Chapter 6

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Chapter 6
1. The greater the risk, the larger the return investors require as compensation for bearing that risk.
  a.  True
  b.  False
ANSWER:   True

2. If the correlation were -1, the portfolio’s standard deviation would be the weighted average of the share’s standard
deviations.
  a.  True
  b.  False
ANSWER:   False

3. By investing in different securities, an investor can lower his exposure to risk.
  a.  True
  b.  False
ANSWER:   True

4. Beta is a measurement of the relationship between a security's returns and the general market's returns.
  a.  True
  b.  False
ANSWER:   True

5. The capital market line (CML) offers the highest return for all levels of risk.
  a.  True
  b.  False
ANSWER:   True

6. The greater the probability that the actual return will be far below the expected return, the lower the asset’s stand-alone
risk.
  a.  True
  b.  False
ANSWER:   False

7. Fully diversifying a portfolio by buying every asset in the market can completely eliminate all types of risk. This would
thereby create a synthetic Treasury bill.
  a.  True
  b.  False
ANSWER:   False

8. A security with a beta of zero has a required rate of return equal to the overall market rate of return.
  a.  True
  b.  False
ANSWER:   False

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

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Chapter 6
  a.  True
  b.  False
ANSWER:   True

10. Most rational investors hold portfolios of assets, and they are less concerned with the risk of their portfolios than with
the risk of individual assets.
  a.  True
  b.  False
ANSWER:   False

11. The distribution of returns, measured over a short interval of time, like daily returns, can be approximated by:
  a.  Lognormal distribution b.  Normal distribution.
  c.  Binomial distribution d.  none of the above
ANSWER:   b

12. The appropriate measure for risk according to the Capital Asset Pricing Model is:
  a.  the standard deviation of a firm's cash flows.
  b.  covariance.
  c.  correlation.
  d.  beta.
  e.  alpha.
ANSWER:   d

13. What type of risk can investors reduce through diversification?


  a.  systematic risk only. b.  uncertainty.
  c.  unsystematic risk only. d.  all type of risk.
ANSWER:   c

14. ABC plc. is expecting the following returns on their stock and related probabilities. Calculate Wilson's expected
return.
State Probability Return
Boom 40% 20%
Normal 60% 10%
  a.  10%.
  b.  12%.
  c.  14%.
  d.  15%.
  e.  none of these answers.
ANSWER:   c

15. Which of the following is NOT an example of factors that affect systematic risk?
  a.  changes in general interest rates.
  b.  changes in economic growth.
  c.  environmental awareness increases throughout the country.
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Chapter 6
  d.  a firm lose a lawsuit dealing with product development.
  e.  changes in tax law.
ANSWER:   d

16. A stock's beta is a measure of its


  a.  unsystematic risk.
  b.  systematic risk.
  c.  company-specific risk.
  d.  diversifiable risk.
  e.  none of these answers
ANSWER:   b

17. What is the standard deviation of an investment that has the following expected scenario? If there is an 30%
probability of a recession with -10% return; if there is a 40% probability of a moderate economy with 0% return; and if
there is a 30% probability of a strong economy with 30% return.
  a.  25.4%. b.  2.6%.
  c.  16.3%. d.  12.7%.
ANSWER:   c

18. Optimum Manufacturing Company's common stock has a beta of 0.68. If the expected risk-free rate of return is 6.0%
and the market offers a premium of 7.6% over the risk-free rate, what is the expected return on the company’s common
stock?
  a.  10.94%. b.  11.17%.
  c.  12.03%. d.  none of these answers.
ANSWER:   b

19. Jack is a summer intern at Schmidt plc, Julie who is the manager of the company ask Jack to compute the
standard deviation of the portfolio consisting of asset A and asset B. Asset A has the expected rate of return of 10%
with standard deviation of 6%; while asset B has the expected rate of return of 14% with standard deviation of
11%. The correlation of asset A and B is 0.6.
  a.  6.65%
  b.  7.86%.
  c.  6.87%.
  d.  7.68%.
  e.  none of these answers.
ANSWER:   d

20. If a stock is under-priced it would plot


  a.  Below the security market line
  b.  On the X-axis
  c.  Above the security market line
  d.  On the security market line
  e.  On the Y-axis
ANSWER:   c
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21. Explain the relationship between risk and return.


ANSWER:   If investors require greater returns, they have to take greater risk. There are positive relationship. Investors
would prefer the investment with the highest possible return for a given level of risk or the investment with
the lowest risk for a given level of return.
PTS: 1

22. Explain how the expected return on an investment is calculated.


ANSWER:   The expected return is calculated as a weighted-average of the possible returns on an investment. The
weights in this calculation are the probabilities that each of the possible returns will be realized.
PTS: 1

23. Explain what the standard deviation of returns is and why it is quite useful in finance.
ANSWER:   The standard deviation can be used to measure the total risk associated with the returns from an asset. When
assets returns are normally distributed, the standard deviation is quite useful in evaluating returns. Normal
distribution of returns is common in finance. The standard deviation of returns measures the dispersion of
returns. This is very important information in finance as it tells the probability that a return will fall within a
particular distance from the expected value.
PTS: 1

24. Define what diversification is.


ANSWER:   If two or more assets have values that do not always move in the same direction at the same time, the strategy
of diversification can be taken to invest in these assets to reduce risk. This strategy can cause risk reduction
as these assets prices do not always move together. Some of the changes in the prices of individual assets
offset each other. So the overall volatility in the value of the portfolio would be lower than if it were invested
in a single asset.
PTS: 1

25. Explain what the two components of total risk are.


ANSWER:   The two components of total risk are unique risk (unsystematic) and systematic risk. Unsystematic risk is risk
that is unique to a particular asset. This is the risk that can be diversified away. On the contrary, systematic
risk is risk that is common to all assets and cannot be diversified away.
PTS: 1

26. Interpret beta when it is 1.2 and 0.85.


ANSWER:   When the beta is 1.2, it indicates that the asset has 1.2 times as much systematic risk as the market. So
investing in the asset is risker than market portfolio. But if the beta is 0.85, it shows the asset only has 85
percent as much systematic risk as the market portfolio.
PTS: 1

27. Differentiate between the expected rate of return and the required rate of return.
ANSWER:   The required rate of return is the rate of return that investors require to compensate them for the risk
associated with an investment. The expected return is a return that is based on the probability-weighted
average of the possible returns from an investment. It is anticipated return. The expected return will not
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necessarily equal the required rate of return.
PTS: 1

28. Define the Capital Asset Pricing Model (CAPM).


ANSWER:   The CAPM is a model that describes the relation between systematic risk and the expected return. The model
tells us that the expected return on an asset with no systematic risk equals the risk-free rate. As systematic
risk increases, the expected return increases linearly with beta. The CAPM is written as E(r i) = rf + âi(E(rm) –
rf).

PTS: 1

29. Briefly explain why the market will not reward investors with additional returns for assuming unsystematic risk.
ANSWER:   Through diversification, risk can be lowered without sacrificing returns. The unsystematic risk can be
diversified away, so market will not reward for taking this type of risks. The market rewards investors for the
systematic risk that cannot be eliminated through diversification.
PTS: 1

30. Define security market line (SML).


ANSWER:   Security Market Line (SML) equation shows the relationship between a security’s market risk and its
required rate of return.
PTS: 1

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