Question 1

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk.

Accepted Answer

The statement accurately describes the use of the coefficient of variation to adjust for differences in expected returns and better compare investments' stand-alone risk.

Question 2

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

Accepted Answer

The slope of the Security Market Line (SML) is determined by the market risk premium. If investors become less averse to risk, the market risk premium decreases, leading to a decrease in the slope of the SML.

Question 3

portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data.

Accepted Answer

Portfolio analysis is done based on historical data, but the ultimate goal is to make decisions for future investments. Despite this, ex post returns and standard deviations are commonly used as proxies for ex ante data in portfolio analysis.

Question 4

standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Accepted Answer

The coefficient of variation is a better measure of risk when comparing securities with significantly different expected returns, as it accounts for both the standard deviation and the mean, providing a relative measure of risk.

Question 5

adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

Accepted Answer

This statement is true. The higher the degree of correlation between the new stock and the existing stocks in the portfolio, the more likely it is that the new stock will move in the same direction as the existing stocks. This means that the portfolio's risk will be less affected by the addition of the new stock. On the other hand, if the new stock has a low correlation with the existing stocks, it may move in a different direction, increasing the portfolio's overall risk.

Question 6

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

Accepted Answer

This is because risk-averse investors are more concerned with the potential loss of their investment and require higher compensation for taking on that risk. If the returns of an investment are uncertain, there is a higher likelihood of losing money, and therefore risk-averse investors require a higher rate of return to take on that risk.

Question 7

Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation.

Accepted Answer

Variance involves squaring the deviation of each actual return from the expected return, which results in larger values than its square root, the standard deviation. Therefore, the statement is true.

Question 8

key conclusion of the Capital Asset Pricing Model 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 well-diversified portfolio The risk of the asset held in isolation is not relevant under the CAPM.

Accepted Answer

The CAPM considers the risk and expected return of an asset within a well-diversified portfolio, not in isolation. Therefore, the risk of the asset held in isolation is not relevant.

Question 9

According to the Capital Asset Pricing Model, investors are primarily concerned with 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 well-diversified portfolio.

Accepted Answer

This statement accurately reflects the Capital Asset Pricing Model (CAPM), which assumes that investors are primarily concerned with the riskiness of their overall portfolios rather than the risks of individual stocks. According to CAPM, a stock's contribution to the risk of a well-diversified portfolio (measured by its beta) is the relevant risk to consider when evaluating the stock's potential return.

Question 10

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

Accepted Answer

Stock's beta measures its systematic risk relative to the systematic risks of other firms, not its diversifiable risk. Diversifiable risk can be reduced through diversification of investments.

Question 11

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

Accepted Answer

Risk aversion means that investors are willing to take on less risk only if they are compensated with higher expected returns. Therefore, they require higher expected returns on riskier securities than on less risky securities.

Question 12

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

Accepted Answer

This statement is actually the opposite of the truth. The tighter the probability distribution of expected future returns, the lower the risk (as measured by standard deviation). This is because a tight distribution means that the range of potential returns is smaller, which means there is less uncertainty and therefore less risk.

Question 13

realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

Accepted Answer

The realized return is the actual return earned on a portfolio, which can differ from the expected return due to market fluctuations and other factors.

Question 14

Market risk refers to the tendency of a stock to move with the general stock market A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

Accepted Answer

This statement is true. Market risk is often measured by beta, which compares the stock's movement to the movement of a reference index (such as the S&P 500). A stock with a beta greater than 1.0 is considered to have above-average market risk and will tend to move more (either up or down) than the market as a whole.

Question 15

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

Accepted Answer

Diversification allows investors to spread their risk by investing in a variety of stocks across different sectors and industries, therefore reducing the impact of any single stock or sector on the overall portfolio. This can lead to a more stable and less risky investment portfolio.

Question 16

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

Accepted Answer

The statement correctly defines the concept of risk aversion and how it affects investment behavior. It also notes that different investors have varying degrees of risk aversion, leading to differing portfolio compositions.

Question 17

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

Accepted Answer

When stocks are held in portfolios, the required return could be higher on the stock with the low standard deviation because it may provide diversification benefits, reducing the overall risk of the portfolio. Therefore, investors may accept a lower required rate of return on a stock with lower volatility in order to achieve a diversified portfolio with lower overall risk.

Question 18

individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

Accepted Answer

Beta measures systematic risk, not diversifiable risk. Diversifiable risk can be reduced by adding more stocks to a portfolio, but beta remains a measure of market-related risk.

Question 19

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

Accepted Answer

This statement is too broad and one-sided. Increasing risk in some cases can lead to higher returns for the firm, so it is not always true that managers should never increase risk. However, managers should carefully weigh the potential benefits and risks of any action before making a decision.

Question 20

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.

Accepted Answer

This is the correct definition of the coefficient of variation.

Quiz 2: Risk and Return: Part I