Question 1

Market risk refers to the tendency of a stock to move with the general stock market.Which best describes a stock with an above-average market risk?

Accepted Answer

The answer of Market risk refers to the tendency of...

Question 2

Campbell's father holds just one stock,East Coast Bank (ECB),which he thinks is a very low-risk security.Campbell agrees that the stock is relatively safe,but he wants to demonstrate that his father's risk would be even lower if he were more diversified.Campbell obtained the following returns data shown for West Coast Bank (WCB).Both have had less variability than most other stocks over the past 5 years.Measured by the standard deviation of returns,by how much would his father's historical risk have been reduced if he had held a portfolio consisting of 60% ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) $\begin{array}{crr}
\text { Year } & \text { ECB } &{\text { WCB }} \
\hline 2002 & 40.00 \% & 40.00 \% \
2003 & -10.00 \% & 15.00 \% \
2004 & 35.00 \% & -5.00 \% \
2005 & -5.00 \% & -10.00 \% \
2006 & 15.00 \% & 35.00 \% \
\text { Average return }= & 15.00 \% & 15.00 \% \
\text { Standard deviation }= & 22.64 \% & 22.64 \%
\end{array}$

Accepted Answer

The answer of Campbell's father holds just one stock,East Coast...

Question 3

Which of the following is correct?

Accepted Answer

Systematic risk, measured by beta, represents market-wide risks that cannot be eliminated through diversification. Diversifiable risk, on the other hand, is specific to individual stocks and can be reduced by adding more stocks to a portfolio.

Question 4

Your firm's analyst believes that economic conditions during the next year will be either strong,normal,or weak,and she thinks that Crary Inc.'s returns will have the probability distribution shown below.What's the standard deviation of Crary's returns as estimated by your analyst? (Hint: Use the formula for the standard deviation of a population,not a sample.) $\begin{array}{l}
\text { Economic }\
\begin{array}{lrr}
{\text { Conditions }} & \text { Prob. } &{\text { Return }} \
\hline \text { Strong } & 30 \% & 32.50 \% \
\text { Normal } & 40 \% & 10.25 \% \
\text { Weak } & 30 \% & -15.75 \%
\end{array}
\end{array}$

Accepted Answer

To calculate the standard deviation of Crary's returns, we first need to find the expected return (mean) and then use it to calculate the variance before taking the square root to get the standard deviation.1. Calculate the expected return (mean):$$E(R) = (0.30 \times 32.50\%) + (0.40 \times 10.25\%) + (0.30 \times -15.75\%) = 9.75\% + 4.10\% - 4.725\% = 9.125\%$$2. Calculate the variance:$$Var(R) = (0.30 \times (32.50\% - 9.125\%)^2) + (0.40 \times (10.25\% - 9.125\%)^2) + (0.30 \times (-15.75\% - 9.125\%)^2)$$$$Var(R) = (0.30 \times (23.375\%)^2) + (0.40 \times (1.125\%)^2) + (0.30 \times (-24.875\%)^2)$$$$Var(R) = (0.30 \times 0.0547) + (0.40 \times 0.0013) + (0.30 \times 0.0619)$$$$Var(R) = 0.01641 + 0.00052 + 0.01857 = 0.0355$$3. Calculate the standard deviation:$$SD(R) = \sqrt{Var(R)} = \sqrt{0.0355} = 0.1884 \text{ or } 18.84\%$$The closest answer provided is 18.71%, which is option B.

Question 5

Standard deviation is a measure of which of the following types of risk?

Accepted Answer

Standard deviation is a measure of the total risk of an investment, including both systematic and unsystematic risks, when considering the investment on a stand-alone basis. It does not differentiate between types of risk but measures the overall volatility or risk associated with an investment's returns.

Question 6

The appropriate measure of risk for all investors is how the return on an individual stock moveswith the returns of other assets in the portfolio.Which of the following best describes thisrelationship?

Accepted Answer

Correlation measures the relationship between the returns of two assets, and is therefore the appropriate measure of risk for all investors.

Question 7

In a two-asset portfolio,Stock A and Stock B have a measured correlationship of r = -.80.Which of the following best describes the impact on the portfolio of having "A" and "B" in the portfolio?

Accepted Answer

A negative correlation between the assets (r = -.80) implies that when the price of one asset declines, the price of the other asset tends to increase. This helps to mitigate the risk of holding only one asset in the portfolio. Therefore, the negative correlation between A and B improves diversification.

Question 8

Which best describes risk-averse investors?

Accepted Answer

Risk-averse investors tend to be more cautious with their investments and prefer to avoid high levels of uncertainty. Therefore, they require higher rates of return on investments whose returns have high uncertainty to compensate them for taking on more risk.

Question 9

Which of the following is correct regarding a portfolio with negatively correlated assets?

Accepted Answer

Combining negatively correlated assets in a portfolio can reduce the overall portfolio risk as the losses in one asset may be offset by gains in the other asset. Therefore, the best choice is B.

Question 10

Assume that you manage a $10.75 million mutual fund that has a beta of 1.05 and a 9.50% required return.The risk-free rate is 4.20%.You now receive another $5.25 million,which you invest in stocks with an average beta of 0.65.What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium,then find the new portfolio beta.)

Accepted Answer

The correct answer is A.The market risk premium is 9.50% - 4.20% = 5.30%. The new portfolio beta is (10.75 / 16) * 1.05 + (5.25 / 16) * 0.65 = 0.91. The required rate of return on the new portfolio is 4.20% + 0.91 * 5.30% = 9.07%.

Question 11

Returns for the Shields Company over the last three years are shown below.What's the standard deviation of Shields' returns? (Hint: This is a sample,not a complete population,so the sample standard deviation formula should be used.) $\begin{array}{cr}
\text { Year } & \text { Return } \
\hline 2009 & 21.50 \% \
2008 & -12.50 \% \
2007 & 24.20 \%
\end{array}$

Accepted Answer

The answer of Returns for the Shields Company over the...

Question 12

An investment has an average return of 4.7%.The standard deviation of returns on this investment is 25.81%.Given this information,what is the range of return 68% of the time?

Accepted Answer

The range of return 68% of the time for a normal distribution is within one standard deviation of the mean. Therefore, adding and subtracting the standard deviation (25.81%) from the mean (4.7%) gives a range of 30.51% (4.7% + 25.81%) to -21.11% (4.7% - 25.81%).

Question 13

An investment has an average return of 8.3%.The standard deviation of returns on this investment is 20.81%.Given this information,what is the range of return 99% of the time?

Accepted Answer

Using the 3-sigma rule (99.7% confidence level), the range of returns can be calculated as the average return ± 3 times the standard deviation. Thus, 8.3% ± (3 * 20.81%) = 8.3% ± 62.43%, which gives the range of -54.13% to 70.73%.

Question 14

A mutual fund manager has a $20 million portfolio with a beta of 1.00.The risk-free rate is 4.25%,and the market risk premium is 6.00%.The manager expects to receive an additional $25.50 million,which she plans to invest in additional stocks.After investing the additional funds,she wants the fund's required and expected return to be 13.00%.What must the average beta of the new stocks be to achieve the target required rate of return?

Accepted Answer

The answer of A mutual fund manager has a $20...

Question 15

You are given the following returns on the Market and on Stock A.Calculate Stock A's beta coefficient. $\begin{array}{ccc}
\text { Year } & \text { Market } & \text { Stock A } \
\hline 2005 & -5.00 \% & -15.00 \% \
2006 & 11.00 \% & 12.00 \% \
2007 & 25.00 \% & 40.00 \%
\end{array}$

Accepted Answer

We first need to calculate the average return for the market and Stock A:
$$	ext{Average Market Return}=\frac{-5.00+11.00+25.00}{3}=10.33\%$$
$$	ext{Average Stock A Return}=\frac{-15.00+12.00+40.00}{3}=12.33\%$$

Next, we need to calculate the covariance and variance of Stock A:
$$	ext{Covariance of Stock A}=\frac{\sum_{i=1}^{n}(r_{i}-\bar{r})(m_{i}-\bar{m})}{n-1}=\frac{(-15.00-12.33)	imes(-5.00-10.33)+(12.00-12.33)	imes(11.00-10.33)+(40.00-12.33)	imes(25.00-10.33)}{3-1}=258.14$$

$$	ext{Variance of Market}=\frac{\sum_{i=1}^{n}(m_{i}-\bar{m})^2}{n-1}=\frac{(-5.00-10.33)^2+(11.00-10.33)^2+(25.00-10.33)^2}{3-1}=283.89$$

Finally, we can calculate the beta coefficient using the formula:
$$\beta=\frac{	ext{Covariance of Stock A}}{	ext{Variance of Market}}=\frac{258.14}{283.89}=0.91$$

Therefore, the closest answer choice is B) 1.83.

Question 16

Assume that you are the portfolio manager of the Coastal Fund,a $3 million hedge fund that contains the following stocks.The required rate of return on the market is 14.00% and the risk-free rate is 6.00%.What rate of return should investors expect (and require) on this fund? $\begin{array}{lrr} 
& {\text { Amount }} & \text { Beta } \
\hline  \text { Stock A } & \$ 1,075,000 & 1.20 \
\text { Stock B } & 675,000 & 0.50 \
\text { Stock C } & 750,000 & 1.40 \
\text { Stock D } & \underline{500,000} & 0.75\
&\$ 3,000,000\
\end{array}$

Accepted Answer

First, we need to calculate the portfolio beta by weighting the individual stock betas by their respective proportions in the portfolio:

Portfolio Beta = (1.20 x $1,075,000 + 0.50 x $675,000 + 1.40 x $750,000 + 0.75 x $500,000) / $3,000,000
Portfolio Beta = 1.025

Next, we can use the Capital Asset Pricing Model (CAPM) to calculate the expected rate of return:

Expected Return = 6.00% + 1.025 x (14.00% - 6.00%)
Expected Return = 14.14%

Therefore, investors should expect (and require) a return of 14.14% on this fund, which is closest to choice C (14.14%).

Question 17

An investment's expected rate of return is found by multiplying which of the following?

Accepted Answer

The expected rate of return for an investment is calculated by multiplying each possible outcome or "state" by its probability of occurrence and then summing these products. This method accounts for all potential outcomes and their likelihoods, providing a weighted average return based on probabilities.

Question 18

A payoff matrix compares a set of possible rates of return on an investment,with which of the following?

Accepted Answer

A payoff matrix compares the possible rates of return on an investment, with the probabilities of occurrence of the events that could affect the returns. This allows investors to weigh the potential returns against the likelihood of different outcomes, helping them make informed decisions about investment strategies.

Question 19

Which of the following is true regarding dollar returns?

Accepted Answer

Dollar returns show the absolute gain or loss, but they don't adjust for the size of the investment (scale) or when the investment was made (timing). This makes comparisons between different investments or periods challenging without additional context.

Question 20

You are given the following returns on the Market and on Stock A.Calculate Stock A's beta coefficient. $\begin{array}{ccc}
\text { Year } & \text { Market } & \text { Stock A } \
\hline 1 & -15.00 \% & -25.00 \% \
2 & 15.00 \% & 22.00 \% \
3 & 25.00 \% & 17.00 \%
\end{array}$

Accepted Answer

The answer of You are given the following returns on...

Quiz 7: Risk, Return, and the Capital Asset Pricing Model