investors expected inflation to increase in the future, what would happen to the security

market line (SML)?

A) The slope of the SML would rise.

B) The SML would shift downward, but the slope would remain the same.

C) The slope of the SML would fall.

D) The SML would shift up, but the slope would remain the same.

Answer: D

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

28) What would happen if investors became more risk averse?

A) The slope of the SML would rise.

B) The SML would shift downward but the slope would remain the same.

C) The slope of the SML would fall.

D) The SML would shift downward and the slope of the SML would fall.

Answer: A

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

29) A security with a beta of zero has a required rate of return equal to the overall market rate of

return.

Answer: FALSE

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

29

Copyright 2011 Pearson Education, Inc.

30) The return for the market during the next period is expected to be 16%; the risk-free rate is

10%. Calculate the required rate of return for a stock with a beta of 1.5.

Answer: K = 10% + 1.5(16% - 10%) = 19%

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

31) Asset A has a required return of 18% and a beta of 1.4. The expected market return is 14%.

What is the risk-free rate? Plot the security market line.

Answer: K = Krf + (Km - Krf)b

18% = X + (14% - X)1.4

18% - X =19.6% - 1.4X

.4X = 1.6%

X = 4% = Risk - free Rate = Krf

Diff: 3

Topic: 8.3 The Security Market Line and the CAPM

Keywords: security market line

Principles: Principle 2: There Is a Risk-Return Tradeoff

32) Security A has an expected rate of return of 22% and a beta of 2.5. Security B has a beta of

1.20. If the Treasury bill rate is 10%, what is the expected rate of return for security B?

Answer: RA = RF + BA(Rm - Rf)

.22 = .10 + 2.5 (Rm - .10)

.12 = 2.5 (Rm - .10) = 2.5 Rm - .25

.37 = 2.5 Rm

.148 = Rm

RB = Rf + BB(Rm - Rf)

RB = .10 + 1.20(.148 - .10)

RB = .1576

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

33) AA & Co. has a beta of .656. If the expected market return is 13.2% and the risk-free rate is

5.7%, what is the appropriate required return of AA & Co. using the CAPM model?

Answer: Required Rate of Return = Risk-Free Rate + (Market Return - Risk-Free Rate) Beta =

5.7% + (13.2% - 5.7%) 0.656 = 10.62%

Diff: 2

Topic: 8.3 The Security Market Line and the CAPM

Keywords: CAPM

Principles: Principle 2: There Is a Risk-Return Tradeoff

30

Copyright 2011 Pearson Education, Inc.

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