Chapter 13 Test Bank
Chapter 13 Test Bank
Chapter 13 Test Bank
I. DEFINITIONS
Topic: PORTFOLIOS
1. A portfolio is ___________________________.
A) a group of assets, such as stocks and bonds, held as a collective unit by an
investor
B) the expected return on a risky asset
C) the expected return on a collection of risky assets
D) the variance of returns for a risky asset
E) the standard deviation of returns for a collection of risky assets
Answer: A
II CONCEPTS
Topic: DIVERSIFICATION
16. Regarding diversification, ______________________.
A) most of the benefits are realized with just 20 stocks.
B) it is the process of increasing the riskiness associated with individual assets by
spreading an investment across numerous assets.
C) it is the only type of risk that matters to a rational investor.
D) the portfolio returns are reduced, and the standard deviation of that portfolio
remains unchanged.
E) there is no limit to the amount of risk that can be eliminated through this process.
Answer: A
Topic: DIVERSIFICATION
17. Diversification works because:
A) Unsystematic risk exists.
B) Forming stocks into portfolios reduces the standard deviation of returns for each
stock.
C) Firm-specific risk can be never be reduced.
D) Stocks earn higher returns than bonds.
E) Portfolios have higher returns than individual assets.
Answer: A
Topic: DIVERSIFIABLE RISK
18. Asset-specific risk is also known as _________ risk.
A) total
B) market
C) systematic
D) diversifiable
E) beta
Answer: D
Topic: BETA
20. The ________ the beta coefficient the _________ the expected return, on
average.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower or higher (depending on the level of the risk-free rate)
E) lower; more risky
Answer: A
Topic: REWARD TO RISK RATIO
21. In market equilibrium:
A) All assets will have the same degree of systematic risk.
B) Assets will have the same reward to risk ratio.
C) Each firm's reward to risk ratio will be based on a different risk-free rate of
return.
D) Systematic risk can be diversified away.
E) All assets will have the same risk premium.
Answer: B
Topic: CAPM
22. The CAPM implies that the expected return for a particular asset does NOT
depend on:
A) The amount of unsystematic risk.
B) The reward for bearing systematic risk.
C) The pure time value of money.
D) The reward to risk ratio.
E) The risk-free interest rate.
Answer: A
Topic: MARKET PORTFOLIO
23. Which of the following is FALSE regarding the market portfolio?
A) The market risk premium determines the slope of the security market line.
B) It plots on the security market line.
C) It has a beta equal to one.
D) It consists of all the stocks on the NYSE and NASDAQ combined.
E) It has the same reward to risk ratio as every individual asset in the market.
Answer: D
I. The minimum expected rate of return the investment must earn to be attractive
to investors.
II. The rate of return investments of similar risk earn in the market.
III. The internal rate of return (IRR) for the project.
IV. The risk-free rate.
A) I only
B) I and II only
C) III only
D) III and IV only
E) II and IV only
Answer: B
Topic: DIVERSIFICATION
29. Which of the following is FALSE concerning diversification? Assume that the
securities being considered for selection into a portfolio are not perfectly correlated.
A) As more securities are added to the portfolio, the unsystematic risk of the
portfolio declines.
B) As more securities are added to the portfolio, the total risk of the portfolio
declines.
C) As more securities are added to the portfolio, the systematic risk of the portfolio
declines.
D) As more securities are added to the portfolio, the portfolio risk eventually
approaches the level of systematic risk in the market.
E) If you hold more than 100 securities, then there is little benefit to be gained by
adding a 101st security to the portfolio.
Answer: C
III. PROBLEMS
A) .05
B) .08
C) .09
D) .10
E) .12
Answer: C
Response: 50(.25) + .35(.05) + .15(-.35) = .09
A) 0.3325
B) 0.1525
C) 0.0525
D) 0.1825
E) 0.2225
Answer: D
Response: .20(.75) + .55(.25) + .15(-10)+ .10(-50) = .2225; RP = .2225 .04 =
.1825
Topic: VARIANCE
54. What is the variance of the following returns?
A) 0.0413
B) 0.1239
C) 0.1944
D) 0.2601
E) 0.3519
Answer: B
Response:
A) 6.75%
B) 9.50%
C) 16.75%
D) 18.25%
E) 21.50%
Answer: C
Response: .35(.20) + .15(.35) + .25(.06) + .25(.12) = .1675
Topic: CAPM
56. What is the expected return on asset A if it has a beta of 0.6, the expected market
return is 15%, and the risk-free rate is 6%?
A) 5.4%
B) 9.6%
C) 11.4%
D) 15.0%
Answer: C
Response: 6 + .6(15 - 6) = 11.4%
Topic: CAPM
57. What is the expected market return if the expected return on asset A is 19% and
the risk-free rate is 5%? Asset A has a beta of 1.4.
A) 14%
B) 15%
C) 16%
D) 19%
E) 24%
Answer: B
Response: [(.19 - .05) / 1.4 ] + .05 = .15
Topic: CAPM
58. Asset A has an expected return of 10%. The expected market return is 14% and
the risk-free rate is 5%. What is asset A's beta?
A) 0.33
B) 0.56
C) 0.67
D) 0.88
E) 1.15
Answer: B
Response: (.10 - .05) / (.14 - .05) = 0.56
Topic: CAPM
59. Asset A has an expected return of 20.4% and a beta of 1.6. The expected market
return is 15%. What is the risk-free rate?
A) 2%
B) 4%
C) 5%
D) 6%
E) 8%
Answer: D
Response: [1.6(.15) - .204] / (1.6 - 1) = .06
Topic: CAPM
60. Asset A has an expected return of 14.5% and a beta of 1.15. The risk-free rate is
5%. What is the market risk premium?
A) 8.3%
B) 9.7%
C) 11.5%
D) 12.4%
E) 14.5%
Answer: A
Response: E(RM) Rf = (.145 - .05) / 1.15 = .0826
Topic: PORTFOLIO BETA
61. What is the portfolio beta if 60% of your money is invested in the market
portfolio, and the remainder is invested in a risk-free asset?
A) 0.40
B) 0.50
C) 0.60
D) 0.75
E) 1.00
Answer: C
Response: .60(1) + .40(0) = .60
State
Probability
Return
Boom
.25
.40
Good
.50
.15
Recession
.25
.05
A) 1.67%
B) 6.47%
C) 9.61%
D) 12.93%
E) 16.80%
Answer: D
A) 0.73
B) 0.81
C) 0.86
D) 0.94
E) 1.07
Answer: C
Response: [(25)(.75) + (10)(.95) + (15)(1.25) + (40)(1.5) + (35)(0)] / 125 = 0.856
A) A by 8%
B) B by 8%
C) A by 4%
D) B by 4%
E) A and B have the same expected return.
Answer: B
Response: A: .2(.5) + .6(.2) + .2(0) = .22; B: .2(.4) + .6(.3) + .2(.2) = .30
Asset
Investment
Return
A
$800
0.10
B
$500
0.25
C
$200
0.20
A) 0.1000
B) 0.1125
C) 0.1267
D) 0.1500
E) 0.1633
Answer: E
Response: (8/15)(.10) + (5/15)(.25) + (2/15)(.20) = 0.1633
Standard Deviation
Beta
Security X
0.35
1.45
Security Y
0.28
1.06
Security Z
0.44
1.22
Security
Return
Standard Deviation
Beta
A
16%
20%
1.2
B
12%
25%
0.8
Risk-free asset
4%
???
???
Topic: TOTAL VS. SYSTEMATIC RISK
84. Which of A and B has the least total risk? The least systematic risk?
A) A; A
B) A; B
C) B; A
D) B; B
E) Cannot be determined without more information.
Answer: B
IV. ESSAYS
Topic: CAPM
93. According to the CAPM, the expected return on a risky asset depends on three
components. Describe each component, and explain its role in determining expected return.
Answer:
The CAPM suggests that expected return is a function of (1) the pure time value of money, (2)
the reward for bearing systematic risk, and (3) the amount of systematic risk present in a
particular asset. Better students will point out that both the pure time value of money and the
reward for bearing systematic risk are exogenously determined and can change on a daily basis,
while the amount of systematic risk for a particular asset is determined by the firm's decision-
makers.
Answer:
The student should draw a picture similar to Figure 11.3, adding a point where the market
portfolio exists. In this case, asset C is underpriced and asset D is overpriced. This condition
cannot persist in equilibrium because investors will buy C with its high expected return and sell D
with its low expected return. The resultant buy and sell activity will force the prices back to a
level that eventually causes both C and D to plot on the SML.
Topic: REWARD TO RISK RATIOS
95. Explain what we mean when we say all assets have the same reward to risk ratio.
What does this mean for investors?
Answer:
A constant reward to risk ratio means that the reward for bearing risk, measured as the risk
premium, increases as the amount of risk, measured by beta, also increases. Investors who are
risk averse will not consider taking additional risk if they expect to receive no additional
compensation for doing so. This is an equilibrium concept which essentially restates the axiom
that prices observed in efficient markets are considered fair.
Answer:
A reasonable answer would, at a minimum, explain that some risks (diversifiable) affect only a
specific security, and when put into a portfolio, losses as a result of these firm-specific events will
tend to be offset by price gains amongst other securities. Nondiversifiable risk, however, is
unavoidable because such risks affect all or almost all securities in the market and can't be
eliminated by forming portfolios. In the second part of the question, the students get a chance to
use a minor amount of imagination. A strong answer would note the dependence of
diversification effects on the degree of correlation between the assets used to form portfolios.
Topic: RISK
97. We routinely assume that investors are risk-averse return-seekers, i.e., they like
returns and dislike risk. If so, why do we contend that only systematic risk is important?
(Alternatively, why is total risk not important to investors, in and of itself?)
Answer:
This question, of course, gets to the point of the chapter: That rational investors will diversify
away as much risk as possible. From the discussion in the text, most students will also have
picked up that it is quite easy to eliminate diversifiable risk in practice, either by holding
portfolios with 15 to 25 assets, or by holding shares in a diversified mutual fund. And, as noted in
the text, there will be no return for bearing diversifiable risk, thus total risk is not particularly
important to a diversified investor.
Topic: EMH, CAPM, AND THE MARKET VALUE RULE
98. In the first chapter, it was stated that financial managers should act to maximize
shareholder wealth. Why are the efficient markets hypothesis (EMH), the CAPM, and the SML
so important in the accomplishment of this objective?
Answer:
In simple terms, one could say that maximizing shareholder wealth by maximizing the current
share price (Chapter 1) is a reasonable objective if and only if we have some assurance that
observed prices are meaningful, i.e., that they reflect the value of the firm. This is a major
implication of the EMH. Further, if we are to be able to assess the wealth effects of future
decisions on security and firm values, we must have a valuation model whose parameters can be
shown to be affected by those decisions (Chapters 6 & 7). Finally, any valuation model we
employ will require us to quantify return and risk (Chapters 10 and 11).
Topic: BETA
99. Explain in words what beta is and why it is important.
Answer:
This is a concept check question that requires students to put into words that beta is a measure of
systematic risk, the only risk an investor can expect to earn compensation for bearing. Beta
specifically measures the amount of systematic risk an asset has relative to an average asset.
Answer:
While it is unlikely to observe a negative beta asset, it would have less systematic risk than the
risk-free asset and would be expected to provide an even lower return. One possibility often cited
is that of gold. The return would be less than the risk-free rate because, while the risk-free rate is
determined by changes in inflation and the business cycle for the economy at large, gold, as an
ultimate store of value, is not affected by these factors (at least to the same degree).