BWFF2033 FINANCIAL MANAGEMENT

TOPIC 6-RISK AND RETURN

PART A

1. The portion of the risk that can be eliminated by diversification is called

A. default risk.
B. unique risk.
C. market risk.
D. interest rate risk.

2. Which of the following are NOT examples of a source of systematic risk?

I. strikes
II. availability of raw materials
III. changes in the inflation rate
IV. effects of foreign competition
V. changes in investor expectations about the economy

A. I, II and III only

B. I, II and IV only
C. II, III and V only
D. II, III and IV only

3. The linear relation between an assets expected return and its beta coefficient is the
__________.

A. portfolio weight
B. market risk premium
C. characteristic line (CL)
D. security market line (SML)

4. Which statement is FALSE?

A. The larger the standard deviation, the higher the total risk.
B. If a stock lies below the security market line (SML), it is undervalued.
C. The slope of the CL for a specific security is an estimate of beta for that security.
D. The less positively correlated the returns from 2 securities are, the greater will be the portfolio
effects of risk reduction.

5. Which of the following statements regarding diversification are TRUE?

I. Diversification over a large number of assets completely eliminates all risk.

II. The risk remaining after extensive diversification is primarily unsystematic risk.
III. A well-diversified portfolio with beta of 2 is twice as risky as the market portfolio.
IV. Diversification reduces risk because prices of different securities do not move exactly
together.

A. I and II only
B. I and III only
C. II and IV only
D. III and IV only

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 6. Which of the following will increase the expected rate of return on an individual security as
computed by the Capital Asset Pricing Model (CAPM)? Assume that the securitys beta, the
risk free rate of return, and the market rate of return are all positive.

I. A decrease in the risk premium.

II. A decrease in the securitys beta.
III. An increase in the securitys beta.
IV. An increase in the market rate of return.

A. I and II only
B. I and III only
C. II and IV only
D. III and IV only

7. A beta coefficient for a risky stock is

A. negative.
B. equal to 1.
C. less than 1.
D. greater than 1.

8. A security that is fairly priced (or valued) will have a return that lies __________ the SML.

A. on
B. above
C. below
D. on or above

9. Based on the information below, what is the amount of the risk premium?

Beta 1.23
Risk-free rate 4.5%
Market rate of return 10%

A. 4.47%
B. 5.50%
C. 6.77%
D. 11.27%

10. What is the beta of a portfolio comprised of the following securities?

Stock Amount invested (RM) Security beta

A 2,000 1.20
B 3,000 1.46
C 5,000 0.72

A. 1.014
B. 1.038
C. 1.067
D. 1.127

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 PART B

1. You have estimated the following probability distributions of expected future returns for
investment instruments.

State of economy Mutual fund Common stock

Probability Return Probabilit Return
y
Weak growth 0.10 -10% 0.20 2%
Semi-weak growth 0.20 10 0.20 7
Moderate growth 0.40 15 0.30 12
Semi-strong growth 0.20 20 0.20 15
Strong growth 0.10 40 0.10 16

a. What is the expected rate of return for Stock A? Stock B?

b. What is the standard deviation for Stock A? Stock B?
c. Which stock would you consider to be riskier? Explain.

2. Nick is thinking on buying stock X, Y and Z which is listed in Bursa Malaysia. Which stock is
considered an undervalued, overvalued and fairly valued. Draw a SML to prove your answer.
3.
Stock Expected return Beta
X 8% 0.8
Y 16% 1.4
Z 20% 2.0

4. The stock of Synergy Bhd has a beta value estimated to be 1.5. How would you interpret this beta
value? How would you evaluate the firms systematic risk?

5. Ahmad invested RM4,000 in a portfolio with an expected return of 10% and RM1,000 in a
portfolio with an expected return of 16%. What is the expected return of the combined portfolio?