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of Foundations Finance, 7e (Keown)
Chapter 6 The Meaning and Measurement of Risk and Return
6.1 Learning Objective 1
True or False
1) Accounting profits is the most relevant variable the financial manager uses to measure returns.
Diff: 1
Keywords: Accounting Profits, Cash Flows, Returns
2) Cash flows is the most relevant variable to measure the returns on debt instruments, while
GAAP net income is the most relevant variable to measure the returns on common stock.
Diff: 1
Keywords: Return, Cash Flow, Net Income
3) The expected rate of return from an investment is equal to the expected cash flows divided by
the initial investment.
Diff: 1
Keywords: Expected Rate of Return, Expected Cash Flows
4) Actual returns are always less than expected returns because actual returns are determined at
the end of the period and must be discounted back to present value.
Diff: 1
Keywords: Actual Returns, Expected Returns
5) Another name for an asset's expected rate of return is holding-period return.
Diff: 1
Keywords: Holding Period Return, Expected Return
6) The realized rate of return, or holding period return, is equal to the holding period dollar gain
divided by the price at the beginning of the period.
Diff: 1
Keywords: Holding Period Return, Holding Period Dollar Gain
7) The risk-return tradeoff that investors face on a day-to-day basis is based on realized rates of
return because expected returns involve too much uncertainty.
Diff: 2
Keywords: Realized Rate of Return, Expected Rate of Return
1
Copyright 2011 Pearson Education, Inc.
Multiple Choice
1) Stock A has the following returns for various states of the economy:
State of
the Economy
Recession
Below Average
Average
Above Average
Boom
Probability
10%
20%
40%
20%
10%
Stock A's Return
-30%
-2%
10%
18%
40%
Stock A's expected return is:
A) 5.4%.
B) 7.2%.
C) 8.2%.
D) 9.6%
Diff: 1
Keywords: Expected Return, Probability
2) Stock A has the following returns for various states of the economy:
State of
the Economy
Probability Stock A's Return
Recession
9%
-72%
Below Average 16%
-15%
Average
51%
16%
Above Average 14%
35%
Boom
10%
85%
Stock A's expected return is:
A) 9.9%.
B) 12.7%.
C) 13.8%.
D) 16.5%.
Diff: 1
Keywords: Expected Return
2
Copyright 2011 Pearson Education, Inc.
3) You are considering a sales job that pays you on a commission basis or a salaried position that
pays you $50,000 per year. Historical data suggests the following probability distribution for
your commission income. Which job has the higher expected income?
Probability of
Commission Occurrence
$15,000
.15
$35,000
.20
$48,000
.35
$67,000
.22
$80,000
.18
A) The salary of $50,000 is greater than the expected commission of $49,630.
B) The salary of $50,000 is greater than the expected commission of $48,400.
C) The salary of $50,000 is less than the expected commission of $50,050.
D) The salary of $50,000 is less than the expected commission of $52,720.
Diff: 2
Keywords: Expected Value
Essay
1) Use the following data:
Market risk premium = 10%
Risk free rate = 2%
Beta of XYZ stock = 1.6
Beta of PDQ stock = 2.4
Investment in XYZ stock = $15,000
Investment in PDQ stock = $60,000
You have no assets other than your investments in XYZ and PDQ stock.
What is the expected return of your portfolio? Show all work.
Answer: Portfolio Beta method:
Bp = (15/75 1.6) + (60/75 2.4) = 2.24
Rp = .02 + (2.24 .10) = .244 = 24.4%
Weighting individual stock return method:
RXYZ = .02 + (1.6 .10) = .18
RPDQ = .02 + (2.4 .10) = .26
WXYZ = $15,000/($15,000 + $60,000) = .2
WPDQ = $50,000 / ($15,000 + $50,000) = .8
RP = (.2 .18) + (.8X .26) = .244 = 24.4%
Both approaches are equivalent.
Diff: 2
Keywords: Beta, Portfolio, Security Market Line
3
Copyright 2011 Pearson Education, Inc.
6.2 Learning Objective 2
True or False
1) Variation in the rate of return of an investment is a measure of the riskiness of that investment.
Diff: 1
Keywords: Rate of Return, Risk, Variability
2) A rational investor will always prefer an investment with a lower standard deviation of
returns, because such investments are less risky.
Diff: 1
Keywords: Standard Deviation of Returns, Risk, Risk-Return Trade Off
3) For a well-diversified investor, an investment with an expected return of 10% with a standard
deviation of 3% dominates an investment with an expected return of 10% with a standard
deviation of 5%.
Diff: 2
Keywords: Expected Return, Standard Deviation, Risk-Return Trade Off, Well-diversified
4) Due to strict stock market controls, the most a stock's value can drop in one trading day is 5%.
Diff: 1
Keywords: Stock Price Volatility
Multiple Choice
1) Stock A has the following returns for various states of the economy:
State of the Economy Probability
Recession
10%
Below Average
20%
Average
40%
Above Average
20%
Boom
10%
Stock A's Return
-30%
-2%
10%
18%
40%
Stock A's standard deviation of returns is:
A) 10%.
B) 14%.
C) 17%.
D) 20%
Diff: 2
Keywords: Standard Deviation
4
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2) Stock A has the following returns for various states of the economy:
State of the Economy
Recession
Below Average
Average
Above Average
Boom
Probability
9%
16%
51%
14%
10%
Stock A's Return
-72%
-15%
16%
35%
85%
Stock A's standard deviation of returns is:
A) 12%.
B) 29%.
C) 37%.
D) 43%.
Diff: 2
Keywords: Standard Deviation
3) Stock A has an expected return of 12% with a standard deviation of 8%. If returns are
normally distributed, then approximately two-thirds of the time the return on stock A will be
A) between 12% and 20%
B) between 8% and 12%
C) between -4% and 28%
D) between 4% and 20%
Diff: 2
Keywords: Normal Distribution, Expected Return, Standard Deviation
4) Which of the following investments is clearly preferred to the others for an investor who is not
holding a well-diversified portfolio?
Investment k
A
18%
B
20%
C
20%
20%
20%
22%
A) Investment A
B) Investment B
C) Investment C
D) Cannot be determined without information regarding the risk-free rate of return.
Diff: 2
Keywords: Expected Return, Standard Deviation, Risk-Return Trade Off
5
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5) Assume that you have $165,000 invested in a stock that is returning 11.50%, $85,000 invested
in a stock that is returning 22.75%, and $235,000 invested in a stock that is returning 10.25%.
What is the expected return of your portfolio?
A) 15.6%
B) 12.9%
C) 18.3%
D) 14.8%
Diff: 2
Keywords: Expected Return, Portfolio
6) Assume that you have $200,000 invested in a stock that is returning 14%, $300,000 invested
in a stock that is returning 18%, and $400,000 invested in a stock that is returning 15%. What is
the expected return of your portfolio?
A) 13.25%
B) 14.97%
C) 15.67%
D) 15.78%
Diff: 2
Keywords: Expected Return, Portfolio
6
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Essay
1) You are given the following probability distribution for XYZ common stocks returns during
the next year, which are assumed to be normally distributed. Show all work below, and complete
the following:
Return
12%
16%
20%
Probability
20%
60%
20%
a. Calculate the standard deviation of the returns, and round to the nearest one-half percent.
b. Draw a graphical representation of XYZs normal distribution below (ye old bell-shaped
curve). LABEL THE AXES OF THE GRAPH OR THE FOLLOWING RESULTS WILL BE
MEANINGLESS. Using your result in part A for the standard deviation (rounded to the nearest
one-half percent) explain and indicate on the graph, the probability that XYZ will return more
than 13.5%, assuming a normal distribution.
Answer: GRAPH:
a. Exp. Return = (.12 .2) + (.16 .6) + (.2 .2) = .16
Std. Dev. = [(.12 - .16)2(0.2) + (.16 - .16)2(0.6)
+ (.20 - .16)2(0.2)]1/2 = .0253 = 2.53% rounded to 2.5%
b. The graph should have probability as the vertical axis and return (outcome, value of the
variable, etc.) as the horizontal axis. It should be bell-shaped and centered at the 16% mean.
13.5% is one standard deviation below the mean. The text indicates that 2/3 of outcomes fall
within one standard deviation of the mean for a normal probability distribution, so 2/3 of
outcomes fall within 13.5% and 18.5%. Since one-half of the remaining 1/3 would be in the
upper tail more than one standard deviation above the mean, 1/6 would fall above 16% + 2.5% =
18.5%. Thus, 2/3 + 1/6 = 5/6, or roughly 83% lie above 13.5%. Note, some students may have
learned 68% fall within one standard deviation of the mean.
Diff: 3
Keywords: Expected Return, Standard Deviation, Normal Deviation
2) Discuss whether the standard deviation of a portfolio is, or is not, a weighted average of the
standard deviations of the assets in the portfolio. Fully explain your answer.
Answer: The standard deviation of a portfolio is not a weighted average of the standard
deviations of the assets in the portfolio. If the portfolio is well-diversified then it should have a
standard deviation that is lower than most or all of the assets placed in that portfolio. Betas can
be averaged, but standard deviations cannot, due to the diversifiable risk that is contained in the
standard deviation but not reflected by beta.
Diff: 2
Keywords: Standard Deviation, Portfolio, Diversification
7
Copyright 2011 Pearson Education, Inc.
3) Bay Land, Inc. has the following distribution of returns:
State
Boom
Normal
Bust
Return
0.3
0.4
0.3
Probability
0.25
0.15
0.30
Assuming that these returns are normally distributed, what is the probability that Bay Land, Inc.
will return less than 7.25%? Show all work, and clearly explain and state your answer.
Answer: Exp. Return = (.3 .25) + (.4 .15) + (.3 .05) = .15
std. Dev. = [(.25 - .15)2(0.3) + (.15 - .15)2(0.4) + (.05 - .15)2(0.3)]1/2 = .0775 = 7.75%
Because 2/3 of the returns fall within one standard deviation of the mean (for a normal
probability distribution), 1/3 do not. One-half of that one third (or 1/6) falls in the tail below one
standard deviation below the mean (below 15% - 7.75% = 7.25%), thus the answer is 1/6, or
16.7%. Note, some students may have learned 68% fall within one standard deviation of the
mean.
Diff: 3
Keywords: Expected Return, Standard Deviation, Normal Distribution
6.3 Learning Objective 3
True or False
1) Historically, investments with the highest returns have the lowest standard deviations because
investors do not like risk.
Diff: 1
Keywords: Risk-Return Trade Off
2) An investor with a required return of 8% for stock A will purchase stock A if the expected
return for stock A is less than or equal to 8%.
Diff: 1
Keywords: Required Return, Expected Return
3) In general, the required rate of return is a function of (1) the time value of money, (2) the risk
of an asset, and (3) the investor's attitude toward risk.
Diff: 1
Keywords: Required Rate of Return
4) As the required rate of return of an investment decreases, the market price of the investment
decreases.
Diff: 1
Keywords: Required Rate of Return
8
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5) In an efficient market, a stock with a standard deviation of returns of 12% could have a higher
expected return than a stock with a standard deviation of 10% because the beta for the higher
standard deviation stock could be lower than the beta for the lower standard deviation stock.
Diff: 2
Keywords: Risk-Return Trade Off, Beta, Standard Deviation
6) Small company stocks have historically had higher average annual returns than large company
stocks, and also a higher risk premium.
Diff: 2
Keywords: Small Company Stocks, Risk Premium
7) Investment A and Investment B both have the same expected return, but Investment A is more
risky than Investment B. In the technical jargon of modern portfolio theory, Investment A is said
to dominate Investment B.
Diff: 2
Keywords: Risk-Return Trade Off
8) Negative historical returns are not possible during periods of high volatility (high standard
deviations of returns) due to the risk-return tradeoff.
Diff: 2
Keywords: Risk-Return Tradeoff, Historical Returns, Standard Deviation
Multiple Choice
1) Investment A has an expected return of 15% per year, while investment B has an expected
return of 12% per year. A rational investor will choose
A) investment A because of the higher expected return.
B) investment B because a lower return means lower risk.
C) investment A if A and B are of equal risk.
D) investment A only if the standard deviation of returns for A is higher than the standard
deviation of returns for B.
Diff: 2
Keywords: Expected Rate of Return, Standard Deviation, Risk-Return Trade Off
9
Copyright 2011 Pearson Education, Inc.
2) Investment A has an expected return of 14% with a standard deviation of 4%, while
investment B has an expected return of 20% with a standard deviation of 9%. Therefore,
A) a risk averse investor will definitely select investment A because the standard deviation is
lower.
B) a rational investor will pick investment B because the return adjusted for risk (20% - 9%) is
higher than the return adjusted for risk for investment A ($14% - 4%).
C) it is irrational for a risk-averse investor to select investment B because its standard deviation
is more than twice as big as investment A's, but the return is not twice as big.
D) rational investors could pick either A or B, depending on their level of risk aversion.
Diff: 2
Keywords: Expected Return, Standard Deviation, Risk-Return Trade Off
3) Which of the following investments is clearly preferred to the others for a risk-averse investor:
Investment
A
B
C
k
14%
22%
18%
12%
20%
16%
A) Investment A
B) Investment B
C) Investment C
D) Cannot be determined without additional information
Diff: 2
Keywords: Expected Return, Standard Deviation, Risk-Return Trade Off
4) Hole Con Shooz, Inc. has normally distributed returns with an expected return of 15% and a
standard deviation of 5%, while Ed Allenmunds Shooz, Inc. has normally distributed returns
with an expected return of 15% and a standard deviation of 15%. Which of the following is true:
A) Ed Allenmunds' investors are not being adequately compensated for relevant risk.
B) Hole Con is likely to experience returns larger than those of Ed Allenmunds.
C) Ed Allenmunds is more likely to have negative returns than Hole Con.
D) Rational investors will prefer Ed Allenmunds, Inc. over Hole Con Shooz, Inc.
Diff: 2
Keywords: Expected Return, Standard Deviation
10
Copyright 2011 Pearson Education, Inc.
5) You are considering investing in a project with the following possible outcomes:
States
Probability of
Occurrence
State 1: Economic boom
State 2: Economic growth
State 3: Economic decline
State 4: Depression
18%
42%
30%
10%
Investment
Returns
20%
16%
3%
-25%
Calculate the expected rate of return and standard deviation of returns for this investment,
respectively.
A) 8.72%, 12.99%
B) 7.35%, 12.99%
C) 3.50%, 1.69%
D) 2.18%, 1.69%
Diff: 2
Keywords: Expected Return, Standard Deviation
6) Changes in the general economy, like changes in interest rates or tax laws represent what type
of risk?
A) Company-unique risk
B) Market risk
C) Unsystematic risk
D) Diversifiable risk
Diff: 1
Keywords: Market Risk
7) The minimum rate of return necessary to attract an investor to purchase or hold a security is
referred to as the:
A) Stock's beta.
B) Investor's risk premium.
C) Investor's required rate of return.
D) Risk-free rate.
Diff: 1
Keywords: Required Rate of Return
11
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8) The relevant variable a financial manager uses to measure returns is:
A) net income determined using generally accepted accounting principles.
B) earnings per share minus dividends per share.
C) cash flows.
D) dividends.
Diff: 1
Keywords: Returns
9) Of the following different types of securities, which is typically considered most risky?
A) Long term corporate bonds
B) Long term government bonds
C) Common stocks of large companies
D) Common stocks of small companies
Diff: 1
Keywords: Risk, Stocks, Bonds
10) Assume that an investment is forecasted to produce the following returns: a 10% probability
of a $1,400 return; a 50% probability of a $6,600 return; and a 40% probability of a $10,500
return. What is the expected amount of return this investment will produce?
A) $6,167
B) $7,640
C) $12,890
D) $18,500
Diff: 2
Keywords: Expected Return
11) Assume that an investment is forecasted to produce the following returns: a 20% probability
of a 12% return; a 50% probability of a 16% return; and a 30% probability of a 19% return. What
is the expected percentage return this investment will produce?
A) 33.3%
B) 16.1%
C) 9.3%
D) 15.7%
Diff: 2
Keywords: Expected Return
12
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12) Assume that an investment is forecasted to produce the following returns: a 20% probability
of a 12% return; a 50% probability of a 16% return; and a 30% probability of a 19% return. What
is the standard deviation of return for this investment?
A) 5.89%
B) 16.1%
C) 2.43%
D) 15.7%
Diff: 2
Keywords: Standard Deviation
13) The category of securities with the highest historical risk premium is
A) large company stocks.
B) small company stocks.
C) government bonds.
D) small company corporate bonds.
Diff: 1
Keywords: Risk Premium
14) If you were to use the standard deviation as a measure of investment risk, which of the
following has historically been the least risky investment?
A) Common stock of large firms
B) U.S. Treasury bills
C) Common stock of small firms
D) Long-term government bonds
Diff: 1
Keywords: Standard Deviation, Risk, U.S. Treasury Bills
15) If you were to use the standard deviation as a measure of investment risk, which of the
following has historically been the highest risk investment?
A) Common stock of large firms
B) U.S. Treasury bills
C) Common stock of small firms
D) Long-term government bonds
Diff: 1
Keywords: Standard Deviation, Risk, Small Cap Common Stocks
13
Copyright 2011 Pearson Education, Inc.
Essay
1) You are considering a security with the following possible rates of return:
Probability
0.15
0.25
0.50
0.10
Return (%)
9.5
13.6
14.9
25.3
a. Calculate the expected rate of return.
b. Calculate the standard deviation of the returns.
Expected Return = (0.15)(9.5) + (0.25)(13.6) + (0.50)(14.9) + (0.1)(25.3) = 14.81%
b. Std. Dev. = [(9.5 - 14.81)2(0.15) + (13.6 - 14.81)2(0.25)
+ (14.9 - 14.81)2(0.5) + (25.3 - 14.81)2(0.1)]1/2 = 3.95%
Diff: 2
Keywords: Expected Rate of Return, Standard Deviation of Returns
2) You are considering the three securities listed below.
Returns
Probability
Stock A
Stock B
Stock C
20%
2%
-3%
5%
50%
10%
8%
8%
30%
15%
20%
12%
a. Calculate the expected return for each security.
b. Calculate the standard deviation of returns for each security.
c. Compare Stock A with Stocks B and C. Is Stock A preferred over the others?
RA = (.2)(2%) + (.5)(10%) + (.3)(15%) = 9.9%
RB = (.2)(-3%) + (.5)(8%) + (.3)(20%) = 9.4%
RC = (.2)(5%) + (.5)(8%) + (.3)(12%) = 8.6%
b.
Std.Dev.A = (2%-9.9%)2(.2) + (10%-9.9%)2(.5) + (15%-9.9%)2(.3) = 4.5%
Std.Dev.B = (-3%-9.4%)2(.2) + (8%-9.4%)2(.5) + (20%-9.4%)2(.3) = 8.1%
Std.Dev.C = (5%-8.6%)2(.2) + (8%-8.6%)2(.5) + (12%-8.6%)2(.3) = 2.5%
c. Stock A dominates stock B because A has a higher expected return and a lower standard
deviation. Stock A has a higher expected return than stock C, but also a higher standard
deviation, so the choice between A and C depends on the level of risk aversion.
Diff: 2
Keywords: Expected Return, Standard Deviation, Risk-Return Trade Off
14
Copyright 2011 Pearson Education, Inc.
6.4 Learning Objective 4
True or False
1) The benefits of diversification occur as long as the investments in a portfolio are not perfectly
positively correlated.
Diff: 1
Keywords: Diversification, Correlation
2) Proper diversification generally results in the elimination of risk.
Diff: 1
Keywords: Diversification, Risk
3) A stock with a beta of 1 has systematic or market risk equal to the "typical" stock in the
marketplace.
Diff: 1
Keywords: Beta, Systematic Risk
4) Diversifying among different kinds of assets is called asset allocation.
Diff: 1
Keywords: Asset Allocation, Diversification
5) Asset allocation is not recommended by financial planners because mixing different types of
assets, such as stocks with bonds, makes it more difficult to track performance and adjust
portfolios to changing market conditions.
Diff: 1
Keywords: Asset Allocation
6) A stock with a beta of 1.4 has 40% more variability in returns than the average stock.
Diff: 1
Keywords: Beta, Variability
7) Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks
have higher standard deviations of returns than bonds.
Diff: 1
Keywords: Diversification, Portfolio Risk
15
Copyright 2011 Pearson Education, Inc.
8) An all-stock portfolio is more risky than a portfolio consisting of all bonds.
Diff: 1
Keywords: Diversification, Portfolio Risk
9) Company unique risk can be virtually eliminated with a portfolio consisting of approximately
20 securities.
Diff: 1
Keywords: Company Unique Risk, Diversification
10) Total risk equals systematic risk plus unsystematic risk.
Diff: 1
Keywords: Systematic Risk, Unsystematic Risk, Total Risk
11) A well-diversified portfolio typically has systematic risk equal to about 40% of the
portfolio's total risk.
Diff: 1
Keywords: Systematic Risk, Diversification
12) A security with a beta of one has a required rate of return equal to the overall market rate of
return.
Diff: 1
Keywords: Beta
13) Unique security risk can be eliminated from an investor's portfolio through diversification.
Diff: 1
Keywords: Diversification, Portfolio
14) The Beta of a T-bill is zero.
Diff: 1
Keywords: Beta, T-bill
15) The Beta of a T-bill is one.
Diff: 1
Keywords: Beta, T-bill
16
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16) Portfolio performance is determined mainly by stock selection and market timing, with less
emphasis on asset allocation.
Diff: 1
Keywords: Asset Allocation, Portfolio Performance
17) Beta is a measurement of the relationship between a security's returns and the general
market's returns.
Diff: 1
Keywords: Beta
18) The relevant risk to an investor is that portion of the variability of returns that cannot be
diversified away.
Diff: 1
Keywords: Relevant Risk, Non-diversifiable Risk
19) The characteristic line for any well-diversified portfolio is horizontal.
Diff: 1
Keywords: Characteristic Line, Well-diversified Portfolio
20) The slope of the characteristic line of a security is that security's Beta.
Diff: 1
Keywords: Characteristic Line, Beta
21) Beta represents the average movement of a company's stock returns in response to a
movement in the market's returns.
Diff: 1
Keywords: Beta
22) Because risk is measured by variability of returns, how long we hold our investments does
not matter very much when it comes to reducing risk.
Diff: 1
Keywords: Diversification, Risk Reduction
23) The market rewards the patient investor, for between 1926 and 2008, there has never been a
time when an investor lost money if she held an all-stock portfolio for ten years.
Diff: 1
Keywords: Diversification, Investment Horizon
17
Copyright 2011 Pearson Education, Inc.
24) The portfolio beta is simply the sum of the betas of the individual stocks in the portfolio.
Diff: 1
Keywords: Beta, Portfolio Beta
Multiple Choice
1) Which of the following statements is most correct concerning diversification and risk?
A) Risk-averse investors often choose companies from different industries for their portfolios
because the correlation of returns is less than if all the companies came from the same industry.
B) Risk-averse investors often select portfolios that include only companies from the same
industry group because the familiarity reduces the risk.
C) Only wealthy investors can diversify their portfolios because a portfolio must contain at least
50 stocks to gain the benefits of diversification.
D) Proper diversification generally results in the elimination of risk.
Diff: 2
Keywords: Diversification, Risk, Correlation
2) Which of the following statements is most correct concerning diversification and risk?
A) Diversification is mainly achieved by the selection of individual securities for each type of
asset held in a portfolio.
B) Diversification is mainly achieved by the asset allocation decision, not the selection of
individual securities within each asset category.
C) Large company stocks and small company stocks together in a portfolio lead to dramatic
reductions in risk because their returns are negatively correlated.
D) Asset allocation is important for pension funds but not for individual investors.
Diff: 2
Keywords: Diversification, Asset Allocation, Risk
3) An investor currently holds the following portfolio:
Amount Invested
8,000 shares of Stock A
$16,000
Beta = 1.3
15,000 shares of Stock B
$48,000
Beta = 1.8
25,000 shares of Stock C
$96,000
Beta = 2.2
The investor is worried that the beta of his portfolio is too high, so he wants to sell some stock C
and add stock D, which has a beta of 1.0, to his portfolio. If the investor wants his portfolio to
have a beta of 1.72, how much stock C must he replace with stock D?
A) $18,000
B) $24,000
C) $31,000
D) $36,000
Diff: 3
Keywords: Beta, Portfolio
18
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4) Joe purchased 800 shares of Robotics Stock at $3 per share on 1/1/09. Bill sold the shares on
12/31/09 for $3.45. Robotics stock has a beta of 1.9, the risk-free rate of return is 4%, and the
market risk premium is 9%. Joe's holding period return is:
A) 15.0%.
B) 16.5%.
C) 17.6%.
D) 21.1%.
Diff: 1
Keywords: Holding Period Return
5) You are thinking of adding one of two investments to an already well- diversified portfolio.
Security A
Expected Return = 14%
Standard Deviation of
Returns = 16%
Beta = 1.2
Security B
Expected Return = 16%
Standard Deviation of
Returns = -20%
Beta = 1.2
If you are a risk-averse investor, which one is the better choice?
A) Security A
B) Security B
C) Either security would be acceptable because they have the same beta.
D) Security B, but only if Security B's required return is greater than 12%.
Diff: 2
Keywords: Risk-Aversion, Well-diversified Portfolio, Beta, Risk-Return Trade Off
19
Copyright 2011 Pearson Education, Inc.
6) You are going to invest all of funds your in one of three projects with the following
distribution of possible returns:
PROJECT 1
Standard
Probability Return Deviation Beta
50% Chance 22%
12%
1.1
50% Chance
-4%
PROJECT 2
Probability Return
30% Chance
36%
40% Chance 10.5%
30% Chance -20%
Standard
Deviation
19.5%
Beta
1.0
PROJECT 3
Standard
Probability Return Deviation Beta
10% Chance 28%
12%
1.2
70% Chance 18%
20% Chance
-8%
If you are a risk averse investor, which one should you choose?
A) Project 1
B) Project 2
C) Project 3
D) Either Project 1 or Project 2 because they have the same expected return.
Diff: 2
Keywords: Standard Deviation, Risk/Return Trade Off, Expected Return, Non-diversified
Portfolio
7) You are considering investing in Ford Motor Company. Which of the following are examples
of diversifiable risk?
I. Risk resulting from possibility of a stock market crash.
II. Risk resulting from uncertainty regarding a possible strike against Ford.
III. Risk resulting from an expensive recall of a Ford product.
IV. Risk resulting from interest rates decreasing.
A) I only
B) I and IV
C) I, II, III, IV
D) II, III
Diff: 1
Keywords: Diversifiable Risk
20
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8) You are considering buying some stock in Continental Grain. Which of the following are
examples of non-diversifiable risks?
I. Risk resulting from a general decline in the stock market.
II. Risk resulting from a possible increase in income taxes.
III. Risk resulting from an explosion in a grain elevator owned by Continental.
IV. Risk resulting from a pending lawsuit against Continental.
A) I and II
B) III and IV
C) I only
D) II, III, and IV
Diff: 2
Keywords: Non-Diversifiable Risk, Systematic Risk
9) Of the following, which differs in meaning from the other three?
A) Systematic Risk
B) Market Risk
C) Undiversifiable Risk
D) Asset-unique Risk
Diff: 2
Keywords: Systematic Risk, Market Risk, Undiversifiable Risk
10) Most stocks have betas between
A) -1.00 and 1.00.
B) 0.00 and 1.00.
C) 0.60 and 1.60.
D) 1.00 and 2.00.
Diff: 1
Keywords: Beta
11) A well-diversified portfolio includes investments in 50 securities. The portfolio's systematic
risk is likely to be about
A) 50% of the total risk.
B) 40% of the total risk.
C) 25% of the total risk.
D) zero because risk is eliminated with a portfolio of 50 securities or more.
Diff: 2
Keywords: Systematic Risk, Well-diversified Portfolio
21
Copyright 2011 Pearson Education, Inc.
12) Beta is a statistical measure of
A) unsystematic risk.
B) total risk.
C) the standard deviation.
D) the relationship between an investment's returns and the market return.
Diff: 1
Keywords: Beta
13) A stock's beta is a measure of its:
A) Unsystematic risk.
B) Systematic risk.
C) Company-unique risk.
D) Diversifiable risk.
Diff: 1
Keywords: Beta, Systematic Risk
14) If you hold a portfolio made up of the following stocks:
Stock A
Stock B
Stock C
Investment Value Beta
$8,000
1.5
$10,000
1.0
$2,000
.5
What is the beta of the portfolio?
A) 1.33
B) 1.24
C) 1.15
D) 1.00
Diff: 2
Keywords: Beta, Portfolio
15) Which of the following is/are true:
A) Most of the unsystematic risk is removed by the time a portfolio contains 30 stocks.
B) Two points on the Characteristic Line are the T-bill and the market portfolio.
C) The greater the total risk of an asset, the greater the expected return.
D) All securities have a beta between 0 and 1.
Diff: 2
Keywords: Systematic Risk, Diversification
22
Copyright 2011 Pearson Education, Inc.
16) If we are able to fully diversify, what is the appropriate measure of risk to use?
A) Expected Return
B) Standard Deviation
C) Beta
D) Risk-free Rate of Return
Diff: 1
Keywords: Diversification, Beta
17) You hold a portfolio with the following securities:
Security
Value Beta
Able Corporation
20%
Baker Corporation 40%
Charlie Corporation 40%
3.20
1.60
.20
Expected
Return
36.0%
20.0%
6.0%
What is the expected return for the portfolio?
A) 17.60%
B) 20.67%
C) 23.54%
D) 28.59%
Diff: 2
Keywords: Expected Return, Portfolio
18) The prices for the Electric Circuit Corporation for the first quarter of 2009 are given below.
The price of the stock on January 1, 2009 was $130. Find the holding period return for an
investor who purchased the stock on January 1, 2009 and sold it the last day of March 2009.
Month End
January
February
March
Price
$125.00
138.50
132.75
A) -4.2%
B) -3.7%
C) 2.1%
D) 3.7%
Diff: 2
Keywords: Holding Period Return
23
Copyright 2011 Pearson Education, Inc.
19) You must add one of two investments to an already well- diversified portfolio.
Security A
Expected Return = 14%
Standard Deviation of
Returns = 15.8%
Beta = 1.8
Security B
Expected Return = 14%
Standard Deviation of
Returns = 19.7%
Beta = 1.5
If you are a risk-averse investor, which one is the better choice?
A) Security A
B) Security B
C) Either security would be acceptable.
D) Cannot be determined with information given.
Diff: 2
Keywords: Well-diversified Portfolio, Risk-Return Trade Off, Beta
20) Beginning with an investment in one company's securities, as we add securities of other
companies to our portfolio, which type of risk declines?
A) Systematic risk
B) Market risk
C) Non-diversifiable risk
D) Unsystematic risk
Diff: 1
Keywords: Unsystematic Risk, Diversification
21) Assume that you expect to hold a $20,000 investment for one year. It is forecasted to have a
yearend value of $21,000 with a 30% probability; a yearend value of $24,000 with a 45%
probability; and a yearend value of $30,000 with a 25% probability. What is the expected
holding period return for this investment?
A) 50%
B) 25%
C) 23%
D) 18%
Diff: 3
Keywords: Holding Period Return, Expected Return
24
Copyright 2011 Pearson Education, Inc.
22) Assume that you expect to hold a $20,000 investment for one year. It is forecasted to have a
yearend value of $21,000 with a 30% probability; a yearend value of $24,000 with a 45%
probability; and a yearend value of $30,000 with a 25% probability. What is the standard
deviation of the holding period return for this investment?
A) 12.06%
B) 14.36%
C) 16.36%
D) 33.45%
Diff: 3
Keywords: Holding Period Return, Standard Deviation
23) You must add one of two investments to an already well- diversified portfolio.
Security A
Expected Return = 14%
Standard Deviation of
Returns = 15.0%
Beta = 1.5
Security B
Expected Return = 12%
Standard Deviation of
Returns = 11%
Beta = 1.5
If you are a risk-averse investor, which one is the better choice?
A) Security A
B) Security B
C) Either security would be acceptable.
D) Cannot be determined with information given.
Diff: 2
Keywords: Well-diversified Portfolio, Risk-Return Trade Off, Beta
24) Portfolio risk is typically measured by ________ while the risk of a single investment is
measured by ________.
A) standard deviation; beta
B) security market line; standard deviation
C) beta; standard deviation
D) beta; slope of the characteristic line
Diff: 2
Keywords: Portfolio Risk, Beta, Standard Deviation
25
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25) How can investors reduce the risk associated with an investment portfolio without having to
accept a lower expected return?
A) Wait until the stock market rises.
B) Increase the amount of money invested in the portfolio.
C) Purchase a variety of securities; i.e., diversify.
D) Purchase stocks that have exceptionally high standard deviations.
Diff: 1
Keywords: Diversification, Risk
26) Which of the following types of risk is diversifiable?
A) Unsystematic, or company-unique risk.
B) Betagenic, or ecocentric risk.
C) Systematic risk.
D) Market risk.
Diff: 1
Keywords: Diversifiable Risk, Unsystematic Risk
27) You purchased 1,000 shares of K.C Inc. common stock one year ago for $50 per share. You
received a dividend of $2 per share today and decide to take your profits by selling at $54.50 per
share. What is your holding period return?
A) 13.0%
B) 9.0%
C) 6.5%
D) 4.0%
Diff: 2
Keywords: Holding Period Return, Dividends
28) Which of the following measures the average relationship between a stock's returns and the
market's returns?
A) Coefficient of validation
B) Standard deviation
C) Geometric regression
D) Beta coefficient
Diff: 1
Keywords: Beta
26
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29) Assume that you have $165,000 invested in a stock whose beta is 1.25, $85,000 invested in a
stock whose beta is 2.35, and $235,000 invested in a stock whose beta is 1.11. What is the beta
of your portfolio?
A) 1.37
B) 2.01
C) 1.85
D) 1.57
Diff: 2
Keywords: Beta, Portfolio
30) Assume that you have $100,000 invested in a stock whose beta is .85, $200,000 invested in a
stock whose beta is 1.05, and $300,000 invested in a stock whose beta is 1.25. What is the beta
of your portfolio?
A) 0.97
B) 1.02
C) 1.12
D) 1.21
Diff: 2
Keywords: Beta, Portfolio
31) Which of the following statements is most correct regarding beta?
A) Beta must be calculated using at least 5 years of monthly returns data to be accurate.
B) Beta can only be measured properly using daily returns.
C) Beta for a particular company remains constant over time.
D) Even professionals may not agree on the measurement of beta.
Diff: 1
Keywords: Beta
32) What is diversifying among different kinds of assets known as?
A) Portfolio funding
B) Capital asset classification
C) Asset allocation
D) Multi-diversification
Diff: 2
Keywords: Asset Allocation, Diversification
27
Copyright 2011 Pearson Education, Inc.
6.5 Learning Objective 5
True or False
1) The required rate of return for an asset is equal to the risk-free rate plus a risk premium.
Diff: 1
Keywords: Required Rate of Return, Risk-free Rate, Risk Premium
2) The T-bill return is used in the CAPM model as the risk free rate.
Diff: 1
Keywords: CAPM, T-bill, Risk-free Rate
3) The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in
terms of beta.
Diff: 1
Keywords: CAPM, Risk-Return Trade Off, Beta
4) The S&P 500 index must be used as the measure of market return in the CAPM or the results
are not theoretically accurate.
Diff: 1
Keywords: CAPM, S&P 500
5) According to the CAPM, for each unit of Beta an asset's required rate of return increases by
the market's return.
Diff: 1
Keywords: CAPM, Beta, Required Return, Market Return
6) According to the CAPM, for each unit of Beta an asset's required rate of return increases by
the market's risk premium.
Diff: 1
Keywords: CAPM, Beta, Required Return, Market Risk Premium
7) Stocks that plot above the security market line are underpriced because their expected returns
exceed their risk-adjusted required returns.
Diff: 2
Keywords: Security Market Line
28
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Multiple Choice
1) The capital asset pricing model:
A) provides a risk-return trade off in which risk is measured in terms of the market volatility.
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.
Diff: 2
Keywords: Capital Asset Pricing Model, Beta, Risk-Return Trade Off
2) A typical measure for the risk-free rate of return is the:
A) U.S. Treasury Bill rate.
B) prime lending rate.
C) money market rate.
D) short-term AAA-rated bond rate.
Diff: 1
Keywords: Risk-Free Rate of Return, U.S. T-bill
3) If the Beta for stock A equals zero, then:
A) stock A's required return is equal to the required return on the market portfolio.
B) stock A's required return is equal to the risk-free rate of return.
C) stock A has a guaranteed return.
D) stock A's required return is greater than the required return on the market portfolio.
Diff: 2
Keywords: Beta, Required Rate of Return, Security Market Line
4) The risk-free rate of interest is 4% and the market risk premium is 9%. Howard Corporation
has a beta of 2.0, and last year generated a return of 16% with a standard deviation of returns of
27%. The required return on Howard Corporation stock is:
A) 36%.
B) 34%.
C) 26%.
D) 22%.
Diff: 2
Keywords: Required Return, Beta, Security Market Line
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Copyright 2011 Pearson Education, Inc.
5) Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta of 1.8
and a standard deviation of returns of 18%. If the market risk premium increases, then
A) the required return on stock B will increase more than the required return on stock A.
B) the required returns on stocks A and B will both increase by the same amount.
C) the required returns on stocks A and B will remain the same.
D) the required return on stock A will increase more than the required return on stock B.
Diff: 2
Keywords: Beta, Security Market Line, Market Risk Premium
6) Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B has a beta of 1.8
and a standard deviation of returns of 18%. If the risk-free rate of return increases and the market
risk premium remains constant, then
A) the required return on stock B will increase more than the required return on stock A.
B) the required returns on stocks A and B will both increase by the same amount.
C) the required returns on stocks A and B will not change.
D) the required return on stock A will increase more than the required return on stock B.
Diff: 2
Keywords: Beta, Security Market Line, Market Risk Premium, Risk-free Rate of Return
7) An investor currently holds the following portfolio:
Amount
Invested
8,000 shares of Stock A
$16,000
Beta = 1.3
15,000 shares of Stock B $48,000
Beta = 1.8
25,000 shares of Stock C $96,000
Beta = 2.2
The beta for the portfolio is:
A) 1.99
B) 1.77
C) 1.45
D) 1.27
Diff: 1
Keywords: Beta, Portfolio, Security Market Line
30
Copyright 2011 Pearson Education, Inc.
8) An investor currently holds the following portfolio:
Amount
Invested
8,000 shares of Stock A $16,000
Beta = 1.3
15,000 shares of Stock B $48,000
Beta = 1.8
25,000 shares of Stock C $96,000
Beta = 2.2
If the risk-free rate of return is 4% and the market risk premium is 9%, then the required return
on the portfolio is:
A) 14.00%.
B) 17.91%.
C) 21.91%.
D) 23.85%.
Diff: 3
Keywords: Beta, Security Market Line, Portfolio, Required Return
9) Joe purchased 800 shares of Robotics Stock at $3 per share on 1/1/09. Bill sold the shares on
12/31/09 for $3.45. Robotics stock has a beta of 1.9, the risk-free rate of return is 4%, and the
market risk premium is 9%. The required return on Robotics Stock is:
A) 15.0%.
B) 16.5%.
C) 17.6%.
D) 21.1%.
Diff: 1
Keywords: Required Return, Security Market Line, Beta, Market Risk Premium
10) Based on the security market line, Robo-Tech stock has a required return of 14% and
Friendly Insurance Company has a required return of 10%. Robo-Tech has a standard deviation
of returns of 18%. Therefore:
A) Friendly must have a standard deviation of returns of less than 18% because Friendly is less
risky than Robo-Tech.
B) All rational investors will prefer Friendly over Robo-Tech.
C) For a well-diversified investor, Friendly is less risky than Robo-Tech.
D) The beta for Friendly must be greater than the beta for Robo-Tech because Friendly is the
better buy for a risk-averse investor.
Diff: 2
Keywords: Security Market Line, Well-diversified, Beta, Risk
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Copyright 2011 Pearson Education, Inc.
11) White Company stock has a beta of 2 and a required return of 23%, while Black Company
stock has a beta of 1.0 and a required return of 14%. The standard deviation of returns for White
Company is 10% more than the standard deviation for Black Company. The expected return on
the market portfolio according to the CAPM is:
A) 9%.
B) 10%.
C) 12%.
D) 14%.
Diff: 3
Keywords: CAPM, Security Market Line, Beta, Required Return
12) White Company stock has a beta of 2 and a required return of 23%, while Black Company
stock has a beta of 1.0 and a required return of 14%. The standard deviation of returns for White
Company is 10% more than the standard deviation for Black Company. The risk free rate of
return according to the CAPM is:
A) 4%.
B) 5%.
C) 6%.
D) Impossible to determine with the information given.
Diff: 3
Keywords: CAPM, Security Market Line, Beta, Required Return
13) Emery Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the
market risk premium is 7.5%, the risk-free rate of return is:
A) 4.1%.
B) 3.4%.
C) 2.0%.
D) 1.5%.
Diff: 2
Keywords: CAPM, Security Market Line, Risk-free Rate of Return
14) Emery Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the
risk free rate of return is 4.2%, the expected return on the market portfolio is:
A) 21%.
B) 19.2%.
C) 13.4%.
D) 10.2%.
Diff: 2
Keywords: CAPM, Security Market Line, Risk-free Rate of Return, Market Portfolio
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15) You are going to add one of the following three projects to your already well-diversified
portfolio.
PROJECT 1
Standard
Probability Return Deviation Beta
50% Chance
22%
12%
1.1
50% Chance
-4%
PROJECT 2
Standard
Probability Return Deviation Beta
30% Chance 36% 19.5%
0.8
40% Chance 10.5%
30% Chance -20%
PROJECT 3
Probability Return
10% Chance 28%
70% Chance 18%
20% Chance
-8%
Standard
Deviation Beta
12%
2.0
Assume the risk-free rate of return is 2% and the market risk premium is 8%. If you are a risk
averse investor, which project should you choose?
A) Project 1
B) Project 2
C) Project 3
D) Either Project 2 or Project 3 because the higher expected return on project 3 offsets its higher
risk.
Diff: 3
Keywords: Beta, Risk-Return Trade Off, Expected Return, Security Market Line, Required
Return
16) 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) the standard deviation of a firm's stock returns.
D) beta.
Diff: 1
Keywords: Beta, CAPM, Risk
17) SeeBreeze Incorporated has a beta of 1.0. If the expected return on the market is 15%, what
is the expected return on SeeBreeze Incorporated's stock?
A) 15%
B) 14%
C) 18%
D) cannot be determined without the risk free rate
Diff: 2
Keywords: Beta, Security Market Line
33
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18) Stanley Corp. common stock has a required return of 17.5% and a beta of 1.75. If the
expected risk free return is 3%, what is the expected return for the market based on the CAPM?
A) 11.29%
B) 14.29%
C) 13.35%
D) 15.27%
Diff: 2
Keywords: Beta, Security Market Line, Expected Return for the Market Portfolio
19) Billings, Inc. common stock has a beta of 1.2. If the expected risk free return is 4% and the
expected market risk premium is 9%, what is the expected return on Billing's stock?
A) 10.0%
B) 12.0%
C) 13.8%
D) 14.8%
Diff: 2
Keywords: Beta, Security Market Line, Market Risk Premium, Expected Return
20) You determine that XYZ common stock has an expected return of 24%. XYZ has a Beta of
1.5. The risk-free rate is 5%, and the market expected return is 15%. Which of the following is
most likely to happen:
A) You and other investors will buy up XYZ stock and its price will rise.
B) You and other investors will sell XYZ stock and its return will fall.
C) You and other investors will buy up XYZ stock and its return will rise.
D) You and other investors will sell XYZ stock and its price will fall.
Diff: 2
Keywords: Security Market Line, Required Return, Expected Return
21) You hold a portfolio made up of the following stocks:
Investment Value
Beta
Stock A
$4,000
2.0
Stock B
$9,000
1.5
Stock C
$7,000
.4
If the market's expected return is 14%, and the risk free rate of return is 5%, what is the expected
return of the portfolio?
A) 17.010%
B) 16.700%
C) 15.935%
D) 14.698%
Diff: 2
Keywords: Security Market Line, Beta, Expected Return, Portfolio
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Copyright 2011 Pearson Education, Inc.
22) Collectibles Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on
the market portfolio is 15% and the risk free rate is 4%. What is the risk premium on the market?
A) 5%
B) 6%
C) 9.00%
D) 11%
Diff: 1
Keywords: Security Market Line, Market Risk Premium
23) Collectibles Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on
the market portfolio is 15% and the risk free rate is 4%. According to CAPM, what is the
required rate of return on Collectible's stock?
A) 37.5%
B) 31.5%
C) 26.5%
D) 23.5%
Diff: 2
Keywords: Security Market Line, Beta, Required Rate of Return
24) You hold a portfolio with the following securities:
Security
Percent
Expected
of Portfolio Beta Return
Able Corporation
Baker Corporation
Charlie Corporation
20%
40%
40%
3.20
1.60
.20
36.0%
20.0%
6.0%
What is the expected return for the market, according to the CAPM?
A) 14.0%
B) 13.8%
C) 12.0%
D) 10.0%
Diff: 3
Keywords: Expected Return on the Market, CAPM, Security Market Line, Beta
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Copyright 2011 Pearson Education, Inc.
25) 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.
Diff: 2
Keywords: Beta, Characteristic Line
26) The rate on T-bills is currently 2%. Environment Help Company stock has a beta of 1.5 and a
required rate of return of 17%. According to CAPM, determine the return on the market
portfolio.
A) 27.5%
B) 19.0%
C) 14.0%
D) 12.0%
Diff: 3
Keywords: T-bill, Beta, Security Market Line, CAPM
27) The return on the market portfolio is currently 12%. Mobile Phone Corporation stockholders
require a rate of return of 30% and the stock has a beta of 3.2. According to CAPM, determine
the risk-free rate.
A) 9.80%
B) 6.50%
C) 4.64%
D) 3.82%
Diff: 3
Keywords: CAPM, Security Market Line, Risk-free Rate of Return
28) Which of the following is the slope of the security market line?
A) beta
B) one
C) it varies, and is steeper for riskier securities
D) the market risk premium
Diff: 2
Keywords: Security Market Line, Market Risk Premium
36
Copyright 2011 Pearson Education, Inc.
29) What is the name given to the equation that financial managers use to measure an investor's
required rate of return?
A) The standard deviation
B) The capital asset pricing model
C) The coefficient of variation
D) The MIRR
Diff: 1
Keywords: CAPM
30) You are considering an investment in First Allegiance Corp. The firm has a beta of 1.6.
Currently, U.S. Treasury bills are yielding 2.75% and the expected return for the S & P 500 is
14%. What rate of return should you expect for your investment in First Allegiance?
A) 11.15%
B) 15.39%
C) 16.75%
D) 20.75%
Diff: 2
Keywords: Security Market Line, Required Return
Essay
1) Answer the questions below using the following information on stocks A, B, and C.
Expected Return
Standard Deviation
Beta
A
20%
12%
1.8
B
21%
10%
2.2
C
10%
10%
0.8
Assume the risk-free rate of return is 3% and the expected market return is 12%
a. Calculate the required return for stocks A, B, and C.
b. Assuming an investor with a well-diversified portfolio, which stock would the investor want
to add to his portfolio?
c. Assuming an investor who will invest all of his money into one security, which stock will the
investor choose?
Stock A: 3% + (12% - 3%)(1.8) = 19.2%
Stock B: 3% + (12% -3%)(2.2) = 22.8%
Stock C: 3% + (12% - 3%)(0.8) =10.2%
b. A well-diversified investor will select Stock A, which is the only stock with an expected
return that exceeds its required return.
c. Stock B is preferred because it has the highest expected return along with the lowest standard
deviation of returns.
Diff: 2
Keywords: Required Return, Security Market Line, Diversification, Risk-Return Trade Off
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Copyright 2011 Pearson Education, Inc.
2) The expected return for the market portfolio is 13%, the expected return on U.S. Treasury
Bills is 2%, and the expected return on AAA-rated short-term corporate bonds is 7%. Calculate
the required return for a stock with a beta equal to 1.5.
Answer: 2% + (13% - 2%)(1.5) = 18.5%
Diff: 2
Keywords: Security Market Line, Beta, Required Return
3) Security A has an expected rate of return of 29.8 percent and a beta of 3.1. Security B has a
beta of 1.70. If the Treasury bill rate is 5 percent, what is the expected rate of return for Security
B?
Answer: Use A to determine the market risk premium.
.298 = .05 + 3.1(market return - .05)
.248 = (3.1 market return) - .155
.403/3.1 = .13 = market return
Return on B = .05 + 1.7(.13 - .05) = .186 = 18.6%
Diff: 3
Keywords: Security Market Line, Beta, Expected Return, Treasury Bill
4) Bankers Corp has a very conservative Beta of .7, while Biotech Corp has a Beta of 2.1. Given
that the T-bill rate is 5%, and the market is expected to return 15%, what is the expected return
of Bankers Corp, Biotech Corp, and a portfolio composed of 60% of Bankers Corp and 40%
Biotech Corp?
a. Solve this problem first by weighting the Betas to calculate a portfolio Beta, and then using
CAPM to calculate the portfolio expected return.
b. Then solve the problem again by calculating the expected return of each asset and weighting
those returns to calculate the portfolio expected return.
c. Why is Biotech Corp's expected return not three times that of Bankers Corp?
Bp = .6 .7 + .4 2.1) = 1.26
Kp = .05 + 1.26(.15 - .05) = .05 + .126 = .176
b.
KBankers = .05 + .7(.15 - .05) = .12
KBiotech = .05 + 2.1(.15-.05) = .26
Kp = (.6 .12) + (.4 .26) = .176
c. Beta is multiplied by the market risk premium only, so a stock with a beta three times that of
another stock will have three times the risk premium, not three times the total return.
Diff: 2
Keywords: Beta, Portfolio, Market Risk Premium, Security Market Line
38
Copyright 2011 Pearson Education, Inc.
5) Redesign Corp is considering a new strategy that would increase its expected return from 12%
to 13.9%, but would also increase its beta from 1.2 to 1.8. If the risk free rate is 5% and the
return on the market is expected to be 10%, should Redesign change its strategy?
Answer: No. Currently the company's required return is 11% and the company is earning 12%.
After the changes, the company's required return would increase to 14%, but its expected return
would increase to only 13.9%. Thus, the increased return is not sufficient to justify the increase
risk.
Diff: 2
Keywords: Risk-Return Tradeoff, CAPM, Security Market Line, Beta
39
Copyright 2011 Pearson Education, Inc.

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