Risk and Rates of Return Exercise

(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
Note that there is some overlap between the T/F and the multiple choice questions, as some T/F
statements are used in the MC questions. See the preface for information on the AACS letter
indicators !F, M, etc." on the sub#ect lines.
Multiple Choice: True/alse
(8-2) Standard deviation F N Answer: b EASY
1
. The tighter the probability distribution of its expected future returns,
the greater the risk of a given investment as measured by its standard
deviation.
a. True
b. False
(8-2) Coefficient of variation F N Answer: a EASY
2
. The coefficient of variation, calculated as the standard deviation of
expected returns divided by the expected return, is a standardized
measure of the risk per unit of expected return.
a. True
b. False
(8-2) CV vs. SD F N Answer: b EASY
3
. The standard deviation is a better measure of risk than the coefficient
of variation if the expected returns of the securities being compared
differ significantly.
a. True
b. False
(8-2) is! aversion F N Answer: a EASY
. !isk"averse investors re#uire higher rates of return on investments

$hose returns are highly uncertain, and most investors are risk averse.
a. True
b. False
(8-") #ortfo$io ris! F N Answer: a EASY
%
. &hen adding a randomly chosen ne$ stock to an existing portfolio, the
higher 'or more positive( the degree of correlation bet$een the ne$
stock and stocks already in the portfolio, the less the additional stock
$ill reduce the portfolio)s risk.
a. True
b. False
Chapter 8: Risk and Return True/False Page 7
2013 Cengage Learning. ll Rights Reser!ed. "a# n$t %e &$pied' s&anned' $r dupli&ated' in (h$le $r in part' e)&ept *$r use as per+itted in
a li&ense distri%uted (ith a &ertain pr$du&t $r ser!i&e $r $ther(ise $n a pass($rd,pr$te&ted (e%site *$r &lassr$$+ use.
CH!"TE# $
#%&' !(D #!TE& ) #ET*#(
*
. +iversification $ill normally reduce the riskiness of a portfolio of
stocks.
a. True
b. False
,
. -n portfolio analysis, $e often use ex post 'historical( returns and
standard deviations, despite the fact that $e are really interested in
ex ante 'future( data.
a. True
b. False
(8-") #ortfo$io ret%rn F N Answer: b EASY
.
. The realized return on a stock portfolio is the $eighted average of the
expected returns on the stocks in the portfolio.
a. True
b. False
(8-") &ar!et ris! F N Answer: a EASY
/
. 0arket risk refers to the tendency of a stock to move $ith the general
stock market. 1 stock $ith above"average market risk $ill tend to be
more volatile than an average stock, and its beta $ill be greater than
1.2.
a. True
b. False
(8-") &ar!et ris! F N Answer: b EASY
12
. 1n individual stock)s diversifiable risk, $hich is measured by its beta,
can be lo$ered by adding more stocks to the portfolio in $hich the stock
is held.
a. True
b. False
(8-") is! and e'(ected ret%rns F N Answer: b EASY
11
. 0anagers should under no conditions take actions that increase their
firm)s risk relative to the market, regardless of ho$ much those actions
$ould increase the firm)s expected rate of return.
a. True
b. False
(8-") CA#& and ris! F N Answer: a EASY
12
. 3ne key conclusion of the 4apital 1sset 5ricing 0odel is that the value
of an asset should be measured by considering both the risk and the
expected return of the asset, assuming that the asset is held in a $ell"
diversified portfolio. The risk of the asset held in isolation is not
relevant under the 4150.
Page 8 True/False Chapter 8: Risk and Return
a. True
b. False
(8-") CA#& and ris! F N Answer: a EASY
13
. 1ccording to the 4apital 1sset 5ricing 0odel, investors are primarily
concerned $ith portfolio risk, not the risks of individual stocks held
in isolation. Thus, the relevant risk of a stock is the stock)s
contribution to the riskiness of a $ell"diversified portfolio.
a. True
b. False
(8-)) S&* and ris! aversion F N Answer: b EASY
1
. -f investors become less averse to risk, the slope of the 6ecurity
0arket 7ine '607( $ill increase.
a. True
b. False
(8-+) #,-sica$ assets F N Answer: a EASY
1%
. 0ost corporations earn returns for their stockholders by ac#uiring and
operating tangible and intangible assets. The relevant risk of each
asset should be measured in terms of its effect on the risk of the
firm)s stockholders.
a. True
b. False
(8-2) Variance F N Answer: a &ED./&
1*
. 8ariance is a measure of the variability of returns, and since it
involves s#uaring the deviation of each actual return from the expected
return, it is al$ays larger than its s#uare root, the standard
deviation.
a. True
b. False
(8-2) Coefficient of variation F N Answer: a &ED./&
1,
. 9ecause of differences in the expected returns on different investments,
the standard deviation is not al$ays an ade#uate measure of risk.
:o$ever, the coefficient of variation ad;usts for differences in
expected returns and thus allo$s investors to make better comparisons of
investments) stand"alone risk.
a. True
b. False
(8-2) is! aversion F N Answer: a &ED./&
1.
. <!isk aversion= implies that investors re#uire higher expected returns
on riskier than on less risky securities.
a. True
b. False
Chapter 8: Risk and Return True/False Page -
(8-2) is! aversion F N Answer: a &ED./&
1/
. -f investors are risk averse and hold only one stock, $e can conclude
that the re#uired rate of return on a stock $hose standard deviation is
2.21 $ill be greater than the re#uired return on a stock $hose standard
deviation is 2.12. :o$ever, if stocks are held in portfolios, it is
possible that the re#uired return could be higher on the stock $ith the
lo$er standard deviation.
a. True
b. False
(8-2) is! (re0. and ris! aversion F N Answer: a &ED./&
22
. 6omeone $ho is risk averse has a general dislike for risk and a
preference for certainty. -f risk aversion exists in the market, then
investors in general are $illing to accept some$hat lo$er returns on
less risky securities. +ifferent investors have different degrees of
risk aversion, and the end result is that investors $ith greater risk
aversion tend to hold securities $ith lo$er risk 'and therefore a lo$er
expected return( than investors $ho have more tolerance for risk.
a. True
b. False
(8-") 1eta coefficient F N Answer: b &ED./&
21
. 1 stock)s beta measures its diversifiable risk relative to the
diversifiable risks of other firms.
a. True
b. False
22
. 1 stock)s beta is more relevant as a measure of risk to an investor $ho
holds only one stock than to an investor $ho holds a $ell"diversified
portfolio.
a. True
b. False
(8-") 1eta coefficient F N Answer: a &ED./&
23
. -f the returns of t$o firms are negatively correlated, then one of them
must have a negative beta.
a. True
b. False
2
. 1 stock $ith a beta e#ual to "1.2 has zero systematic 'or market( risk.
a. True
b. False
(8-") 1eta coefficient F N Answer: a &ED./&
2%
. -t is possible for a firm to have a positive beta, even if the
correlation bet$een its returns and those of another firm is negative.
a. True
b. False
(8-") #ortfo$io ris! F N Answer: a &ED./&
2*
. 5ortfolio 1 has but one security, $hile 5ortfolio 9 has 122 securities.
9ecause of diversification effects, $e $ould expect 5ortfolio 9 to have
the lo$er risk. :o$ever, it is possible for 5ortfolio 1 to be less
risky.
a. True
b. False
(8-") #ortfo$io ris! F N Answer: b &ED./&
2,
. 5ortfolio 1 has but one stock, $hile 5ortfolio 9 consists of all stocks
that trade in the market, each held in proportion to its market value.
9ecause of its diversification, 5ortfolio 9 $ill by definition be
riskless.
a. True
b. False
(8-") #ortfo$io ris! F N Answer: b &ED./&
2.
. 1 portfolio)s risk is measured by the $eighted average of the standard
deviations of the securities in the portfolio. -t is this aspect of
portfolios that allo$s investors to combine stocks and thus reduce the
riskiness of their portfolios.
a. True
b. False
(8-") #ortfo$io ris! and ret%rn F N Answer: b &ED./&
2/
. The distributions of rates of return for 4ompanies 11 and 99 are given
belo$>
6tate of the 5robability of
?conomy This 6tate 3ccurring 11 99
9oom 2.2 32@ "12@
Aormal 2.* 12@ %@
!ecession 2.2 "%@ %2@
&e can conclude from the above information that any rational, risk"
averse investor $ould be better off adding 6ecurity 11 to a $ell"
diversified portfolio over 6ecurity 99.
a. True
b. False
(8-") Cor. coefficient and ris! F N Answer: b &ED./&
32
. ?ven if the correlation bet$een the returns on t$o securities is B1.2,
if the securities are combined in the correct proportions, the resulting
2"asset portfolio $ill have less risk than either security held alone.
a. True
b. False
(8-") Co0(an--s(ecific ris! F N Answer: a &ED./&
31
. 9ad managerial ;udgments 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 a$ay.
a. True
b. False
(8-") #ortfo$io beta F N Answer: b &ED./&
32
. &e $ould generally find that the beta of a single security is more
stable over time than the beta of a diversified portfolio.
a. True
b. False
(8-") #ortfo$io beta F N Answer: b &ED./&
33
. &e $ould almost al$ays find that the beta of a diversified portfolio is
less stable over time than the beta of a single security.
a. True
b. False
(8-") Diversification effects F N Answer: b &ED./&
3
. -f an investor buys enough stocks, he or she can, through
diversification, eliminate all of the market risk inherent in o$ning
stocks, but as a general rule it $ill not be possible to eliminate all
diversifiable risk.
a. True
b. False
(8-") CA#& F N Answer: b &ED./&
3%
. The 4150 is built on historic conditions, although in most cases $e use
expected future data in applying it. 9ecause betas used in the 4150 are
calculated using expected future data, they are not sub;ect to changes
in future volatility. This is one of the strengths of the 4150.
a. True
b. False
(8-)) e2%ired ret%rn F N Answer: b &ED./&
3*
. Cnder the 4150, the re#uired rate of return on a firm)s common stock is
determined only by the firm)s market risk. -f its market risk is kno$n,
and if that risk is expected to remain constant, then analysts have all
the information they need to calculate the firm)s re#uired rate of
return.
a. True
b. False
(8-)) C,an3es in beta F N Answer: a &ED./&
3,
. 1 firm can change its beta through managerial decisions, including
capital budgeting and capital structure decisions.
a. True
b. False
(8-)) C,an3es in beta F N Answer: a &ED./&
3.
. 1ny change in its beta is likely to affect the re#uired rate of return
on a stock, $hich implies that a change in beta $ill likely have an
impact on the stock)s price, other things held constant.
a. True
b. False
(8-)) S&* F N Answer: b &ED./&
3/
. The slope of the 607 is determined by the value of beta.
a. True
b. False
(8-)) S&* F N Answer: a &ED./&
2
. The slope of the 607 is determined by investors) aversion to risk. The
greater the average investor)s risk aversion, the steeper the 607.
a. True
b. False
1
. -f you plotted the returns of a company against those of the market and
found that the slope of your line $as negative, the 4150 $ould indicate
that the re#uired rate of return on the stock should be less than the
risk"free rate for a $ell"diversified investor, assuming that the
observed relationship is expected to continue in the future.
a. True
b. False
2
. -f you plotted the returns on a given stock against those of the market,
and if you found that the slope of the regression line $as negative, the
4150 $ould indicate that the re#uired rate of return on the stock should
be greater than the risk"free rate for a $ell"diversified investor,
assuming that the observed relationship is expected to continue into the
future.
a. True
b. False
3
. The D"axis intercept of the 607 represents the re#uired return of a
portfolio $ith a beta of zero, $hich is the risk"free rate.
Page 1. True/False Chapter 8: Risk and Return
a. True
b. False
. The 607 relates re#uired returns to firms) systematic 'or market( risk.
The slope and intercept of this line can be influenced by a manager)s
actions.
a. True
b. False
%
. The D"axis intercept of the 607 indicates the re#uired return on an
individual asset $henever the realized return on an average 'b E 1(
stock is zero.
a. True
b. False
(8-)) CA#& and inf$ation F N Answer: a &ED./&
*
. -f the price of money 'e.g., interest rates and e#uity capital costs(
increases due to an increase in anticipated inflation, the risk"free
rate $ill also increase. -f there is no change in investors) risk
aversion, then the market risk premium 'r
0
F r
!F
( $ill remain constant.
1lso, if there is no change in stocks) betas, then the re#uired rate of
return on each stock as measured by the 4150 $ill increase by the same
amount as the increase in expected inflation.
a. True
b. False
(8-)) &ar!et ris! (re0i%0 F N Answer: a &ED./&
,
. 6ince the market return represents the expected return on an average
stock, the market return reflects a certain amount of risk. 1s a
result, there exists a market risk premium, $hich is the amount over and
above the risk"free rate, that is re#uired to compensate stock investors
for assuming an average amount of risk.
a. True
b. False
(8-") 1eta coefficient F N Answer: a 4AD
.
. 1ssume that t$o investors each hold a portfolio, and that portfolio is
their only asset. -nvestor 1)s portfolio has a beta of minus 2.2, $hile
-nvestor 9)s portfolio has a beta of plus 2.2. 1ssuming that the
unsystematic risks of the stocks in the t$o portfolios are the same,
then the t$o investors face the same amount of risk. :o$ever, the
holders of either portfolio could lo$er their risks, and by exactly the
same amount, by adding some <normal= stocks $ith beta E 1.2.
a. True
b. False
(8-5) CA#& F N Answer: b 4AD
Chapter 8: Risk and Return True/False Page 1/
/
. The 4150 is a multi"period model that takes account of differences in
securities) maturities, and it can be used to determine the re#uired
rate of return for any given level of systematic risk.
a. True
b. False
Multiple Choice: Conceptual
(8-") is! aversion C N Answer: c &ED./&
%2
. Dou have the follo$ing data on three stocks>
6tock 6tandard +eviation 9eta
1 22@ 2.%/
9 12@ 2.*1
4 12@ 1.2/
-f you are a strict risk minimizer, you $ould choose 6tock GGGG if it is
to be held in isolation and 6tock GGGG if it is to be held as part of a
$ell"diversified portfolio.
a. 1H 1.
b. 1H 9.
c. 9H 1.
d. 4H 1.
e. 4H 9.
(8-") is! 0eas%res C N Answer: d &ED./&
%1
. &hich is the best measure of risk for a single asset held in isolation,
and $hich is the best measure for an asset held in a diversified
portfolioI
a. 8arianceH correlation coefficient.
b. 6tandard deviationH correlation coefficient.
c. 9etaH variance.
d. 4oefficient of variationH beta.
e. 9etaH beta.
(8-") Stoc! se$ection in (ortfo$io C N Answer: c &ED./&
%2
. 1 highly risk"averse investor is considering adding one additional stock
to a 3"stock portfolio, to form a "stock portfolio. The three stocks
currently held all have b E 1.2, and they are perfectly positively
correlated $ith the market. 5otential ne$ 6tocks 1 and 9 both have
expected returns of 1%@, are in e#uilibrium, and are e#ually correlated
$ith the market, $ith r E 2.,%. :o$ever, 6tock 1)s standard deviation
of returns is 12@ versus .@ for 6tock 9. &hich stock should this
investor add to his or her portfolio, or does the choice not matterI
a. ?ither 1 or 9, i.e., the investor should be indifferent bet$een the
t$o.
b. 6tock 1.
c. 6tock 9.
d. Aeither 1 nor 9, as neither has a return sufficient to compensate for
risk.
e. 1dd 1, since its beta must be lo$er.
Chapter 8: Risk and Return C$n&eptual "/C Page 17
(8-") 1eta coefficients C N Answer: c &ED./&
%3
. &hich of the follo$ing is A3T a potential problem $hen estimating and
using betas, i.e., $hich statement is F176?I
a. The fact that a security or pro;ect may not have a past history that
can be used as the basis for calculating beta.
b. 6ometimes, during a period $hen the company is undergoing a change
such as to$ard more leverage or riskier assets, the calculated beta
$ill be drastically different from the <true= or <expected future=
beta.
c. The beta of an <average stock,= or <the market,= can change over
time, sometimes drastically.
d. 6ometimes the past data used to calculate beta do not reflect the
likely risk of the firm for the future because conditions have
changed.
e. The beta coefficient of a stock is normally found by regressing past
returns on a stock against past market returns. This calculated
historical beta may differ from the beta that exists in the future.
%
. &hich of the follo$ing statements is 43!!?4TI
a. The beta of a portfolio of stocks is al$ays smaller than the betas of
any of the individual stocks.
b. -f you found a stock $ith a zero historical beta and held it as the
only stock in your portfolio, you $ould by definition have a riskless
portfolio.
c. The beta coefficient of a stock is normally found by regressing past
returns on a stock against past market returns. 3ne could also
construct a scatter diagram of returns on the stock versus those on
the market, estimate the slope of the line of best fit, and use it as
beta. :o$ever, this historical beta may differ from the beta that
exists in the future.
d. The beta of a portfolio of stocks is al$ays larger than the betas of
any of the individual stocks.
e. -t is theoretically possible for a stock to have a beta of 1.2. -f a
stock did have a beta of 1.2, then, at least in theory, its re#uired
rate of return $ould be e#ual to the risk"free 'default"free( rate of
return, r
!F
.
Page 18 C$n&eptual "/C Chapter 8: Risk and Return
(8-") 1eta coefficients C N Answer: b &ED./&
%%
a. 4ollections -nc. is in the business of collecting past"due accounts
for other companies, i.e., it is a collection agency. 4ollections)
revenues, profits, and stock price tend to rise during recessions.
This suggests that 4ollections -nc.)s beta should be #uite high, say
2.2, because it does so much better than most other companies $hen
the economy is $eak.
b. 6uppose the returns on t$o stocks are negatively correlated. 3ne has
a beta of 1.2 as determined in a regression analysis using data for
the last % years, $hile the other has a beta of "2.*. The returns on
the stock $ith the negative beta must have been negatively correlated
$ith returns on most other stocks during that %"year period.
c. 6uppose you are managing a stock portfolio, and you have information
that leads you to believe the stock market is likely to be very
strong in the immediate future. That is, you are convinced that the
market is about to rise sharply. Dou should sell your high"beta
stocks and buy lo$"beta stocks in order to take advantage of the
expected market move.
d. Dou think that investor sentiment is about to change, and investors
are about to become more risk averse. This suggests that you should
rebalance your portfolio to include more high"beta stocks.
e. -f the market risk premium remains constant, but the risk"free rate
declines, then the re#uired returns on lo$"beta stocks $ill rise
$hile those on high"beta stocks $ill decline.
(8-") 1eta coefficients C N Answer: e &ED./&
%*
a. -f a company $ith a high beta merges $ith a lo$"beta company, the
best estimate of the ne$ merged company)s beta is 1.2.
b. 7ogically, it is easier to estimate the betas associated $ith capital
budgeting pro;ects than the betas associated $ith stocks, especially
if the pro;ects are closely associated $ith research and development
activities.
c. The beta of an <average stock,= $hich is also <the market beta,= can
change over time, sometimes drastically.
d. -f a ne$ly issued stock does not have a past history that can be used
for calculating beta, then $e should al$ays estimate that its beta
$ill turn out to be 1.2. This is especially true if the company
finances $ith more debt than the average firm.
e. +uring a period $hen a company is undergoing a change such as
increasing its use of leverage or taking on riskier pro;ects, the
calculated historical beta may be drastically different from the beta
that $ill exist in the future.
(8-") 1eta coefficients C N Answer: e &ED./&
%,
. 6tock 1)s beta is 1.% and 6tock 9)s beta is 2.%. &hich of the follo$ing
statements must be true, assuming the 4150 is correct.
a. 6tock 1 $ould be a more desirable addition to a portfolio then 6tock
9.
Chapter 8: Risk and Return C$n&eptual "/C Page 1-
b. -n e#uilibrium, the expected return on 6tock 9 $ill be greater than
that on 6tock 1.
c. &hen held in isolation, 6tock 1 has more risk than 6tock 9.
d. 6tock 9 $ould be a more desirable addition to a portfolio than 1.
e. -n e#uilibrium, the expected return on 6tock 1 $ill be greater than
that on 9.
%.
. 6tock J has a beta of 2.% and 6tock D has a beta of 1.%. &hich of the
follo$ing statements must be true, according to the 4150I
a. -f you invest K%2,222 in 6tock J and K%2,222 in 6tock D, your 2"stock
portfolio $ould have a beta significantly lo$er than 1.2, provided
the returns on the t$o stocks are not perfectly correlated.
b. 6tock D)s realized return during the coming year $ill be higher than
6tock J)s return.
c. -f the expected rate of inflation increases but the market risk
premium is unchanged, the re#uired returns on the t$o stocks should
increase by the same amount.
d. 6tock D)s return has a higher standard deviation than 6tock J.
e. -f the market risk premium declines, but the risk"free rate is
unchanged, 6tock J $ill have a larger decline in its re#uired return
than $ill 6tock D.
(8-") 1eta coefficients C N Answer: d &ED./&
%/
. Dou have the follo$ing data on '1( the average annual returns of the
market for the past % years and '2( similar information on 6tocks 1 and
9. &hich of the possible ans$ers best describes the historical betas
for 1 and 9I
Dears 0arket 6tock 1 6tock 9
1 2.23 2.1* 2.2%
2 "2.2% 2.22 2.2%
3 2.21 2.1. 2.2%
"2.12 2.2% 2.2%
% 2.2* 2.1 2.2%
a. b
1
L 2H b
9
E 1.
b. b
1
L B1H b
9
E 2.
c. b
1
E 2H b
9
E "1.
d. b
1
M 2H b
9
E 2.
e. b
1
M "1H b
9
E 1.
(8-") #ortfo$io ris! C N Answer: e &ED./&
*2
a. 1n investor can eliminate virtually all market risk if he or she
holds a very large and $ell diversified portfolio of stocks.
b. The higher the correlation bet$een the stocks in a portfolio, the
lo$er the risk inherent in the portfolio.
c. -t is impossible to have a situation $here the market risk of a
single stock is less than that of a portfolio that includes the
stock.
d. 3nce a portfolio has about 2 stocks, adding additional stocks $ill
not reduce its risk by even a small amount.
e. 1n investor can eliminate virtually all diversifiable risk if he or
she holds a very large, $ell"diversified portfolio of stocks.
(8-") #ortfo$io ris! and beta C N Answer: c &ED./&
*1
a. -f you add enough randomly selected stocks to a portfolio, you can
completely eliminate all of the market risk from the portfolio.
b. -f you $ere restricted to investing in publicly traded common stocks,
yet you $anted to minimize the riskiness of your portfolio as
measured by its beta, then according to the 4150 theory you should
invest an e#ual amount of money in each stock in the market. That
is, if there $ere 12,222 traded stocks in the $orld, the least risky
possible portfolio $ould include some shares of each one.
c. -f you formed a portfolio that consisted of all stocks $ith betas
less than 1.2, $hich is about half of all stocks, the portfolio $ould
itself have a beta coefficient that is e#ual to the $eighted average
beta of the stocks in the portfolio, and that portfolio $ould have
less risk than a portfolio that consisted of all stocks in the
market.
d. 0arket risk can be eliminated by forming a large portfolio, and if
some Treasury bonds are held in the portfolio, the portfolio can be
made to be completely riskless.
e. 1 portfolio that consists of all stocks in the market $ould have a
re#uired return that is e#ual to the riskless rate.
(8-") &ar!et ris! C N Answer: c &ED./&
*2
. -nflation, recession, and high interest rates are economic events that
are best characterized as being
a. systematic risk factors that can be diversified a$ay.
b. company"specific risk factors that can be diversified a$ay.
c. among the factors that are responsible for market risk.
d. risks that are beyond the control of investors and thus should not be
considered by security analysts or portfolio managers.
e. irrelevant except to governmental authorities like the Federal
!eserve.
(8-") is! and (ort. divers. C N Answer: e &ED./&
*3
a. 1 stock)s beta is less relevant as a measure of risk to an investor
$ith a $ell"diversified portfolio than to an investor $ho holds only
that one stock.
b. -f an investor buys enough stocks, he or she can, through
diversification, eliminate all of the diversifiable risk inherent in
o$ning stocks. Therefore, if a portfolio contained all publicly
traded stocks, it $ould be essentially riskless.
c. The re#uired return on a firm)s common stock is, in theory,
determined solely by its market risk. -f the market risk is kno$n,
and if that risk is expected to remain constant, then no other
information is re#uired to specify the firm)s re#uired return.
d. 5ortfolio diversification reduces the variability of returns 'as
measured by the standard deviation( of each individual stock held in
a portfolio.
e. 1 security)s beta measures its non"diversifiable, or market, risk
relative to that of an average stock.
(8-") is! and (ort. divers. C N Answer: b &ED./&
*
a. 1 large portfolio of randomly selected stocks $ill al$ays have a
standard deviation of returns that is less than the standard
deviation of a portfolio $ith fe$er stocks, regardless of ho$ the
stocks in the smaller portfolio are selected.
b. +iversifiable risk can be reduced by forming a large portfolio, but
normally even highly"diversified portfolios are sub;ect to market 'or
systematic( risk.
c. 1 large portfolio of randomly selected stocks $ill have a standard
deviation of returns that is greater than the standard deviation of a
1"stock portfolio if that one stock has a beta less than 1.2.
d. 1 large portfolio of stocks $hose betas are greater than 1.2 $ill
have less market risk than a single stock $ith a beta E 2...
e. -f you add enough randomly selected stocks to a portfolio, you can
completely eliminate all of the market risk from the portfolio.
(8-") #ort. ris!6 ret%rn6 and beta C N Answer: b &ED./&
*%
a. 1 t$o"stock portfolio $ill al$ays have a lo$er standard deviation
than a one"stock portfolio.
b. 1 portfolio that consists of 2 stocks that are not highly correlated
$ith <the market= $ill probably be less risky than a portfolio of 2
stocks that are highly correlated $ith the market, assuming the
stocks all have the same standard deviations.
c. 1 t$o"stock portfolio $ill al$ays have a lo$er beta than a one"stock
portfolio.
d. -f portfolios are formed by randomly selecting stocks, a 12"stock
portfolio $ill al$ays have a lo$er beta than a one"stock portfolio.
e. 1 stock $ith an above"average standard deviation must also have an
above"average beta.
(8-") #ortfo$io ris! conce(ts C N Answer: d &ED./&
**
. 4onsider the follo$ing information for three stocks, 1, 9, and 4. The
stocks) returns are positively but not perfectly positively correlated
$ith one another, i.e., the correlations are all bet$een 2 and 1.
?xpected 6tandard
6tock !eturn +eviation 9eta
1 12@ 22@ 1.2
9 12@ 12@ 1.2
4 12@ 12@ 1.
5ortfolio 19 has half of its funds invested in 6tock 1 and half in 6tock
9. 5ortfolio 194 has one third of its funds invested in each of the
three stocks. The risk"free rate is %@, and the market is in
e#uilibrium, so re#uired returns e#ual expected returns. &hich of the
follo$ing statements is 43!!?4TI
a. 5ortfolio 19 has a standard deviation of 22@.
b. 5ortfolio 19)s coefficient of variation is greater than 2.2.
Page 2. C$n&eptual "/C Chapter 8: Risk and Return
c. 5ortfolio 19)s re#uired return is greater than the re#uired return on
6tock 1.
d. 5ortfolio 194)s expected return is 12.****,@.
e. 5ortfolio 194 has a standard deviation of 22@.
(8-") #ort. ret%rn6 CA#&6 and beta C N Answer: b &ED./&
*,
a. -f the returns on t$o stocks are perfectly positively correlated
'i.e., the correlation coefficient is B1.2( and these stocks have
identical standard deviations, an e#ually $eighted portfolio of the
t$o stocks $ill have a standard deviation that is less than that of
the individual stocks.
b. 1 portfolio $ith a large number of randomly selected stocks $ould
have more market risk than a single stock that has a beta of 2.%,
assuming that the stock)s beta $as correctly calculated and is
stable.
c. -f a stock has a negative beta, its expected return must be negative.
d. 1 portfolio $ith a large number of randomly selected stocks $ould
have less market risk than a single stock that has a beta of 2.%.
e. 1ccording to the 4150, stocks $ith higher standard deviations of
returns must also have higher expected returns.
(8-") #ortfo$io ris! and ret%rn C N Answer: d &ED./&
*.
. For a portfolio of 2 randomly selected stocks, $hich of the follo$ing
is most likely to be trueI
a. The riskiness of the portfolio is greater than the riskiness of each
of the stocks if each $as held in isolation.
b. The riskiness of the portfolio is the same as the riskiness of each
stock if it $as held in isolation.
c. The beta of the portfolio is less than the $eighted average of the
betas of the individual stocks.
d. The beta of the portfolio is e#ual to the $eighted average of the
e. The beta of the portfolio is larger than the $eighted average of the
(8-") #ortfo$io ris! and ret%rn C N Answer: a &ED./&
*/
. &hich of the follo$ing statements best describes $hat you should expect
if you randomly select stocks and add them to your portfolioI
a. 1dding more such stocks $ill reduce the portfolio)s unsystematic, or
diversifiable, risk.
b. 1dding more such stocks $ill increase the portfolio)s expected rate
of return.
c. 1dding more such stocks $ill reduce the portfolio)s beta coefficient
and thus its systematic risk.
d. 1dding more such stocks $ill have no effect on the portfolio)s risk.
e. 1dding more such stocks $ill reduce the portfolio)s market risk but
not its unsystematic risk.
Chapter 8: Risk and Return C$n&eptual "/C Page 2/
(8-") #ortfo$io ris! and ret%rn C N Answer: b &ED./&
,2
. 9ob has a K%2,222 stock portfolio $ith a beta of 1.2, an expected return
of 12..@, and a standard deviation of 2%@. 9ecky also has a K%2,222
portfolio, but it has a beta of 2.., an expected return of /.2@, and a
standard deviation that is also 2%@. The correlation coefficient, r,
bet$een 9ob)s and 9ecky)s portfolios is zero. -f 9ob and 9ecky marry
and combine their portfolios, $hich of the follo$ing best describes
their combined K122,222 portfolioI
a. The combined portfolio)s expected return $ill be less than the simple
$eighted average of the expected returns of the t$o individual
portfolios, 12.2@.
b. The combined portfolio)s beta $ill be e#ual to a simple $eighted
average of the betas of the t$o individual portfolios, 1.2H its
expected return $ill be e#ual to a simple $eighted average of the
expected returns of the t$o individual portfolios, 12.2@H and its
standard deviation $ill be less than the simple average of the t$o
portfolios) standard deviations, 2%@.
c. The combined portfolio)s expected return $ill be greater than the
simple $eighted average of the expected returns of the t$o individual
portfolios, 12.2@.
d. The combined portfolio)s standard deviation $ill be greater than the
simple average of the t$o portfolios) standard deviations, 2%@.
e. The combined portfolio)s standard deviation $ill be e#ual to a simple
average of the t$o portfolios) standard deviations, 2%@.
(8-") #ortfo$io ris! and ret%rn C N Answer: c &ED./&
,1
. Dour portfolio consists of K%2,222 invested in 6tock J and K%2,222
invested in 6tock D. 9oth stocks have an expected return of 1%@, betas
of 1.*, and standard deviations of 32@. The returns of the t$o stocks
are independent, so the correlation coefficient bet$een them, r
JD
, is
zero. &hich of the follo$ing statements best describes the
characteristics of your 2"stock portfolioI
a. Dour portfolio has a standard deviation of 32@, and its expected
return is 1%@.
b. Dour portfolio has a standard deviation less than 32@, and its beta
is greater than 1.*.
c. Dour portfolio has a beta e#ual to 1.*, and its expected return is
1%@.
d. Dour portfolio has a beta greater than 1.*, and its expected return
is greater than 1%@.
e. Dour portfolio has a standard deviation greater than 32@ and a beta
e#ual to 1.*.
(8-") #ortfo$io ris! and ret%rn C N Answer: a &ED./&
,2
. &hich of the follo$ing is most likely to occur as you add randomly
selected stocks to your portfolio, $hich currently consists of 3 average
stocksI
a. The diversifiable risk of your portfolio $ill likely decline, but the
expected market risk should not change.
b. The expected return of your portfolio is likely to decline.
c. The diversifiable risk $ill remain the same, but the market risk $ill
likely decline.
d. 9oth the diversifiable risk and the market risk of your portfolio are
likely to decline.
e. The total risk of your portfolio should decline, and as a result, the
expected rate of return on the portfolio should also decline.
,3
. Nane has a portfolio of 22 average stocks, and +ick has a portfolio of 2
average stocks. 1ssuming the market is in e#uilibrium, $hich of the
a. Nane)s portfolio $ill have less diversifiable risk and also less
market risk than +ick)s portfolio.
b. The re#uired return on Nane)s portfolio $ill be lo$er than that on
+ick)s portfolio because Nane)s portfolio $ill have less total risk.
c. +ick)s portfolio $ill have more diversifiable risk, the same market
risk, and thus more total risk than Nane)s portfolio, but the
re#uired 'and expected( returns $ill be the same on both portfolios.
d. -f the t$o portfolios have the same beta, their re#uired returns $ill
be the same, but Nane)s portfolio $ill have less market risk than
+ick)s.
e. The expected return on Nane)s portfolio must be lo$er than the
expected return on +ick)s portfolio because Nane is more diversified.
,
. 6tocks 1 and 9 each have an expected return of 12@, a beta of 1.2, and a
standard deviation of 2%@. The returns on the t$o stocks have a
correlation of B2.*. 5ortfolio 5 has %2@ in 6tock 1 and %2@ in 6tock 9.
&hich of the follo$ing statements is 43!!?4TI
a. 5ortfolio 5 has a beta that is greater than 1.2.
b. 5ortfolio 5 has a standard deviation that is greater than 2%@.
c. 5ortfolio 5 has an expected return that is less than 12@.
d. 5ortfolio 5 has a standard deviation that is less than 2%@.
e. 5ortfolio 5 has a beta that is less than 1.2.
(8-") #ortfo$io ris! and ret%rn C N Answer: e &ED./&
,%
. 6tocks 1, 9, and 4 all have an expected return of 12@ and a standard
deviation of 2%@. 6tocks 1 and 9 have returns that are independent of
one another, i.e., their correlation coefficient, r, e#uals zero.
6tocks 1 and 4 have returns that are negatively correlated $ith one
another, i.e., r is less than 2. 5ortfolio 19 is a portfolio $ith half
of its money invested in 6tock 1 and half in 6tock 9. 5ortfolio 14 is a
portfolio $ith half of its money invested in 6tock 1 and half invested
in 6tock 4. &hich of the follo$ing statements is 43!!?4TI
a. 5ortfolio 14 has an expected return that is less than 12@.
b. 5ortfolio 14 has an expected return that is greater than 2%@.
c. 5ortfolio 19 has a standard deviation that is greater than 2%@.
d. 5ortfolio 19 has a standard deviation that is e#ual to 2%@.
e. 5ortfolio 14 has a standard deviation that is less than 2%@.
(8-") #ortfo$io ris! and ret%rn C N Answer: b &ED./&
,*
. 6tocks 1 and 9 each have an expected return of 1%@, a standard deviation
of 22@, and a beta of 1.2. The returns on the t$o stocks have a
correlation coefficient of B2.*. Dou have a portfolio that consists of
%2@ 1 and %2@ 9. &hich of the follo$ing statements is 43!!?4TI
a. The portfolio)s beta is less than 1.2.
b. The portfolio)s expected return is 1%@.
c. The portfolio)s standard deviation is greater than 22@.
d. The portfolio)s beta is greater than 1.2.
e. The portfolio)s standard deviation is 22@.
,,
. 6tock 1 has a beta of 2.., 6tock 9 has a beta of 1.2, and 6tock 4 has a
beta of 1.2. 5ortfolio 5 has 1O3 of its value invested in each stock.
?ach stock has a standard deviation of 2%@, and their returns are
independent of one another, i.e., the correlation coefficients bet$een
each pair of stocks is zero. 1ssuming the market is in e#uilibrium,
$hich of the follo$ing statements is 43!!?4TI
a. 5ortfolio 5)s expected return is greater than the expected return on
6tock 9.
b. 5ortfolio 5)s expected return is e#ual to the expected return on
6tock 1.
c. 5ortfolio 5)s expected return is less than the expected return on
6tock 9.
d. 5ortfolio 5)s expected return is e#ual to the expected return on
6tock 9.
e. 5ortfolio 5)s expected return is greater than the expected return on
6tock 4.
,.
. -n a portfolio of three randomly selected stocks, $hich of the follo$ing
could A3T be true, i.e., $hich statement is falseI
a. The riskiness of the portfolio is less than the riskiness of each of
the stocks if they $ere held in isolation.
b. The riskiness of the portfolio is greater than the riskiness of one
or t$o of the stocks.
c. The beta of the portfolio is lo$er than the lo$est of the three
betas.
d. The beta of the portfolio is higher than the highest of the three
betas.
e. The beta of the portfolio is calculated as a $eighted average of the
individual stocksP betas.
(8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: b &ED./&
,/
. 6tock 1 has a beta E 2.., $hile 6tock 9 has a beta E 1.*. &hich of the
a. 6tock 9)s re#uired return is double that of 6tock 1)s.
b. -f the marginal investor becomes more risk averse, the re#uired
return on 6tock 9 $ill increase by more than the re#uired return on
6tock 1.
c. 1n e#ually $eighted portfolio of 6tocks 1 and 9 $ill have a beta
lo$er than 1.2.
d. -f the marginal investor becomes more risk averse, the re#uired
return on 6tock 1 $ill increase by more than the re#uired return on
6tock 9.
e. -f the risk"free rate increases but the market risk premium remains
constant, the re#uired return on 6tock 1 $ill increase by more than
that on 6tock 9.
(8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: b &ED./&
.2
. 6tock 1 has an expected return of 12@, a beta of 1.2, and a standard
deviation of 22@. 6tock 9 also has a beta of 1.2, but its expected
return is 12@ and its standard deviation is 1%@. 5ortfolio 19 has
K/22,222 invested in 6tock 1 and K322,222 invested in 6tock 9. The
correlation bet$een the t$o stocks) returns is zero 'that is, r
1,9
E 2(.
a. 5ortfolio 19)s standard deviation is 1,.%@.
b. The stocks are not in e#uilibrium based on the 4150H if 1 is valued
correctly, then 9 is overvalued.
c. The stocks are not in e#uilibrium based on the 4150H if 1 is valued
correctly, then 9 is undervalued.
d. 5ortfolio 19)s expected return is 11.2@.
e. 5ortfolio 19)s beta is less than 1.2.
(8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: e &ED./&
.1
. 6tock J has a beta of 2., and 6tock D has a beta of 1.3. The standard
deviation of each stock)s returns is 22@. The stocks) returns are
independent of each other, i.e., the correlation coefficient, r, bet$een
them is zero. 5ortfolio 5 consists of %2@ J and %2@ D. Qiven this
information, $hich of the follo$ing statements is 43!!?4TI
a. 5ortfolio 5 has a standard deviation of 22@.
b. The re#uired return on 5ortfolio 5 is e#ual to the market risk
premium 'r
0
F r
!F
(.
c. 5ortfolio 5 has a beta of 2.,.
d. 5ortfolio 5 has a beta of 1.2 and a re#uired return that is e#ual to
the riskless rate, r
!F
.
e. 5ortfolio 5 has the same re#uired return as the market 'r
0
(.
(8-)) &ar!et ris! (re0i%0 C N Answer: d &ED./&
.2
. &hich of the follo$ing statements is 43!!?4TI '1ssume that the risk"
free rate is a constant.(
a. -f the market risk premium increases by 1@, then the re#uired return
$ill increase for stocks that have a beta greater than 1.2, but it
$ill decrease for stocks that have a beta less than 1.2.
b. The effect of a change in the market risk premium depends on the
slope of the yield curve.
c. -f the market risk premium increases by 1@, then the re#uired return
on all stocks $ill rise by 1@.
d. -f the market risk premium increases by 1@, then the re#uired return
$ill increase by 1@ for a stock that has a beta of 1.2.
e. The effect of a change in the market risk premium depends on the
level of the risk"free rate.
(8-)) is! 7 ret. re$ations,i(s C N Answer: c &ED./&
.3
. 3ver the past . years, $e have observed that investments $ith the
highest average annual returns also tend to have the highest standard
deviations of annual returns. This observation supports the notion that
there is a positive correlation bet$een risk and return. &hich of the
follo$ing ans$ers correctly ranks investments from highest to lo$est
risk 'and return(, $here the security $ith the highest risk is sho$n
first, the one $ith the lo$est risk lastI
a. 6mall"company stocks, long"term corporate bonds, large"company
stocks, long"term government bonds, C.6. Treasury bills.
b. 7arge"company stocks, small"company stocks, long"term corporate
bonds, C.6. Treasury bills, long"term government bonds.
c. 6mall"company stocks, large"company stocks, long"term corporate
bonds, long"term government bonds, C.6. Treasury bills.
d. C.6. Treasury bills, long"term government bonds, long"term corporate
bonds, small"company stocks, large"company stocks.
e. 7arge"company stocks, small"company stocks, long"term corporate
bonds, long"term government bonds, C.6. Treasury bills.
(8-)) e2%ired ret%rn C N Answer: c &ED./&
.
. +uring the coming year, the market risk premium 'r
0
F r
!F
(, is expected
to fall, $hile the risk"free rate, r
!F
, is expected to remain the same.
Qiven this forecast, $hich of the follo$ing statements is 43!!?4TI
a. The re#uired return $ill increase for stocks $ith a beta less than
1.2 and $ill decrease for stocks $ith a beta greater than 1.2.
b. The re#uired return on all stocks $ill remain unchanged.
c. The re#uired return $ill fall for all stocks, but it $ill fall more
for stocks $ith higher betas.
d. The re#uired return for all stocks $ill fall by the same amount.
e. The re#uired return $ill fall for all stocks, but it $ill fall less
for stocks $ith higher betas.
(8-)) CA#& C N Answer: c &ED./&
.%
. The risk"free rate is *@H 6tock 1 has a beta of 1.2H 6tock 9 has a beta
of 2.2H and the market risk premium, r
0
F r
!F
, is positive. &hich of the
a. -f the risk"free rate increases but the market risk premium stays
unchanged, 6tock 9)s re#uired return $ill increase by more than 6tock
1)s.
b. 6tock 9)s re#uired rate of return is t$ice that of 6tock 1.
c. -f 6tock 1)s re#uired return is 11@, then the market risk premium is
%@.
d. -f 6tock 9)s re#uired return is 11@, then the market risk premium is
%@.
e. -f the risk"free rate remains constant but the market risk premium
increases, 6tock 1)s re#uired return $ill increase by more than 6tock
9)s.
(8-)) CA#& and re2%ired ret%rn C N Answer: b &ED./&
.*
. 1ssume that in recent years both expected inflation and the market risk
premium 'r
0
F r
!F
( have declined. 1ssume also that all stocks have
positive betas. &hich of the follo$ing $ould be most likely to have
occurred as a result of these changesI
a. The re#uired returns on all stocks have fallen, but the decline has
been greater for stocks $ith lo$er betas.
b. The re#uired returns on all stocks have fallen, but the fall has been
greater for stocks $ith higher betas.
c. The average re#uired return on the market, r
0
, has remained constant,
but the re#uired returns have fallen for stocks that have betas
greater than 1.2.
d. !e#uired returns have increased for stocks $ith betas greater than
1.2 but have declined for stocks $ith betas less than 1.2.
e. The re#uired returns on all stocks have fallen by the same amount.
(8-)) CA#& and re2%ired ret%rn C N Answer: a &ED./&
.,
. 1ssume that the risk"free rate is %@. &hich of the follo$ing statements
is 43!!?4TI
a. -f a stock has a negative beta, its re#uired return under the 4150
$ould be less than %@.
b. -f a stock)s beta doubled, its re#uired return under the 4150 $ould
also double.
c. -f a stock)s beta doubled, its re#uired return under the 4150 $ould
more than double.
d. -f a stock)s beta $ere 1.2, its re#uired return under the 4150 $ould
be %@.
e. -f a stock)s beta $ere less than 1.2, its re#uired return under the
4150 $ould be less than %@.
..
. 6tock :9 has a beta of 1.% and 6tock 79 has a beta of 2.%. The market
is in e#uilibrium, $ith re#uired returns e#ualing expected returns.
a. -f expected inflation remains constant but the market risk premium
'r
0
F r
!F
( declines, the re#uired return of 6tock 79 $ill decline but
the re#uired return of 6tock :9 $ill increase.
b. -f both expected inflation and the market risk premium 'r
0
F r
!F
(
increase, the re#uired return on 6tock :9 $ill increase by more than
that on 6tock 79.
c. -f both expected inflation and the market risk premium 'r
0
F r
!F
(
increase, the re#uired returns of both stocks $ill increase by the
same amount.
d. 6ince the market is in e#uilibrium, the re#uired returns of the t$o
stocks should be the same.
e. -f expected inflation remains constant but the market risk premium
'r
0
F r
!F
( declines, the re#uired return of 6tock :9 $ill decline but
the re#uired return of 6tock 79 $ill increase.
./
. 6tock 1 has a beta of 2.., 6tock 9 has a beta of 1.2, and 6tock 4 has a
beta of 1.2. 5ortfolio 5 has e#ual amounts invested in each of the
three stocks. ?ach of the stocks has a standard deviation of 2%@. The
returns on the three stocks are independent of one another 'i.e., the
correlation coefficients all e#ual zero(. 1ssume that there is an
increase in the market risk premium, but the risk"free rate remains
unchanged. &hich of the follo$ing statements is 43!!?4TI
a. The re#uired return of all stocks $ill remain unchanged since there
$as no change in their betas.
b. The re#uired return on 6tock 1 $ill increase by less than the
increase in the market risk premium, $hile the re#uired return on
6tock 4 $ill increase by more than the increase in the market risk
premium.
c. The re#uired return on the average stock $ill remain unchanged, but
the returns of riskier stocks 'such as 6tock 4( $ill increase $hile
the returns of safer stocks 'such as 6tock 1( $ill decrease.
d. The re#uired returns on all three stocks $ill increase by the amount
of the increase in the market risk premium.
e. The re#uired return on the average stock $ill remain unchanged, but
the returns on riskier stocks 'such as 6tock 4( $ill decrease $hile
the returns on safer stocks 'such as 6tock 1( $ill increase.
(8-)) CA#& and re2%ired ret%rn C N Answer: e &ED./&
/2
a. -f a company)s beta doubles, then its re#uired rate of return $ill
also double.
b. 3ther things held constant, if investors suddenly become convinced
that there $ill be deflation in the economy, then the re#uired
returns on all stocks should increase.
c. -f a company)s beta $ere cut in half, then its re#uired rate of
return $ould also be halved.
d. -f the risk"free rate rises by 2.%@ but the market risk premium
declines by that same amount, then the re#uired rates of return on
stocks $ith betas less than 1.2 $ill decline $hile returns on stocks
$ith betas above 1.2 $ill increase.
e. -f the risk"free rate rises by 2.%@ but the market risk premium
declines by that same amount, then the re#uired rate of return on an
average stock $ill remain unchanged, but re#uired returns on stocks
$ith betas less than 1.2 $ill rise.
(8-)) CA#&6 beta6 and re2. ret%rn C N Answer: a &ED./&
/1
. 1ssume that the risk"free rate is *@ and the market risk premium is %@.
Qiven this information, $hich of the follo$ing statements is 43!!?4TI
a. 1n index fund $ith beta E 1.2 should have a re#uired return of 11@.
b. -f a stock has a negative beta, its re#uired return must also be
negative.
c. 1n index fund $ith beta E 1.2 should have a re#uired return less than
11@.
d. -f a stock)s beta doubles, its re#uired return must also double.
e. 1n index fund $ith beta E 1.2 should have a re#uired return greater
than 11@.
Page 3. C$n&eptual "/C Chapter 8: Risk and Return
(8-)) S&* C N Answer: a &ED./&
/2
a. The slope of the security market line is e#ual to the market risk
premium.
b. 7o$er beta stocks have higher re#uired returns.
c. 1 stock)s beta indicates its diversifiable risk.
d. +iversifiable risk cannot be completely diversified a$ay.
e. T$o securities $ith the same stand"alone risk must have the same
betas.
(8-)) S&* C N Answer: e &ED./&
/3
a. 9eta is measured by the slope of the security market line.
b. -f the risk"free rate rises, then the market risk premium must also
rise.
c. -f a company)s beta is halved, then its re#uired return $ill also be
halved.
d. -f a company)s beta doubles, then its re#uired return $ill also
double.
e. The slope of the security market line is e#ual to the market risk
premium, 'r
0
F r
!F
(.
/
. 6tock 1 has a beta of 1.2 and a standard deviation of 22@. 6tock 9 has
a beta of 2.. and a standard deviation of 2%@. 5ortfolio 5 has K222,222
consisting of K122,222 invested in 6tock 1 and K122,222 in 6tock 9.
&hich of the follo$ing statements is 43!!?4TI '1ssume that the stocks
are in e#uilibrium.(
a. 6tock 1)s returns are less highly correlated $ith the returns on most
other stocks than are 9)s returns.
b. 6tock 9 has a higher re#uired rate of return than 6tock 1.
c. 5ortfolio 5 has a standard deviation of 22.%@.
d. 0ore information is needed to determine the portfolio)s beta.
e. 5ortfolio 5 has a beta of 1.2.
(8-)) S&* C N Answer: d &ED./&
/%
. Aile Food)s stock has a beta of 1., $hile ?lba ?ateries) stock has a
beta of 2.,. 1ssume that the risk"free rate, r
!F
, is %.%@ and the
market risk premium, 'r
0
F r
!F
(, e#uals @. &hich of the follo$ing
statements is 43!!?4TI
a. -f the risk"free rate increases but the market risk premium remains
unchanged, the re#uired return $ill increase for both stocks but the
increase $ill be larger for Aile since it has a higher beta.
b. -f the market risk premium increases but the risk"free rate remains
unchanged, Aile)s re#uired return $ill increase because it has a beta
greater than 1.2 but ?lba)s re#uired return $ill decline because it
has a beta less than 1.2.
c. 6ince Aile)s beta is t$ice that of ?lba)s, its re#uired rate of
return $ill also be t$ice that of ?lba)s.
Chapter 8: Risk and Return C$n&eptual "/C Page 3/
d. -f the risk"free rate increases $hile the market risk premium remains
constant, then the re#uired return on an average stock $ill increase.
e. -f the market risk premium decreases but the risk"free rate remains
unchanged, Aile)s re#uired return $ill decrease because it has a beta
greater than 1.2 and ?lba)s $ill also decrease, but by more than
Aile)s because it has a beta less than 1.2.
/*
. 6tock J has a beta of 2.*, $hile 6tock D has a beta of 1.. &hich of
the follo$ing statements is 43!!?4TI
a. 1 portfolio consisting of K%2,222 invested in 6tock J and K%2,222
invested in 6tock D $ill have a re#uired return that exceeds that of
the overall market.
b. 6tock D must have a higher expected return and a higher standard
deviation than 6tock J.
c. -f expected inflation increases but the market risk premium is
unchanged, then the re#uired return on both stocks $ill fall by the
same amount.
d. -f the market risk premium declines but expected inflation is
unchanged, the re#uired return on both stocks $ill decrease, but the
decrease $ill be greater for 6tock D.
e. -f expected inflation declines but the market risk premium is
unchanged, then the re#uired return on both stocks $ill decrease but
the decrease $ill be greater for 6tock D.
/,
. 6tock 1 has a beta of 2.. and 6tock 9 has a beta of 1.2. %2@ of
5ortfolio 5 is invested in 6tock 1 and %2@ is invested in 6tock 9. -f
the market risk premium 'r
0
F r
!F
( $ere to increase but the risk"free
rate 'r
!F
( remained constant, $hich of the follo$ing $ould occurI
a. The re#uired return $ould increase for both stocks but the increase
$ould be greater for 6tock 9 than for 6tock 1.
b. The re#uired return $ould decrease by the same amount for both
6tock 1 and 6tock 9.
c. The re#uired return $ould increase for 6tock 1 but decrease for
6tock 9.
d. The re#uired return on 5ortfolio 5 $ould remain unchanged.
e. The re#uired return $ould increase for 6tock 9 but decrease for
6tock 1.
/.
. 6tock 1 has a beta of 2.,, $hereas 6tock 9 has a beta of 1.3. 5ortfolio
5 has %2@ invested in both 1 and 9. &hich of the follo$ing $ould occur
if the market risk premium increased by 1@ but the risk"free rate
remained constantI
a. The re#uired return on 5ortfolio 5 $ould increase by 1@.
b. The re#uired return on both stocks $ould increase by 1@.
c. The re#uired return on 5ortfolio 5 $ould remain unchanged.
d. The re#uired return on 6tock 1 $ould increase by more than 1@, $hile
the return on 6tock 9 $ould increase by less than 1@.
e. The re#uired return for 6tock 1 $ould fall, but the re#uired return
for 6tock 9 $ould increase.
//
. 1ssume that the risk"free rate remains constant, but the market risk
premium declines. &hich of the follo$ing is most likely to occurI
a. The re#uired return on a stock $ith beta E 1.2 $ill not change.
b. The re#uired return on a stock $ith beta L 1.2 $ill increase.
c. The return on <the market= $ill remain constant.
d. The return on <the market= $ill increase.
e. The re#uired return on a stock $ith a positive beta M 1.2 $ill decline.
(8-)) S&* C N Answer: c &ED./&
122
a. The slope of the 607 is determined by the value of beta.
b. The 607 sho$s the relationship bet$een companies) re#uired returns
and their diversifiable risks. The slope and intercept of this line
cannot be influenced by a firm)s managers, but the position of the
company on the line can be influenced by its managers.
c. 6uppose you plotted the returns of a given stock against those of the
market, and you found that the slope of the regression line $as
negative. The 4150 $ould indicate that the re#uired rate of return
on the stock should be less than the risk"free rate for a $ell
diversified investor, assuming investors expect the observed
relationship to continue on into the future.
d. -f investors become less risk averse, the slope of the 6ecurity
0arket 7ine $ill increase.
e. -f a company increases its use of debt, this is likely to cause the
slope of its 607 to increase, indicating a higher re#uired return on
the stock.
121
. 3ther things held constant, if the expected inflation rate decreases and
investors also become more risk averse, the 6ecurity 0arket 7ine $ould
be affected as follo$s>
a. The y"axis intercept $ould decline, and the slope $ould increase.
b. The x"axis intercept $ould decline, and the slope $ould increase.
c. The y"axis intercept $ould increase, and the slope $ould decline.
d. The 607 $ould be affected only if betas changed.
e. 9oth the y"axis intercept and the slope $ould increase, leading to
higher re#uired returns.
122
. 1ssume that the risk"free rate, r
!F
, increases but the market risk
premium, 'r
0
F r
!F
(, declines $ith the net effect being that the overall
re#uired return on the market, r
0
, remains constant. &hich of the
a. The re#uired return of all stocks $ill increase by the amount of the
increase in the risk"free rate.
b. The re#uired return $ill decline for stocks that have a beta less
than 1.2 but $ill increase for stocks that have a beta greater than
1.2.
c. 6ince the overall return on the market stays constant, the re#uired
return on each individual stock $ill also remain constant.
d. The re#uired return $ill increase for stocks that have a beta less
than 1.2 but decline for stocks that have a beta greater than 1.2.
e. The re#uired return of all stocks $ill fall by the amount of the
decline in the market risk premium.
123
. 1ssume that to cool off the economy and decrease expectations for
inflation, the Federal !eserve tightened the money supply, causing an
increase in the risk"free rate, r
!F
. -nvestors also became concerned
that the Fed)s actions $ould lead to a recession, and that led to an
increase in the market risk premium, 'r
0
" r
!F
(. Cnder these conditions,
$ith other things held constant, $hich of the follo$ing statements is
most correctI
a. The re#uired return on all stocks $ould increase by the same amount.
b. The re#uired return on all stocks $ould increase, but the increase
$ould be greatest for stocks $ith betas of less than 1.2.
c. 6tocks) re#uired returns $ould change, but so $ould expected returns,
and the result $ould be no change in stocks) prices.
d. The prices of all stocks $ould decline, but the decline $ould be
greatest for high"beta stocks.
e. The prices of all stocks $ould increase, but the increase $ould be
greatest for high"beta stocks.
(8-)) S&*6 CA#&6 and beta C N Answer: e &ED./&
12
a. -f a stock has a beta of to 1.2, its re#uired rate of return $ill be
unaffected by changes in the market risk premium.
b. The slope of the 6ecurity 0arket 7ine is beta.
c. 1ny stock $ith a negative beta must in theory have a negative
re#uired rate of return, provided r
!F
is positive.
d. -f a stock)s beta doubles, its re#uired rate of return must also
double.
e. -f a stock)s returns are negatively correlated $ith returns on most
other stocks, the stock)s beta $ill be negative.
(8-)) S&* and ris! aversion C N Answer: a &ED./&
12%
. 1ssume that investors have recently become more risk averse, so the
market risk premium has increased. 1lso, assume that the risk"free rate
and expected inflation have not changed. &hich of the follo$ing is most
likely to occurI
a. The re#uired rate of return for an average stock $ill increase by an
amount e#ual to the increase in the market risk premium.
b. The re#uired rate of return $ill decline for stocks $hose betas are
less than 1.2.
c. The re#uired rate of return on the market, r
0
, $ill not change as a
result of these changes.
d. The re#uired rate of return for each individual stock in the market
$ill increase by an amount e#ual to the increase in the market risk
premium.
e. The re#uired rate of return on a riskless bond $ill decline.
(8-)) S&*6 CA#&6 and (ort. ris! C N Answer: e &ED./&
12*
a. 1 graph of the 607 as applied to individual stocks $ould sho$
re#uired rates of return on the vertical axis and standard deviations
of returns on the horizontal axis.
b. The 4150 has been thoroughly tested, and the theory has been
confirmed beyond any reasonable doubt.
c. -f t$o <normal= or <typical= stocks $ere combined to form a 2"stock
portfolio, the portfolio)s expected return $ould be a $eighted
average of the stocks) expected returns, but the portfolio)s standard
deviation $ould probably be greater than the average of the stocks)
standard deviations.
d. -f investors become more risk averse, then '1( the slope of the 607
$ould increase and '2( the re#uired rate of return on lo$"beta stocks
$ould increase by more than the re#uired return on high"beta stocks.
e. 1n increase in expected inflation, combined $ith a constant real
risk"free rate and a constant market risk premium, $ould lead to
identical increases in the re#uired returns on a riskless asset and
on an average stock, other things held constant.
(8-)) &ar!et e2%i$ibri%0 C N Answer: a &ED./&
12,
. For markets to be in e#uilibrium, that is, for there to be no strong
pressure for prices to depart from their current levels,
a. The expected rate of return must be e#ual to the re#uired rate of
returnH that is,
rR E r.
b. The past realized rate of return must be e#ual to the expected future
rate of returnH that is,
r
E
rR.
c. The re#uired rate of return must e#ual the past realized rate of
returnH that is, r E
r
.
d. 1ll three of the above statements must hold for e#uilibrium to existH
that is
rR E r E
r
.
e. Aone of the above statements is correct.
(Co0(.) is! conce(ts C N Answer: d &ED./&
12.
a. &hen diversifiable risk has been diversified a$ay, the inherent risk
that remains is market risk, $hich is constant for all stocks in the
market.
b. 5ortfolio diversification reduces the variability of returns on an
individual stock.
c. !isk refers to the chance that some unfavorable event $ill occur, and
a probability distribution is completely described by a listing of
the likelihoods of unfavorable events.
d. The 607 relates a stock)s re#uired return to its market risk. The
slope and intercept of this line cannot be controlled by the firms)
managers, but managers can influence their firms) positions on the
line by such actions as changing the firm)s capital structure or the
type of assets it employs.
e. 1 stock $ith a beta of "1.2 has zero market risk if held in a 1"stock
portfolio.
Page .0 C$n&eptual "/C Chapter 8: Risk and Return
(Co0(.) is! 0eas%res C N Answer: b &ED./&
12/
. Dou observe the follo$ing information regarding 4ompanies J and D>
4ompany J has a higher expected return than 4ompany D.
4ompany J has a lo$er standard deviation of returns than 4ompany D.
4ompany J has a higher beta than 4ompany D.
Qiven this information, $hich of the follo$ing statements is 43!!?4TI
a. 4ompany J has more diversifiable risk than 4ompany D.
b. 4ompany J has a lo$er coefficient of variation than 4ompany D.
c. 4ompany J has less market risk than 4ompany D.
d. 4ompany J)s returns $ill be negative $hen D)s returns are positive.
e. 4ompany J)s stock is a better buy than 4ompany D)s stock.
(8-") #ortfo$io ris! C N Answer: c &ED./&84AD
112
. 6tocks 1 and 9 both have an expected return of 12@ and a standard
deviation of returns of 2%@. 6tock 1 has a beta of 2.. and 6tock 9 has
a beta of 1.2. The correlation coefficient, r, bet$een the t$o stocks
is B2.*. 5ortfolio 5 has %2@ invested in 6tock 1 and %2@ invested in 9.
a. 5ortfolio 5 has a standard deviation of 2%@ and a beta of 1.2.
b. 9ased on the information $e are given, and assuming those are the
vie$s of the marginal investor, it is apparent that the t$o stocks
are in e#uilibrium.
c. 5ortfolio 5 has more market risk than 6tock 1 but less market risk
than 9.
d. 6tock 1 should have a higher expected return than 6tock 9 as vie$ed
by the marginal investor.
e. 5ortfolio 5 has a coefficient of variation e#ual to 2.%.
(8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: d 4AD
111
. The risk"free rate is *@ and the market risk premium is %@. Dour K1
million portfolio consists of K,22,222 invested in a stock that has a
beta of 1.2 and K322,222 invested in a stock that has a beta of 2...
a. -f the stock market is efficient, your portfolio)s expected return
should e#ual the expected return on the market, $hich is 11@.
b. The re#uired return on the market is 12@.
c. The portfolio)s re#uired return is less than 11@.
d. -f the risk"free rate remains unchanged but the market risk premium
increases by 2@, your portfolio)s re#uired return $ill increase by
more than 2@.
e. -f the market risk premium remains unchanged but expected inflation
increases by 2@, your portfolio)s re#uired return $ill increase by
more than 2@.
Chapter 8: Risk and Return C$n&eptual "/C Page .1
(8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: a 4AD
112
. 6tock 1 has an expected return of 12@ and a standard deviation of 22@.
6tock 9 has an expected return of 13@ and a standard deviation of 32@.
The risk"free rate is %@ and the market risk premium, r
0
F r
!F
, is *@.
1ssume that the market is in e#uilibrium. 5ortfolio 19 has %2@ invested
in 6tock 1 and %2@ invested in 6tock 9. The returns of 6tock 1 and
6tock 9 are independent of one another, i.e., the correlation
coefficient bet$een them is zero. &hich of the follo$ing statements is
43!!?4TI
a. 6tock 1)s beta is 2..333.
b. 6ince the t$o stocks have zero correlation, 5ortfolio 19 is riskless.
c. 6tock 9)s beta is 1.2222.
d. 5ortfolio 19)s re#uired return is 11@.
e. 5ortfolio 19)s standard deviation is 2%@.
(8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: c 4AD
113
. 6tock 1 has a beta of 1.2 and a standard deviation of 2%@. 6tock 9 has
a beta of 1. and a standard deviation of 22@. 5ortfolio 19 $as created
by investing in a combination of 6tocks 1 and 9. 5ortfolio 19 has a
beta of 1.2% and a standard deviation of 1.@. &hich of the follo$ing
statements is 43!!?4TI
a. 6tock 1 has more market risk than 5ortfolio 19.
b. 6tock 1 has more market risk than 6tock 9 but less stand"alone risk.
c. 5ortfolio 19 has more money invested in 6tock 1 than in 6tock 9.
d. 5ortfolio 19 has the same amount of money invested in each of the t$o
stocks.
e. 5ortfolio 19 has more money invested in 6tock 9 than in 6tock 1.
(8-)) S&* C N Answer: e 4AD
11
a. -f 0utual Fund 1 held e#ual amounts of 122 stocks, each of $hich had
a beta of 1.2, and 0utual Fund 9 held e#ual amounts of 12 stocks $ith
betas of 1.2, then the t$o mutual funds $ould both have betas of 1.2.
Thus, they $ould be e#ually risky from an investor)s standpoint,
assuming the investor)s only asset is one or the other of the mutual
funds.
b. -f investors become more risk averse but r
!F
does not change, then
the re#uired rate of return on high"beta stocks $ill rise and the
re#uired return on lo$"beta stocks $ill decline, but the re#uired
return on an average"risk stock $ill not change.
c. 1n investor $ho holds ;ust one stock $ill generally be exposed to
more risk than an investor $ho holds a portfolio of stocks, assuming
the stocks are all e#ually risky. 6ince the holder of the 1"stock
portfolio is exposed to more risk, he or she can expect to earn a
higher rate of return to compensate for the greater risk.
d. There is no reason to think that the slope of the yield curve $ould
have any effect on the slope of the 607.
e. 1ssume that the re#uired rate of return on the market, r
0
, is given
and fixed at 12@. -f the yield curve $ere up$ard sloping, then the
6ecurity 0arket 7ine '607( $ould have a steeper slope if 1"year
Page .2 C$n&eptual "/C Chapter 8: Risk and Return
Treasury securities $ere used as the risk"free rate than if 32"year
Treasury bonds $ere used for r
!F
.
Chapter 8: Risk and Return C$n&eptual "/C Page .3
Multiple Choice: "ro+lems
$enerall%, the SM& is used to find the required return, but on occasion the required return is
'iven and we must solve for one of the other variables. (e warn our students before the test that
to answer a number of the questions the% will have to transform the SM& equation to solve for
beta, the mar)et ris) premium, the ris)*free rate, or the mar)et return.
(8-2) E'(ected ret%rn C N Answer: c EASY
11%
. Taggart -nc.)s stock has a %2@ chance of producing a 2%@ return, a 32@
chance of producing a 12@ return, and a 22@ chance of producing a "2.@
return. &hat is the firm)s expected rate of returnI
a. /.1@
b. /.*%@
c. /./2@
d. 12.1%@
e. 12.2@
(8-2) E'(ected ret%rn C N Answer: d EASY
11*
. +othan -nc.)s stock has a 2%@ chance of producing a 32@ return, a %2@
chance of producing a 12@ return, and a 2%@ chance of producing a "1.@
return. &hat is the firm)s expected rate of returnI
a. ,.,2@
b. ..12@
c. ..%%@
d. /.22@
e. /.%2@
(8-2) Coefficient of variation C N Answer: a EASY
11,
. 4heng -nc. is considering a capital budgeting pro;ect that has an
expected return of 2%@ and a standard deviation of 32@. &hat is the
pro;ect)s coefficient of variationI
a. 1.22
b. 1.2*
c. 1.32
d. 1.3/
e. 1.*
(8-2) Coefficient of variation C N Answer: a EASY
11.
. 9ae -nc. is considering an investment that has an expected return of 1%@
and a standard deviation of 12@. &hat is the investment)s coefficient
of variationI
a. 2.*,
b. 2.,3
c. 2..1
d. 2../
e. 2./.
Page .. "/C Pr$%le+s Chapter 8: Risk and Return
(8-") #ortfo$io beta C N Answer: e EASY
11/
. 9ill +ukes has K122,222 invested in a 2"stock portfolio. K3%,222 is
invested in 6tock J and the remainder is invested in 6tock D. J)s beta
is 1.%2 and DPs beta is 2.,2. &hat is the portfolio)s betaI
a. 2.*%
b. 2.,2
c. 2..2
d. 2../
e. 2./.
(8-") #ortfo$io beta C N Answer: a EASY
122
. Tom 3)9rien has a 2"stock portfolio $ith a total value of K122,222.
K3,,%22 is invested in 6tock 1 $ith a beta of 2.,% and the remainder is
invested in 6tock 9 $ith a beta of 1.2. &hat is his portfolioPs betaI
a. 1.1,
b. 1.23
c. 1.2/
d. 1.3%
e. 1.2
(8-") #ortfo$io beta C N Answer: b EASY
121
. 1ssume that you hold a $ell"diversified portfolio that has an expected
return of 11.2@ and a beta of 1.22. Dou are in the process of buying
1,222 shares of 1lpha 4orp at K12 a share and adding it to your
portfolio. 1lpha has an expected return of 13.2@ and a beta of 1.%2.
The total value of your current portfolio is K/2,222. &hat $ill the
expected return and beta on the portfolio be after the purchase of the
1lpha stockI
a. 12.*@H 1.1,
b. 11.22@H 1.23
c. 11.,*@H 1.2/
d. 12.3%@H 1.3*
e. 12./,@H 1.2
(8-)) CA#&: re2%ired rate of ret%rn C N Answer: d EASY
122
. 4alculate the re#uired rate of return for 4limax -nc., assuming that '1(
investors expect a .2@ rate of inflation in the future, '2( the real
risk"free rate is 3.2@, '3( the market risk premium is %.2@, '( the
firm has a beta of 1.22, and '%( its realized rate of return has
averaged 1%.2@ over the last % years.
a. 12.2/@
b. 12..3@
c. 11.2@
d. 12.22@
e. 12.*2@
Chapter 8: Risk and Return "/C Pr$%le+s Page ./
(8-)) CA#&: re2%ired rate of ret%rn C N Answer: c EASY
123
. 4ooley 4ompany)s stock has a beta of 1.2, the risk"free rate is .2%@,
and the market risk premium is %.%2@. &hat is the firm)s re#uired rate
of returnI
a. 11.3*@
b. 11.*%@
c. 11./%@
d. 12.2%@
e. 12.%%@
(8-)) &ar!et ris! (re0i%0 C N Answer: a EASY
12
. 5orter -nc)s stock has an expected return of 12.2%@, a beta of 1.2%, and
is in e#uilibrium. -f the risk"free rate is %.22@, $hat is the market
risk premiumI
a. %..2@
b. %./%@
c. *.2/@
d. *.2%@
e. *.2@
(8-2) Coefficient of variation C N Answer: b &ED./&
12%
. !oenfeld 4orp believes the follo$ing probability distribution exists for
its stock. &hat is the coefficient of variation on the company)s stockI
5robability 6tock)s
6tate of of 6tate ?xpected
the ?conomy 3ccurring !eturn
9oom 2.% 2%@
Aormal 2.%2 1%@
!ecession 2.2% %@
a. 2.2.3/
b. 2.32*/
c. 2.32//
d. 2.3%,
e. 2.3.13
(8-") #ortfo$io beta C N Answer: b &ED./&
12*
. Nim 1ngel holds a K222,222 portfolio consisting of the follo$ing stocks>
6tock -nvestment 9eta
1 K %2,222 2./%
9 %2,222 2..2
4 %2,222 1.22
+ %2,222 1.22
Total K222,222
&hat is the portfolio)s betaI
a. 2./3.
b. 2./..
c. 1.23,
Page .0 "/C Pr$%le+s Chapter 8: Risk and Return
d. 1.2./
e. 1.13
12,
. Nill 1ngel holds a K222,222 portfolio consisting of the follo$ing
stocks. The portfolio)s beta is 2..,%.
1 K %2,222 2.%2
9 %2,222 2..2
4 %2,222 1.22
+ %2,222 1.22
Total K222,222
-f Nill replaces 6tock 1 $ith another stock, ?, $hich has a beta of
1.%2, $hat $ill the portfolio)s ne$ beta beI
a. 1.2,
b. 1.13
c. 1.1.
d. 1.2
e. 1.32
12.
. 0ike Flannery holds the follo$ing portfolio>
1 K1%2,222 1.2
9 %2,222 2..2
4 122,222 1.22
+ ,%,222 1.22
Total K3,%,222
&hat is the portfolio)s betaI
a. 1.2*
b. 1.1,
c. 1.2/
d. 1.2
e. 1.%*
(8-") #ortfo$io beta C N Answer: d &ED./&
12/
. Tom Aoel holds the follo$ing portfolio>
1 K1%2,222 1.2
9 %2,222 2..2
4 122,222 1.22
+ ,%,222 1.22
Total K3,%,222
Tom plans to sell 6tock 1 and replace it $ith 6tock ?, $hich has a beta
of 2.,%. 9y ho$ much $ill the portfolio beta changeI
Chapter 8: Risk and Return "/C Pr$%le+s Page .7
a. "2.1/2
b. "2.211
c. "2.23
d. "2.2*2
e. "2.2.*
(8-") #ortfo$io beta C N Answer: e &ED./&
132
. Dou hold a diversified K122,222 portfolio consisting of 22 stocks $ith
K%,222 invested in each. The portfolio)s beta is 1.12. Dou plan to
sell a stock $ith b E 2./2 and use the proceeds to buy a ne$ stock $ith
b E 1..2. &hat $ill the portfolio)s ne$ beta beI
a. 1.2.*
b. 1.2%%
c. 1.22
d. 1.1/
e. 1.1*%
(8-)) CA#&: re2. rate of ret%rn C N Answer: a &ED./&
131
. 0ikkelson 4orporation)s stock had a re#uired return of 11.,%@ last year,
$hen the risk"free rate $as %.%2@ and the market risk premium $as .,%@.
Then an increase in investor risk aversion caused the market risk
premium to rise by 2@. The risk"free rate and the firm)s beta remain
unchanged. &hat is the company)s ne$ re#uired rate of returnI ':int>
First calculate the beta, then find the re#uired return.(
a. 1.3.@
b. 1.,@
c. 1%.11@
d. 1%./@
e. 1%..,@
(8-)) CA#&: re2. rate of ret%rn C N Answer: e &ED./&
132
. 4ompany 1 has a beta of 2.,2, $hile 4ompany 9)s beta is 1.22. The
re#uired return on the stock market is 11.22@, and the risk"free rate is
.2%@. &hat is the difference bet$een 1)s and 9)s re#uired rates of
returnI ':int> First find the market risk premium, then find the
re#uired returns on the stocks.(
a. 2.,%@
b. 2../@
c. 3.2%@
d. 3.21@
e. 3.3.@
(8-)) CA#&: re2. rate of ret%rn C N Answer: c &ED./&
133
. 6tock 1)s stock has a beta of 1.32, and its re#uired return is 12.22@.
6tock 9)s beta is 2..2. -f the risk"free rate is .,%@, $hat is the
re#uired rate of return on 9)s stockI ':int> First find the market
risk premium.(
a. ..,*@
b. ../.@
c. /.21@
Page .8 "/C Pr$%le+s Chapter 8: Risk and Return
d. /.@
e. /.*.@
Chapter 8: Risk and Return "/C Pr$%le+s Page .-
(8-)) CA#&: re2. rate of ret%rn C N Answer: d &ED./&
13
. Sollo ?nterprises has a beta of 1.12, the real risk"free rate is 2.22@,
investors expect a 3.22@ future inflation rate, and the market risk
premium is .,2@. &hat is Sollo)s re#uired rate of returnI
a. /.3@
b. /.*,@
c. /./2@
d. 12.1,@
e. 12.2@
13%
. 7inke 0otors has a beta of 1.32, the T"bill rate is 3.22@, and the T"
bond rate is *.%@. The annual return on the stock market during the
past 3 years $as 1%.22@, but investors expect the annual future stock
market return to be 13.22@. 9ased on the 607, $hat is the firm)s
re#uired returnI
a. 13.%1@
b. 13..*@
c. 1.21@
d. 1.%.@
e. 1./%@
(8-)) CA#&: re2. rate of ret%rn C N Answer: b &ED./&
13*
. Aagel ?#uipment has a beta of 2... and an expected dividend gro$th rate
of .22@ per year. The T"bill rate is .22@, and the T"bond rate is
%.2%@. The annual return on the stock market during the past years
$as 12.2%@. -nvestors expect the average annual future return on the
market to be 12.%2@. Csing the 607, $hat is the firm)s re#uired rate of
returnI
a. 11.3@
b. 11.*3@
c. 11./2@
d. 12.22@
e. 12.%2@
13,
. 4onsider the follo$ing information and then calculate the re#uired rate
of return for the Qlobal -nvestment Fund, $hich holds stocks. The
marketPs re#uired rate of return is 13.2%@, the risk"free rate is ,.22@,
and the Fund)s assets are as follo$s>
1 K 222,222 1.%2
9 322,222 "2.%2
4 %22,222 1.2%
+ K1,222,222 2.,%
a. /.%.@
b. 12.2/@
c. 12.*2@
d. 11.1.@
Page /0 "/C Pr$%le+s Chapter 8: Risk and Return
e. 11.,,@
Chapter 8: Risk and Return "/C Pr$%le+s Page /1
(8-)) CA#&: re2. rate of ret%rn C N Answer: a &ED./&
13.
. +ata for +ana -ndustries is sho$n belo$. Ao$ +ana ac#uires some risky
assets that cause its beta to increase by 32@. -n addition, expected
inflation increases by 2.22@. &hat is the stock)s ne$ re#uired rate of
returnI
-nitial beta 1.22
-nitial re#uired return 'r
s
( 12.22@
0arket risk premium, !5
0
*.22@
5ercentage increase in beta 32.22@
-ncrease in inflation premium, -5 2.22@
a. 1.22@
b. 1.,2@
c. 1%.@
d. 1*.21@
e. 1,.22@
(8-)) et%rn on t,e 0ar!et C N Answer: a &ED./&
13/
. 0ulherin)s stock has a beta of 1.23, its re#uired return is 11.,%@, and
the risk"free rate is .32@. &hat is the re#uired rate of return on the
marketI ':int> First find the market risk premium.(
a. 12.3*@
b. 12.*2@
c. 12...@
d. 11.1%@
e. 11.3@
(8-") #ortfo$io beta C N Answer: c &ED./&84AD
12
. 6uppose you hold a portfolio consisting of a K12,222 investment in each
of . different common stocks. The portfolioPs beta is 1.2%. Ao$
suppose you decided to sell one of your stocks that has a beta of 1.22
and to use the proceeds to buy a replacement stock $ith a beta of 1.3%.
&hat $ould the portfolioPs ne$ beta beI
a. 1.1,
b. 1.23
c. 1.2/
d. 1.3*
e. 1.3
(8-2) Std. dev.6 ,istorica$ ret%rns C N Answer: b 4AD
11
. !eturns for the +ayton 4ompany over the last 3 years are sho$n belo$.
&hat)s the standard deviation of the firm)s returnsI ':int> This is a
sample, not a complete population, so the sample standard deviation
formula should be used.(
Dear !eturn
2212 21.22@
2211 "12.%2@
2212 2%.22@
a. 22.2.@
Page /2 "/C Pr$%le+s Chapter 8: Risk and Return
b. 22.%/@
c. 21.11@
d. 21.*@
e. 22.1.@
(8-2) Std. dev.6 (rob. data C N Answer: b 4AD
12
. 4arson -nc.)s manager believes that economic conditions during the next
year $ill be strong, normal, or $eak, and she thinks that the firm)s
returns $ill have the probability distribution sho$n belo$. &hat)s the
standard deviation of the estimated returnsI ':int> Cse the formula for
the standard deviation of a population, not a sample.(
?conomic
4onditions 5rob. !eturn
6trong 32@ 32.2@
Aormal 2@ 12.2@
&eak 32@ "1*.2@
a. 1,.*/@
b. 1..*2@
c. 1/.%%@
d. 22.%2@
e. 21.%%@
(8-") #ortfo$io ris! red%ction C N Answer: d 4AD
13
. 1ssume that your uncle holds ;ust one stock, ?ast 4oast 9ank '?49(,
$hich he thinks has very little risk. Dou agree that the stock is
relatively safe, but you $ant to demonstrate that his risk $ould be even
lo$er if he $ere more diversified. Dou obtain the follo$ing returns
data for &est 4oast 9ank '&49(. 9oth banks have had less variability
than most other stocks over the past % years. 0easured by the standard
deviation of returns, by ho$ much $ould your uncle)s risk have been
reduced if he had held a portfolio consisting of *2@ in ?49 and the
remainder in &49I ':int> Cse the sample standard deviation formula.(
Dear ?49 &49
222. 2.22@ 2.22@
222/ "12.22@ 1%.22@
2212 3%.22@ "%.22@
2211 "%.22@ "12.22@
2212 1%.22@ 3%.22@
1verage return E 1%.22@ 1%.22@
6tandard deviation E 22.*@ 22.*@
a. 3.2/@
b. 3.*@
c. 3.*%@
d. 3..@
e. .23@
(8-") #ortfo$io beta C N Answer: a 4AD
1
. 1ssume that you manage a K12.22 million mutual fund that has a beta of
1.2% and a /.%2@ re#uired return. The risk"free rate is .22@. Dou no$
Chapter 8: Risk and Return "/C Pr$%le+s Page /3
receive another K%.22 million, $hich you invest in stocks $ith an
average beta of 2.*%. &hat is the re#uired rate of return on the ne$
portfolioI ':int> Dou must first find the market risk premium, then
find the ne$ portfolio beta.(
a. ...3@
b. /.2%@
c. /.2,@
d. /.%1@
e. /.,@
(8-") #ortfo$io beta C N Answer: b 4AD
1%
. 1 mutual fund manager has a K2 million portfolio $ith a beta of 1.22.
The risk"free rate is .2%@, and the market risk premium is *.22@. The
manager expects to receive an additional K*2 million $hich she plans to
invest in additional stocks. 1fter investing the additional funds, she
$ants the fundPs re#uired and expected return to be 13.22@. &hat must
the average beta of the ne$ stocks be to achieve the target re#uired
rate of returnI
a. 1.*.
b. 1.,*
c. 1..%
d. 1./
e. 2.2
(8-)) #ort. beta and re2. ret. C N Answer: c 4AD
1*
. 1ssume that you are the portfolio manager of the 6F Fund, a K3 million
hedge fund that contains the follo$ing stocks. The re#uired rate of
return on the market is 11.22@ and the risk"free rate is %.22@. &hat
rate of return should investors expect 'and re#uire( on this fundI
6tock 1mount 9eta
1 K1,2,%,222 1.22
9 *,%,222 2.%2
4 ,%2,222 1.2
+ %22,222 2.,%
K3,222,222
a. 12.%*@
b. 12..3@
c. 11.11@
d. 11.3.@
e. 11.*,@
(8-)) CA#&: re2. rate of ret%rn C N Answer: c 4AD
1,
. 444 4orp has a beta of 1.% and is currently in e#uilibrium. The
re#uired rate of return on the stock is 12.22@ versus a re#uired return
on an average stock of 12.22@. Ao$ the re#uired return on an average
stock increases by 32.2@ 'not percentage points(. Aeither betas nor the
risk"free rate change. &hat $ould 444)s ne$ re#uired return beI
a. 1../@
b. 1%.*.@
Page /. "/C Pr$%le+s Chapter 8: Risk and Return
c. 1*.%2@
d. 1,.33@
e. 1..1/@
Chapter 8: Risk and Return "/C Pr$%le+s Page //
Page /0 ns(ers Chapter 8: Risk and Return
CH!"TE# $
!(&,E#& !(D &)L*T%)(&
1. (8-2) Standard deviation F N Answer: b EASY
2. (8-2) Coefficient of variation F N Answer: a EASY
3. (8-2) CV vs. SD F N Answer: b EASY
. (8-2) is! aversion F N Answer: a EASY
%. (8-") #ortfo$io ris! F N Answer: a EASY
*. (8-") #ortfo$io ris! F N Answer: a EASY
,. (8-") #ortfo$io ris! F N Answer: a EASY
.. (8-") #ortfo$io ret%rn F N Answer: b EASY
/. (8-") &ar!et ris! F N Answer: a EASY
12. (8-") &ar!et ris! F N Answer: b EASY
11. (8-") is! and e'(ected ret%rns F N Answer: b EASY
12. (8-") CA#& and ris! F N Answer: a EASY
13. (8-") CA#& and ris! F N Answer: a EASY
1. (8-)) S&* and ris! aversion F N Answer: b EASY
1%. (8-+) #,-sica$ assets F N Answer: a EASY
1*. (8-2) Variance F N Answer: a &ED./&
1,. (8-2) Coefficient of variation F N Answer: a &ED./&
1.. (8-2) is! aversion F N Answer: a &ED./&
1/. (8-2) is! aversion F N Answer: a &ED./&
22. (8-2) is! (re0. and ris! aversion F N Answer: a &ED./&
21. (8-") 1eta coefficient F N Answer: b &ED./&
23. (8-") 1eta coefficient F N Answer: a &ED./&
2%. (8-") 1eta coefficient F N Answer: a &ED./&
2*. (8-") #ortfo$io ris! F N Answer: a &ED./&
2,. (8-") #ortfo$io ris! F N Answer: b &ED./&
2.. (8-") #ortfo$io ris! F N Answer: b &ED./&
2/. (8-") #ortfo$io ris! and ret%rn F N Answer: b &ED./&
The stocks have the same expected returns, but BB does badly in booms and well in recessions. Therefore, it
would do more to reduce risk.
32. (8-") Cor. coefficient and ris! F N Answer: b &ED./&
31. (8-") Co0(an--s(ecific ris! F N Answer: a &ED./&
32. (8-") #ortfo$io beta F N Answer: b &ED./&
33. (8-") #ortfo$io beta F N Answer: b &ED./&
3. (8-") Diversification effects F N Answer: b &ED./&
3%. (8-") CA#& F N Answer: b &ED./&
3*. (8-)) e2%ired ret%rn F N Answer: b &ED./&
3,. (8-)) C,an3es in beta F N Answer: a &ED./&
3.. (8-)) C,an3es in beta F N Answer: a &ED./&
3/. (8-)) S&* F N Answer: b &ED./&
2. (8-)) S&* F N Answer: a &ED./&
1. (8-)) S&* F N Answer: a &ED./&
2. (8-)) S&* F N Answer: b &ED./&
3. (8-)) S&* F N Answer: a &ED./&
. (8-)) S&* F N Answer: b &ED./&
The slope and intercept of the SML are determined by the market, generally not the actions of a single firm.
owever, managers can influence their firms! beta, and thus their firms! re"uired returns.
%. (8-)) S&* F N Answer: b &ED./&
*. (8-)) CA#& and inf$ation F N Answer: a &ED./&
,. (8-)) &ar!et ris! (re0i%0 F N Answer: a &ED./&
.. (8-") 1eta coefficient F N Answer: a 4AD
Both portfolios would be twice as risky as a portfolio of average stocks. Their risks would decline if they
added b # $.% stocks, as those stocks would move the portfolios! betas toward $.%.
/. (8-5) CA#& F N Answer: b 4AD
The &'(M is a single)period model, and it does not take account of securities! maturities.
%2. (8-") is! aversion C N Answer: c &ED./&
%1. (8-") is! 0eas%res C N Answer: d &ED./&
%2. (8-") Stoc! se$ection in (ortfo$io C N Answer: c &ED./&
*ith only + stocks in the portfolio, unsystematic risk matters, and B has less.
%3. (8-") 1eta coefficients C N Answer: c &ED./&
%. (8-") 1eta coefficients C N Answer: c &ED./&
%%. (8-") 1eta coefficients C N Answer: b &ED./&
%*. (8-") 1eta coefficients C N Answer: e &ED./&
%,. (8-") 1eta coefficients C N Answer: e &ED./&
%.. (8-") 1eta coefficients C N Answer: c &ED./&
%/. (8-") 1eta coefficients C N Answer: d &ED./&
,irst, note that B!s beta must be -ero, so either b or d must be correct. Second, note that '!s returns are
highest when the market!s returns are negative and lowest when the market!s returns are positive. This
indicates that '!s beta is negative. Thus, d must be correct.
*2. (8-") #ortfo$io ris! C N Answer: e &ED./&
*1. (8-") #ortfo$io ris! and beta C N Answer: c &ED./&
*2. (8-") &ar!et ris! C N Answer: c &ED./&
*3. (8-") is! and (ort. divers. C N Answer: e &ED./&
*. (8-") is! and (ort. divers. C N Answer: b &ED./&
*%. (8-") #ort. ris!6 ret%rn6 and beta C N Answer: b &ED./&
**. (8-") #ortfo$io ris! conce(ts C N Answer: d &ED./&
*,. (8-") #ort. ret%rn6 CA#&6 and beta C N Answer: b &ED./&
*.. (8-") #ortfo$io ris! and ret%rn C N Answer: d &ED./&
*/. (8-") #ortfo$io ris! and ret%rn C N Answer: a &ED./&
,2. (8-") #ortfo$io ris! and ret%rn C N Answer: b &ED./&
,1. (8-") #ortfo$io ris! and ret%rn C N Answer: c &ED./&
,2. (8-") #ortfo$io ris! and ret%rn C N Answer: a &ED./&
,3. (8-") #ortfo$io ris! and ret%rn C N Answer: c &ED./&
,. (8-") #ortfo$io ris! and ret%rn C N Answer: d &ED./&
,%. (8-") #ortfo$io ris! and ret%rn C N Answer: e &ED./&
,*. (8-") #ortfo$io ris! and ret%rn C N Answer: b &ED./&
,,. (8-") #ortfo$io ris! and ret%rn C N Answer: d &ED./&
,.. (8-") #ortfo$io ris! and ret%rn C N Answer: c &ED./&
,/. (8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: b &ED./&
.2. (8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: b &ED./&
.1. (8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: e &ED./&
.2. (8-)) &ar!et ris! (re0i%0 C N Answer: d &ED./&
.3. (8-)) is! 7 ret. re$ations,i(s C N Answer: c &ED./&
.. (8-)) e2%ired ret%rn C N Answer: c &ED./&
.%. (8-)) CA#& C N Answer: c &ED./&
.*. (8-)) CA#& and re2%ired ret%rn C N Answer: b &ED./&
.,. (8-)) CA#& and re2%ired ret%rn C N Answer: a &ED./&
... (8-)) CA#& and re2%ired ret%rn C N Answer: b &ED./&
./. (8-)) CA#& and re2%ired ret%rn C N Answer: b &ED./&
/2. (8-)) CA#& and re2%ired ret%rn C N Answer: e &ED./&
/1. (8-)) CA#&6 beta6 and re2. ret%rn C N Answer: a &ED./&
/2. (8-)) S&* C N Answer: a &ED./&
/3. (8-)) S&* C N Answer: e &ED./&
/. (8-)) S&* C N Answer: e &ED./&
/%. (8-)) S&* C N Answer: d &ED./&
/*. (8-)) S&* C N Answer: d &ED./&
/,. (8-)) S&* C N Answer: a &ED./&
/.. (8-)) S&* C N Answer: a &ED./&
//. (8-)) S&* C N Answer: e &ED./&
122. (8-)) S&* C N Answer: c &ED./&
121. (8-)) S&* C N Answer: a &ED./&
122. (8-)) S&* C N Answer: d &ED./&
123. (8-)) S&* C N Answer: d &ED./&
12. (8-)) S&*6 CA#&6 and beta C N Answer: e &ED./&
12%. (8-)) S&* and ris! aversion C N Answer: a &ED./&
12*. (8-)) S&*6 CA#&6 and (ort. ris! C N Answer: e &ED./&
12,. (8-)) &ar!et e2%i$ibri%0 C N Answer: a &ED./&
12.. (Co0(.) is! conce(ts C N Answer: d &ED./&
12/. (Co0(.) is! 0eas%res C N Answer: b &ED./&
112. (8-") #ortfo$io ris! C N Answer: c &ED./&84AD
111. (8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: d 4AD
d is correct. The portfolio!s beta is $.%.. Therefore, if the market risk premium increases by /.%0 the
portfolio!s re"uired return will increase by /.$10.
112. (8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: a 4AD
a is correct. Stock '!s re"uired return is $%0 # 20 3 b4105, so b # 20610 # %..7777.
113. (8-)) #ort. ris! 7 ret. re$ations,i(s C N Answer: c 4AD
c is correct. b( # 0'4$./5 30B4$.+5 # $./2. 8f 2%0 is in each stock, then we would have b( # %.24$./5 3
%.24$.+5 # $.7. But b( 9 $.7, so more money must be invested in the low)beta stock, '.
11. (8-)) S&* C N Answer: e 4AD
11%. (8-2) E'(ected ret%rn C N Answer: c EASY
(rob.
&onditions (rob. :eturn ; :eturn
<ood %.2% /2.%0 $/.2%0
'verage %.7% $%.%0 7.%%0
(oor %./% )/..%0 )2.1%0
$.%% =.=%0 # >xpected return
11*. (8-2) E'(ected ret%rn C N Answer: d EASY
(rob.
&onditions (rob. :eturn ; :eturn
<ood %./2 7%.%0 ?.2%0
'verage %.2% $/.%0 1.%%0
(oor %./2 )$..%0 )+.2%0
$.%% =.%%0 # >xpected return
11,. (8-2) Coefficient of variation C N Answer: a EASY
>xpected return /2.%0
Standard deviation 7%.%0
&oefficient of variation # std dev6expected return # $./
11.. (8-2) Coefficient of variation C N Answer: a EASY
>xpected return $2.%0
Standard deviation $%.%0
&oefficient of variation # std dev6expected return # %.1?
11/. (8-") #ortfo$io beta C N Answer: e EASY
*eight
&ompany 8nvestment *eight Beta ; beta
@ A72,%%% %.72 $.2% %.27
B A12,%%% %.12 %.?% %.+1
A$%%,%%% $.%% %.=. # (ortfolio beta
122. (8-") #ortfo$io beta C N Answer: a EASY
(ort. *eight
&ompany 8nvestment weight Beta ; beta
Stock ' A7?,2%% %.7?2 %.?2 %./.
Stock B A1/,2%% % .1/2 $.+/ %..=
A$%%,%%% $ .%% $.$? # (ortfolio beta
121. (8-") #ortfo$io beta C N Answer: b EASY
Cld portfolio return $$.%0
Cld portfolio beta $./%
Dew stock return $7.%0
Dew stock beta $.2%
0 of portfolio in new stock # A in Dew64A in old 3 A in new5 # A$%,%%%6A$%%,%%% # $%0
Dew expected portfolio return # rp # %.$ ; $70 3 %.= ; $$0 # $$./%0
Dew expected portfolio beta # bp # %.$ ; $.2% 3 %.= ; $./% # $./7
122. (8-)) CA#&: re2. rate of ret%rn C N Answer: d EASY
:eal rate 4rE5F 7.%%0
8(F +.%%0
:(MF 2.%%0
BetaF $.%%
:e"uired return # r:, 3 b4:(M5 # rE 3 8( 3 b4:(M5 # $/.%%0
123. (8-)) CA#&: re2. rate of ret%rn C N Answer: c EASY
Beta $.+%
:isk)free rate +./20
Market risk premium 2.2%0
:e"uired return $$.=20
12. (8-)) &ar!et ris! (re0i%0 C N Answer: a EASY
Gse the SML to determine the market risk premium with the given data.
rs # r:, 3 bStock ; :(M
$/./20 # 2.%%0 3 $./2 ; :(M
?./20 # :(M ; $./2
2..%0 # :(M
12%. (8-2) Coefficient of variation C N Answer: b &ED./&
This is a relatively technical problem. 8t should be used only if calculations are emphasi-ed in class, or on a
take)home exam where students have time to look up formulas.
(robability of :eturn Heviation S"uared State (rob.
This state This state from Mean Heviation ; S". Hev.
%.+2 /2.%%0 1.%%0 %.710 %.$1/%0
%.2% $2.%%0 )+.%%0 %.$10 %.%.%%0
%.%2 2 .%%0 )$+.%%0 $ .=10 % .%=.%0
>xpected return # $= .%%0 % .7+0 % .7+%%0 # >xpected variance
I # 2..70
&oefficient of variation # I6>xpected return # %.7%1=
12*. (8-") #ortfo$io beta C N Answer: b &ED./&
Stock 8nvestment (ercentage Beta (roduct
' A2%,%%% /2.%%0 %.=2 %./7.
B A2%,%%% /2.%%0 %..% %./%%
& A2%,%%% /2.%%0 $.%% %./2%
H A2%,%%% /2 .%%0 $./% %.7%%
Total A/%%,%%% $%% .%%0 %.=.. # (ortfolio Beta
12,. (8-") #ortfo$io beta C N Answer: b &ED./&
Criginal (ortfolio Dew (ortfolio
Stock 8nvestment
(ercentage
Beta (roduct(ercentage Beta (roduct
' A2%,%%% /2.%%0 %.2% %.$/2
B A2%,%%% /2.%%0 %..% %./%% /2.%%0 %..% %./%%
& A2%,%%% /2.%%0 $.%% %./2% /2.%%0 $.%% %./2%
H A2%,%%% /2.%%0 $./% %.7%% /2.%%0 $./% %.7%%
> /2.%%0 $.2% % .7?2
Total A/%%,%%% $%% .%%0 % ..?2 Dew (ortfolio Beta # $ .$/2
'lternative solutionF 4b> J b'540'5 3 bCld # $.$/2
12.. (8-") #ortfo$io beta C N Answer: b &ED./&
Stock 8nvestment (ercentage Beta (roduct
' A$2%,%%% +%.%%0 $.+% %.21
B A2%,%%% $7.770 %..% %.$$
& A$%%,%%% /1.1?0 $.%% %./?
H A?2,%%% /% .%%0 $./% %./+
Total A7?2,%%% $%% .%%0 $.$? # (ortfolio Beta
12/. (8-") #ortfo$io beta C N Answer: d &ED./&
Criginal Dew
Stock 8nvestment
(ercentage
Beta (roductBeta (roduct
' A$2%,%%% +%.%%0 $.+%% %.21% %.?2% %.7%%
B A2%,%%% $7.770 %..%% %.$%? %..%% %.$%?
& A$%%,%%% /1.1?0 $.%%% %./1? $.%%% %./1?
H A?2,%%% /% .%%0 $./%% % ./+% $./%% % ./+%
Total A7?2,%%% $%% .%%0 Cld b # $ .$?7 Dew b # % .=$7
&hange in beta # Dew J Cld # )%./1%
'lternative solutionF 4b> K b'5 ; 0' # )%./1%
132. (8-") #ortfo$io beta C N Answer: e &ED./&
0 in each stockF 20
Cld stock!s betaF %.=%
Dew stock!s betaF $..%
Cld port. betaF $.$/
Dew beta # 4bnew K bold5 ; 0' 3 bCld # $.$12
131. (8-)) CA#&: re2. rate of ret%rn C N Answer: a &ED./&
:isk)free rate 2.2%0
Cld market risk premium +.?20
Cld re"uired return $$.?20
b # 4old return J r:,56old :(M $.7/
Dew market risk premium 1.?20
Dew re"uired return # r:, 3 b4:(M5 # $+.7.0
132. (8-)) CA#&: re2. rate of ret%rn C N Answer: e &ED./&
BetaF ' %.?%
BetaF B $./%
Market return $$.%%0
Market risk premium 1.?20
:e"uired return ' # r:, 3 b'4:(M5 # ..=.0
:e"uired return B # r:, 3 bB4:(M5 # $/.720
Hifference 7.7.0
133. (8-)) CA#&: re2. rate of ret%rn C N Answer: c &ED./&
BetaF ' $.7%
BetaF B %..%
'!s re"uired return $/.%%0
:isk)free rate +.?20
:(M # 4'!s return J r:,56beta' # 2.2.0
B!s re"uired return # r:, 3 b4:(M5 # =./$0
13. (8-)) CA#&: re2. rate of ret%rn C N Answer: d &ED./&
:eal risk)free rate, rE /.%%0
>xpected inflation, 8( 7.%%0
Market risk premium, :(M +.?%0
Beta, b $.$%
:isk)free rate # rE 3 8( # 2.%%0
Lollo!s re"uired return # r:, 3 b4:(M5 # $%.$?0
13%. (8-)) CA#&: re2. rate of ret%rn C N Answer: e &ED./&
Gse SML to determine the market risk premium. Dote that r:, is based on T)bonds, not short)term T)bills.
rs # r:, 3 :(M
$7.%%0 # 1.2%0 3 :(M
1.2%0 # :(M
Gse the SML to determine Linke!s re"uired return using the :(M calculated aboveF
rs # r:, 3 :(M ; b
# 1.2%0 3 1.2%0 ; $.7%
# $+.=20
13*. (8-)) CA#&: re2. rate of ret%rn C N Answer: b &ED./&
Gse SML to determine the market risk premium. Dote that r:, is based on T)bonds, not short)term T)bills.
'lso, note that the dividend growth rate is not needed.
rs # r:, 3 :(M
$/.2%0 # 2./20 3 :(M
:(M # ?./20
Gse SML to determine Dagel!s re"uired return using :(M calculated above.
rs # r:, 3 :(M ; b
# 2./20 3 ?./20 ; %...
# $$.170
13,. (8-)) CA#&: re2. rate of ret%rn C N Answer: e &ED./&
rM $7./20
r:, ?.%%0
,ind portfolio betaF
*eight Beta (roduct
A/%%,%%% %.$%% $.2% %.$2%%
A7%%,%%% %.$2% )%.2% )%.%?2%
A2%%,%%% %./2% $./2 %.7$/2
A$,%%%,%%% %.2%% %.?2 %.7?2%
A/,%%%,%%% $.%%% %.?1/2 # portfolio beta
,ind :(M # rM J r:, # 1./20
rs # r:, 3 b4:(M5 # $$.??0
13.. (8-)) CA#&: re2. rate of ret%rn C N Answer: a &ED./&
Cld betaF $.%%
Cld rs # r:, 3 b4:(M5 $%./%0
:(M 1.%%0
(ercentage increase in betaF 7%.%%0
8ncrease in 8(F /.%%0
,ind new beta after increase # $.7%
,ind old r:,F Cld rs # r:,3 b4:(M5F $%./0 # r:, 3 $.%41.%05F r:, # $%./0 J 1.%0 # +./%0
,ind new r:,F Cld r:, 3 increase in 8( # 1./%0
,ind new rs # new r:, 3 new beta4:(M5 $+.%%0
13/. (8-)) et%rn on t,e 0ar!et C N Answer: a &ED./&
Beta $./7
:isk)free rate +.7%0
:e"uired return on stock $$.?20
:(M # 4rstock J r:,56beta 1.%10
:e"uired return on market # r:, 3 :(M # $%.710
12. (8-") #ortfo$io beta C N Answer: c &ED./&84AD
Dumber of stocks .
(ercent in each stock # $6number of stocks # $/.2%%0
(ortfolio beta $./2
Stock that!s sold $.%%
Stock that!s bought $.72
&hange in portfolio!s beta # %.$/2 ; 4b/ K b$5 # %.%+7.
Dew portfolio beta $./=
11. (8-2) Std. dev.6 ,istorica$ ret%rns C N Answer: b 4AD
This is a relatively technical problem. 8t should be used only if calculations are emphasi-ed in class or on a
take)home exam where students have time to look up formulas or to use >xcel or their calculator functions.
Heviation S"uared
Bear :eturn from Mean Heviation
/%$/ /$.%%0 =..70 %.=?0
/%$$ )$/.2%0 )/7.1?0 2.1%0
/%$% /2.%%0 $7..70 $.=$0
>xpected return $$.$?0 ..+.0 Sum s"d deviations
+./+0 Sum64D J $5
SM:T # I # /%.2=0 /%.2=0 with >xcel
12. (8-2) Std. dev.6 (rob. data C N Answer: b 4AD
This is a relatively technical problem. 8t should be used only if calculations are emphasi-ed in class, or on
a take)home exam where students have time to look up formulas or to use >xcel or their calculator
functions.
>conomic :eturn Hev. from S"uared S"d. dev.
&onditions (rob. This state Mean Hev. ; (rob
Strong 7%0 7/.%0 /7./%0 2.7.0 $.1$0
Dormal +%0 $%.%0 $./%0 %.%$0 %.%$0
*eak 7%0 )$1.%0 )/+..%0 1.$20 $..20
$%%0 ...0 Nariance 7.+?0
I # S"rt of variance $..1/0 $..1/0 by >xcel
13. (8-") #ortfo$io ris! red%ction C N Answer: d 4AD
This is a relatively technical problem. 8t should be used only if calculations are emphasi-ed in class or on
a take)home exam where students have time to look up formulas or to use >xcel or their calculator
functions.
0 >&BF Bear >&B *&B (ortfolio >&B6*&B
1%0 /%%. +%.%%0 +%.%%0 +%.%%0
/%%= )$%.%%0 $2.%%0 %.%%0
/%$% 72.%%0 )2.%%0 $=.%%0
/%$$ )2.%%0 )$%.%%0 )?.%%0
/%$/ $2.%%0 72.%%0 /7.%%0
'verage return # $2.%%0 $2.%%0 $2.%%0
Standard deviation # //.1+0 //.1+0 $...%0
:eduction in the SH vs. >&B!s SHF 7..+0
1.(8-") #ortfo$io beta C N Answer: a 4AD
0 of Dew (ort.
Cld funds 4millions5 A$%.%% 11.1?0
Dew funds 4millions5 A2.%% 77.770
Total portfolio A$2.%% $%%.%%0
:e"!d return, old stocks =.2%0
:isk)free rate +./%0
Market risk premiumF r( # r:, 3 b4:(M5
=.20# +./0 3 $.%24:(M5 2.7%0
:(M # 4=.20 J +./056$.%2 # 2.%20
New portfolio
Cld portfolio!s beta $.%2
Dew stocks! beta %.12
Dew portfolio beta %.=$1?
Dew portfolio re"uired return # r:, 3 new beta4:(M5 # .../?%0
1%. (8-") #ortfo$io beta C N Answer: b 4AD
Cld funds 4millions5 A+%.%% +%.%%0
Dew funds 4millions5 A1%.%% 1%.%%0
Total new funds A$%%.%% $%%.%%0
Beta on existing portfolio $.%%
Market risk premium 1.%%0
Hesired re"uired return $7.%%0 $70 # r:, 3 b4:(M5O b # 4$70 J r:,56:(M
:e"uired new portfolio beta $.+2.7 beta # 4return J risk)free56:(M
:e"uired beta on new stocks $.?1 :e" b # 4oldA6totalA5 ; old b 3 4newA6totalA5 ; new b
Beta on new stocks # 4:e" b J 4oldA6totalA5 ; old b564newA6totalA5
1*. (8-)) #ort. beta and re2. ret. C N Answer: c 4AD
&ompany 'mount *eight Beta *t ; beta
Stock ' A$,%?2,%%% %.72. $./% %.+7
Stock B 1?2,%%% %.//2 %.2% %.$$
Stock & ?2%,%%% %./2% $.+% %.72
Stock H 2%%,%%% %.$1? %.?2 %.$7
A7,%%%,%%% $.%%% b(ortfolio # $.%/ 8ntermediate step
:e"uired market return $$.%%0
:isk free rate 2.%%0
Market risk premium # rMarket K r:, # 1.%%0
(ortfolio!s re"uired return # r:, 3 b4:(M5 # $$.$$0
1,. (8-)) CA#&: re2. rate of ret%rn C N Answer: c 4AD
This problem re"uires some algebraF
&&&!s beta $.2%
&&&!s initial re"uired return $/.%%0
(ercentage 8ncrease in re"uired market returnF 7%.%0
8nitial re"uired return on the market $%.%%0
Dew re"uired return on the market $7.%%0
Dow for the algebraF
rStock # r:, 3 b4:(M5 # r:, 3 $.24:(M5
rMarket # r:, 3 b4:(M5 # r:, 3 $.%4:(M5
Dow insert known data and transposeF
$/0 # r:, 3 $.24:(M5
$/0 K r:, #$.24:(M5
$%0 # r:, 3 4:(M5
$%0 K r:, # $.%4:(M5
Dow subtract the second e"uation from the first. r:, and one of the :(Ms cancel, leavingF /0 # %.24:(M5
Dow solve for :(MF :(M # /06%.2 +.%%0
Dow find the risk)free rateF r:, # 8nitial rMarket K :(M # $%0 K +0 # 1.%%0
Dew :(M # Dew re"uired return on the market K r:, ?.%%0
Dow find the new return on &&& # r:, 3 b4new :(M5 # $1.2%0

Risk and Rates of Return Exercise

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. !isk"averse investors re#uire higher rates of return on investments

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