Question 1

The relevant risk, which is the risk for which investors should be compensated, is the portion of the total risk that cannot be diversified away.

Accepted Answer

This statement is true. The relevant risk is also known as systematic or non-diversifiable risk, which refers to the part of the total risk that is associated with the entire market or a specific industry and cannot be eliminated through diversification. Investors should be compensated for taking on this type of risk as it is inherent in investing and cannot be avoided.

Question 2

Which of the following statements about the various kinds of risks is correct?

Accepted Answer

Interest rate risk is considered a systematic risk because it affects all investments across the board. Systematic risks are inherent to the entire market or market segment, meaning they cannot be eliminated through diversification. Therefore, investors expect to be compensated for taking on such risks, which is why the market rewards them.

Question 3

A stock's beta coefficient measures the tendency of its returns to move with the returns on the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and it will have a beta greater than 1.0.

Accepted Answer

This is an accurate description of a stock's beta coefficient.

Question 4

A stock might be quite risky if held by itself, but if much of this total (stand-alone) risk can be eliminated through diversification, then its relevant risk-that is, its contribution to the portfolio's risk-is much smaller than its total risk.

Accepted Answer

Diversification helps to reduce the total risk of a portfolio by spreading it across different assets. This means that even if one asset (such as a stock) is quite risky, its contribution to the overall risk of the portfolio can be smaller if it is combined with other assets that have different risk characteristics. Therefore, the statement is true.

Question 5

Short-term investments have higher maturity risks than long-term investments.

Accepted Answer

Short-term investments typically have lower maturity risks because they have shorter maturities, while long-term investments expose investors to more risks over an extended period of time.

Question 6

Other things held constant, a risk-averse investor requires a higher return to invest in securities with higher risks, which means they will pay lower prices for such investments.

Accepted Answer

This statement is true. Risk-averse investors require a higher return to compensate for the additional risk they are taking on, and as a result, they are willing to pay lower prices for investments with higher risks.

Question 7

Economic risk is an unsystematic risk that can be diversified by the investors.

Accepted Answer

Economic risk is a type of systematic risk that affects all businesses and investments broadly and cannot be eliminated through diversification.

Question 8

The market portfolio contains only unsystematic risk, therefore the market risk premium represents the return that investors require to be compensated for taking an average amount of relevant, or unsystematic, risk.

Accepted Answer

The market portfolio contains both systematic and unsystematic risk, therefore the market risk premium represents the return that investors require to be compensated for taking an average amount of relevant, or systematic, risk.

Question 9

Systematic risk is diversifiable, so it is an investment's relevant risk. Unsystematic risk is nondiversifiable risk and therefore not relevant.

Accepted Answer

The statement is incorrect. Systematic risk is nondiversifiable and not under the control of the investor, while unsystematic risk is diversifiable and can be reduced through portfolio diversification. Both are relevant risks in investment analysis as they affect the total portfolio risk.

Question 10

A stock's standard deviation indicates how the stock affects the riskiness of a diversified portfolio. Therefore, the standard deviation is a better measure of a stock's relevant risk than its beta coefficient, which measures total, or stand-alone, risk.

Accepted Answer

The beta coefficient is actually a better measure of a stock's relevant risk in a diversified portfolio because it measures the stock's volatility relative to the market, not its total or stand-alone risk. The standard deviation measures total risk, including both systematic and unsystematic risk, making it less relevant for diversified portfolios where unsystematic risk is minimized.

Question 11

A firm can affect its beta risk by changing the composition of its assets and by modifying its use of debt financing, but external factors do not have any bearing on a firm's beta.

Accepted Answer

External factors, such as changes in the market or industry conditions, can impact a firm's beta by affecting its expected returns and market risk. Therefore, a firm's beta is not entirely within its control and can be influenced by external factors.

Question 12

Two stocks can be combined to form a portfolio that is risk free (i.e., has no risk) if the stocks are perfectly negatively correlated (r = −1.0) with each other.

Accepted Answer

When two stocks have a perfect negative correlation of -1, it means that the returns of one stock move in the opposite direction of the other stock. As a result, combining the two stocks will cancel out the risk and create a risk-free portfolio.

Question 13

The standard deviation is calculated as the weighted average of all the deviations of possible returns from the expected value, and it indicates how far above or below the expected value the actual value is expected to be.

Accepted Answer

The standard deviation is a measure of the dispersion of a set of data from its mean. It is calculated as the square root of the variance, which is the average of the squared deviations from the mean. The standard deviation indicates how far above or below the mean the actual value is expected to be.

Question 14

Which of the following statements about the various kinds of risk is true?

Accepted Answer

Economic risk and political risk are systematic risks because they affect the entire market or economy, rather than just a specific company or industry.

Question 15

A probability distribution consists of a listing of all possible outcomes, or events, with the chance of occurrence assigned to each.

Accepted Answer

This statement accurately describes a probability distribution.

Question 16

Risk refers to the chance that no unfavorable event will occur.

Accepted Answer

Risk refers to the chance that an unfavorable event will occur, not the chance that it won't.

Question 17

Risk is indicated by variability of returns, whether the variability is considered positive or negative. Both the positive and negative outcomes must be evaluated when considering risk.

Accepted Answer

This statement is true, as risk refers to the possibility of experiencing unexpected or undesirable outcomes, which can be either negative or positive. Therefore, both types of variability in returns should be taken into account when assessing risk.

Quiz 8: Risk and Rates of Return