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Exam 2: Risk and Return: Part I

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Question 31

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"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

A) True
B) False

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Question 32

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For markets to be in equilibrium,that is,for there to be no strong pressure for prices to depart from their current levels,

A) The past realized rate of return must be equal to the expected future rate of return; that is, $\overline { \mathrm { r } } = \hat { \mathrm { r } }$ .
B) The required rate of return must equal the past realized rate of return; that is, r = $\overline { \mathbf { r } }$ .
C) The expected rate of return must be equal to the required rate of return; that is, $\hat { r}$ = r.
D) All of the above statements must hold for equilibrium to exist; that is $\hat { r}$ = r = $\overline { \mathbf { r } }$ .
E) None of the above statements is correct.

F) A) and B)
G) A) and C)

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Question 33

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If investors become less averse to risk,the slope of the Security Market Line (SML)will increase.

Suppose Stan holds a portfolio consisting of a $10,000 investment in each of 8 different common stocks.The portfolio's beta is 1.25.Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35.What would the portfolio's new beta be?

Diversification will normally reduce the riskiness of a portfolio of stocks.

The SML relates required returns to firms' systematic (or market)risk.The slope and intercept of this line can be influenced by a manager's actions.

Returns for the Alcoff Company over the last 3 years are shown below.What's the standard deviation of the firm's returns? (Hint: This is a sample,not a complete population,so the sample standard deviation formula should be used.) $\begin{array} { r r } \text { Year } & \text { Return } \\2010 & 21.00 \% \\2009 & - 12.50 \% \\2008 & 25.00 \%\end{array}$

Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)

The tighter the probability distribution of its expected future returns,the greater the risk of a given investment as measured by its standard deviation.

If the returns of two firms are negatively correlated,then one of them must have a negative beta.

Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5.The market is in equilibrium,with required returns equaling expected returns.Which of the following statements is CORRECT?

We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero,which is the risk-free rate.

A stock with a beta equal to −1.0 has zero systematic (or market)risk.

The CAPM is built on historic conditions,although in most cases we use expected future data in applying it.Because betas used in the CAPM are calculated using expected future data,they are not subject to changes in future volatility.This is one of the strengths of the CAPM.

Someone who is risk averse has a general dislike for risk and a preference for certainty.If risk aversion exists in the market,then investors in general are willing to accept somewhat lower returns on less risky securities.Different investors have different degrees of risk aversion,and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return)than investors who have more tolerance for risk.

Assume that the risk-free rate is 5%.Which of the following statements is CORRECT?

Assume that your cousin holds just one stock,Eastman Chemical Bonding (ECB) ,which he thinks has very little risk.You agree that the stock is relatively safe,but you want to demonstrate that his risk would be even lower if he were more diversified.You obtain the following returns data for Wilder's Creations and Buildings (WCB) .Both companies have had less variability than most other stocks over the past 5 years.Measured by the standard deviation of returns,by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.)

Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8.The risk-free rate is 6% and the market risk premium is 5%.Which of the following statements is CORRECT?

Charlie and Lucinda each have $50,000 invested in stock portfolios.Charlie's has a beta of 1.2,an expected return of 10.8%,and a standard deviation of 25%.Lucinda's has a beta of 0.8,an expected return of 9.2%,and a standard deviation that is also 25%.The correlation coefficient,r,between Charlie's and Lucinda's portfolios is zero.If Charlie and Lucinda marry and combine their portfolios,which of the following best describes their combined $100,000 portfolio?