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CHAPTER 10 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM) Answers to Concepts Review and Critical Thinking Questions 1. Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns. 2. a. systematic b. unsystematic c. both; probably mostly systematic d. unsystematic e. unsystematic f. systematic 3. No to both questions. The portfolio expected return is a weighted average of the asset’s returns, so it must be less than the largest asset return and greater than the smallest asset return. 4. False. The variance of the individual assets is a measure of the total risk. The variance on a well- diversified portfolio is a function of systematic risk only. 5. Yes, the standard deviation can be less than that of every asset in the portfolio. However, p cannot be less than the smallest beta because p is a weighted average of the individual asset betas. 6. Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a diversification instrument. 7. The covariance is a more appropriate measure of a security’s risk in a well-diversified portfolio because the covariance reflects the effect of the security on the variance of the portfolio. Investors are concerned with the variance of their portfolios and not the variance of the individual securities. Since covariance measures the impact of an individual security on the variance of the portfolio, covariance is the appropriate measure of risk.
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SOLUTIONS B-248 8. If we assume that the market has not stayed constant during the past three years, then the lack in movement of Southern Co.’s stock price only indicates that the stock either has a standard deviation or a beta that is very near to zero. The large amount of movement in Texas Instrument’ stock price does not imply that the firm’s beta is high. Total volatility (the price fluctuation) is a function of both systematic and unsystematic risk. The beta only reflects the systematic risk. Observing the standard deviation of price movements does not indicate whether the price changes were due to systematic factors or firm specific factors. Thus, if you observe large stock price movements like that of TI, you cannot claim that the beta of the stock is high. All you know is that the total risk of TI is high.
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