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Exam 2: Risk and Return: Part I

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Question 1

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Which of the following is most likely to be true for a portfolio of 40 randomly selected stocks?

A) The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
B) The beta of the portfolio is less than the average of the betas of the individual stocks.
C) The beta of the portfolio is equal to the average of the betas of the individual stocks.
D) The beta of the portfolio is larger than the average of the betas of the individual stocks.
E) The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.

F) None of the above
G) C) and D)

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Question 2

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Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events,and their effects on investment risk can in theory be diversified away.

A) True
B) False

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Question 3

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Which of the following statements is CORRECT?

The slope of the SML is determined by the value of beta.

The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return.The risk-free rate is 4.20%.Henry now receives another $5.00 million,which he invests in stocks with an average beta of 0.65.What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium,then find the new portfolio beta.)

The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1)stock is zero.

Which of the following are the factors for the Fama-French model?

Your friend is considering adding one additional stock to a 3-stock portfolio,to form a 4-stock portfolio.She is highly risk averse and has asked for your advice.The three stocks currently held all have b = 1.0,and they are perfectly positively correlated with the market.Potential new Stocks A and B both have expected returns of 15%,are in equilibrium,and are equally correlated with the market,with r = 0.75.However,Stock A's standard deviation of returns is 12% versus 8% for Stock B.Which stock should this investor add to his or her portfolio,or does the choice not matter?

Portfolio A has but one stock,while Portfolio B consists of all stocks that trade in the market,each held in proportion to its market value.Because of its diversification,Portfolio B will by definition be riskless.

If investors are risk averse and hold only one stock,we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10.However,if stocks are held in portfolios,it is possible that the required return could be higher on the stock with the low standard deviation.

Calculate the required rate of return for Everest Expeditions Inc.,assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00,and (5) its realized rate of return has averaged 15.0% over the last 5 years.

Which of the following statements is CORRECT?

Any change in its beta is likely to affect the required rate of return on a stock,which implies that a change in beta will likely have an impact on the stock's price,other things held constant.

Stocks A and B each have an expected return of 15%,a standard deviation of 20%,and a beta of 1.2.The returns on the two stocks have a correlation coefficient of +0.6.Your portfolio consists of 50% A and 50% B.Which of the following statements is CORRECT?

If a stock's market price exceeds its intrinsic value as seen by the marginal investor,then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

Even if the correlation between the returns on two securities is +1.0,if the securities are combined in the correct proportions,the resulting 2-asset portfolio will have less risk than either security held alone.

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

If an investor buys enough stocks,he or she can,through diversification,eliminate all of the market risk inherent in owning stocks,but as a general rule it will not be possible to eliminate all diversifiable risk.

How would the Security Market Line be affected,other things held constant,if the expected inflation rate decreases and investors also become more risk averse?

Martin Ortner holds a $200,000 portfolio consisting of the following stocks: $\begin{array} { c r r } \text { Stock } & \text { Investment } & \text { Beta } \\\hline \text { A } & \$ 50,000 & 0.95 \\\text { B } & 50,000 & 0.80 \\\text { C }& 50,000 & 1.00 \\\text { D } & 50,000 & 1.20 \\\text { Total } & \underline{\$ 200,000} &\end{array}$ What is the portfolio's beta?