Finance Chapter 8: Risk and Return Analysis

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Questions and Answers

The the standard deviation, the the investment.

smaller, riskier
larger, smaller the expected return on
larger, riskier (correct)
smaller, larger the expected return on

The coefficient of variation is a(n) __ measure of risk.

unsystematic
absolute
systematic
relative (correct)

The primary difference between the standard deviation and the coefficient of variation as measures of risk is:

the coefficient of variation is easier to compute.
the standard deviation is rarely used in practice whereas the coefficient of variation is widely used.
the standard deviation is a measure of relative risk whereas the coefficient of variation is a measure of absolute risk.
the coefficient of variation is a measure of relative risk whereas the standard deviation is a measure of absolute risk. (correct)

Security A's expected return is 10 percent while the expected return of B is 14 percent. The standard deviation of A's returns is 5 percent, and it is 9 percent for B. An investor plans to invest equal amounts in A and B. Which of the following statements is true about this portfolio consisting of stock A and stock B.

The higher the correlation of returns between the two stocks, the higher the portfolio's risk. (B) Signup and view all the answers

Which of the following is not an example of a source of systematic risk?

foreign competition with an industry's products (C) Signup and view all the answers

The security market line

provides a picture of the risk-return tradeoff required by diversified investors considering various risky assets. (C) Signup and view all the answers

All other things being equal, what is the major impact that an increase in the expected inflation rate would be expected to have on the security market line?

shift it up and to the left (C) Signup and view all the answers

Beta is defined as:

a measure of volatility of a security’s returns relative to the returns of a broad-based market portfolio of securities. (B) Signup and view all the answers

A beta value of 0.5 for a security indicates

the security has below-average systematic risk (D) Signup and view all the answers

The security market line can be thought of as expressing relationships between required rates of return and

Beta (D) Signup and view all the answers

Users of the CAPM should be aware of some of the problems in its practical application. These problems include which of the following?

all of these are problems in application of the CAPM (D) Signup and view all the answers

All of the following are primary sources of systematic risk except

changes in the amount of foreign competition facing an industry (A) Signup and view all the answers

All of the following factors have their primary impact on unsystematic risk except

changes in inflation (C) Signup and view all the answers

The _ correlated the returns from two securities are, the _ will be the portfolio effects of risk reduction.

less positively, greater (B) Signup and view all the answers

The risk remaining after extensive diversification is primarily:

systematic risk (D) Signup and view all the answers

Texas Computers (TC) stock has a beta of 1.5 and American Water (AW) stock has a beta of 0.5. Which of the following statements will be true about these securities?

The required return for TC is greater than the required return for AW. (A) Signup and view all the answers

The risk premium for an individual security is equal to the

difference between the required return and the risk free rate (B) Signup and view all the answers

The risk-free rate of return can be thought of as consisting of the following two components:

a real rate of return, an inflation premium (A) Signup and view all the answers

What will happen to the Security Market Line if: (1) inflation expectations increase, and (2) investors become more risk averse?

shift up and have a steeper slope (B) Signup and view all the answers

Arbitrage pricing theory is a model that relates expected returns on securities to

multiple risk factors (C) Signup and view all the answers

Which of the following is not an approach for managing risk:

ignoring systematic risk (C) Signup and view all the answers

Which of the following (if any) is a relative (rather than absolute) measure of risk?

coefficient of variation (A) Signup and view all the answers

A portfolio is efficient if

for a given standard deviation, there is no other portfolio with a higher expected return and if, for a given expected return, there is no other portfolio with a lower standard deviation (A) Signup and view all the answers

In general, when the correlation coefficient between the returns on two securities is _, the risk of a portfolio is _ the weighted average of the total risk of the two individual securities.

a and b (A) Signup and view all the answers

An increase in the expected future inflation rate has the effect of ___

shifting the security market line upward by the amount of the expected increase in inflation (D) Signup and view all the answers

An increase in uncertainty regarding the future economic outlook has the effect of ___

increasing the slope of the security market line (A) Signup and view all the answers

In the ___, the expected return on a security is equal to the risk-free rate plus a single risk premium that is equal to the product of the expected rate of return on the market portfolio less the risk-free rate times the sensitivity of the security's returns to the market return.

Capital Asset Pricing Model (D) Signup and view all the answers

The ___ is a relative measure of variability because it measures the risk per unit of expected return.

coefficient of variation (A) Signup and view all the answers

The security returns from multinational companies tend to have ___systematic risk than domestic companies.

less (B) Signup and view all the answers

Investors generally are considered to be risk ___ because they expect to be compensated for assuming risk.

averse (B) Signup and view all the answers

Investors can obtain high returns in their investments if:

they assume high risks (D) Signup and view all the answers

The term structure of interest rates is the pattern of interest rate yields for securities that differ only in

the length of time to maturity (D) Signup and view all the answers

The term structure of interest rates is the pattern of interest rate yields for debt securities that are similar in all respects except for differences in

maturity (A) Signup and view all the answers

The maturity premium reflects a preference by many lenders for

shorter maturities (C) Signup and view all the answers

The default risk premium reflects the fact that

there is a positive relationship between default risk and required returns (B) Signup and view all the answers

The business risk of a firm refers to the

variability in the firm's operating earnings over time (D) Signup and view all the answers

The difference in yields is due primarily to

default risk premium (C) Signup and view all the answers

The ability of an investor to buy and sell a company's securities quickly and without a significant loss of value is known as the

marketability risk (D) Signup and view all the answers

According to the ___, long-term interest rates are a function of expected short-term interest rates.

Expectations theory (B) Signup and view all the answers

The term structure of interest rates is related to the ___

maturity risk premium (B) Signup and view all the answers

____refers to the ability of an investor to buy and sell a company’s securities quickly and without a significant loss of value.

Marketability risk (D) Signup and view all the answers

The risk-free rate of return is composed of which of the following elements:

real rate of return and risk premium (D) Signup and view all the answers

The two elements that make up the risk-free rate of return are

the required return plus a risk premium (D) Signup and view all the answers

The____ theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity.

liquidity premium (A) Signup and view all the answers

Business risk is influenced by all the following factors except:

variability in interest expenses (A) Signup and view all the answers

Correlation is a statistical measure of the relationship between a series of numbers representing data. Which of the following statements about correlation is/are correct? I. Perfectly negatively correlated describes two negatively correlated stocks that have a correlation coefficient of -1. II. Perfectly positively correlated describes two positively correlated stocks that have a correlation coefficient of 0.

Only statement I is correct (A) Signup and view all the answers

All of the following statements about risk are correct EXCEPT:

Risk refers to the certainty of returns associated with a given asset. (C) Signup and view all the answers

That portion of the risk premium that is based on the ability of the borrower to repay principal and interest is the:

Default risk (B) Signup and view all the answers

What kind of probability distribution shows all possible outcomes for a given event?

continuous (D) Signup and view all the answers

The_____ is a statistical measure of the mean or average value of the possible outcomes.

expected value (C) Signup and view all the answers

The the standard deviation, the_ the investment.

larger, riskier (B) Signup and view all the answers

When comparing two equal-sized investments, the____ is an appropriate measure of total risk.

standard deviation (A) Signup and view all the answers

The slope of the characteristic line for a specific security is an estimate of____ for that security.

both beta and systematic risk (D) Signup and view all the answers

The is the ratio of to the .

coefficient of variation, standard deviation, expected value (C) Signup and view all the answers

The of a portfolio of two or more securities is equal to the weighted average of the of each of the individual securities in the portfolio

expected return, expected return (C) Signup and view all the answers

Values of the_____ can range from +1.0 to -1.0.

correlation coefficient (B) Signup and view all the answers

The most relevant risk that must be considered for any widely traded individual security is its____ .

systematic risk (D) Signup and view all the answers

In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset portfolio, the correlation coefficient between the securities must be___ .

equal to -1.0 (D) Signup and view all the answers

Flashcards

Expected Value

A statistical measure of the mean or average value of the possible outcomes.

Standard Deviation

A measure of how much the actual outcomes are likely to vary from the expected value.

Coefficient of Variation

A relative measure of risk that considers the risk per unit of return, calculated as standard deviation divided by expected return.

Security Market Line (SML)

The relationship between the expected return of a security and its systematic risk as measured by beta.