Question 1

Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value.Because of its diversification, Portfolio B will by definition be riskless.

Accepted Answer

While Portfolio B may have reduced some specific risks associated with individual stocks, it is not completely riskless as it is still exposed to overall market risk and other systematic risks that affect the entire market.

Question 2

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Accepted Answer

If the returns of two firms are negatively correlated, it means that when the return of one firm increases, the return of the other firm tends to decrease. This suggests that the two firms are in different industries or have different business models, and their returns are not influenced by the same factors. In such a scenario, it is possible for one of the firms to have a negative beta, which means that its returns tend to move in the opposite direction of the market.

Question 3

We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

Accepted Answer

The beta of a single security is affected by company-specific factors and can be subject to significant fluctuations over time. On the other hand, the beta of a diversified portfolio is influenced by macroeconomic trends and industry-wide factors, which tend to be more stable over time. Thus, the beta of a diversified portfolio is generally more stable than the beta of a single security.

Question 4

Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk.If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

Accepted Answer

The answer of Under the CAPM, the required rate of...

Question 5

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio.It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

Accepted Answer

A portfolio's risk is measured by its variance or standard deviation, but not simply by the weighted average of the standard deviations of the securities in the portfolio. Risk reduction in a portfolio is achieved through diversification, which depends on the correlation between the returns of the securities, not just their individual risks.

Question 6

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

Accepted Answer

Beta measures the volatility of a stock in relation to the overall market. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative because beta measures the relationship between the stock and the overall market, not the relationship between two specific stocks.

Question 7

A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

Accepted Answer

Beta measures a stock's volatility relative to the market and is more relevant to investors with diversified portfolios, as it helps assess systematic risk, which cannot be eliminated through diversification.

Question 8

The CAPM is built on historic conditions, although in most cases we use expected future data in applying it.Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility.This is one of the strengths of the CAPM.

Accepted Answer

Betas in the CAPM are typically calculated using historical data, not expected future data, and they are subject to changes in future volatility, which can affect the accuracy of the CAPM predictions.

Question 9

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

Accepted Answer

A firm's beta is a measure of its systematic risk, which is influenced by external factors such as market volatility and industry trends. However, managerial decisions such as investing in riskier projects or leveraging the firm's capital structure can also affect the firm's beta. For example, taking on more debt can increase a firm's beta, as it increases the financial risk associated with the firm. Similarly, investing in projects that are more volatile or correlated with the market can also increase a firm's beta. Therefore, a firm can change its beta through managerial decisions.

Question 10

A stock with a beta equal to -1.0 has zero systematic (or market)risk.

Accepted Answer

A stock with a beta of -1.0 is perfectly negatively correlated with the market, meaning it moves in the opposite direction of the market but still has systematic risk, as its performance is related to market movements.

Question 11

The slope of the SML is determined by the value of beta.

Accepted Answer

The slope of the Security Market Line (SML) is determined by the market risk premium, not by the value of beta. Beta measures the sensitivity of a security's returns to the returns of the market, but the slope of the SML is the difference between the expected return on the market portfolio and the risk-free rate.

Question 12

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.

Accepted Answer

Diversification can help reduce unsystematic (diversifiable) risk, which is specific to individual stocks or sectors, but it cannot eliminate systematic (market) risk, which affects the entire market.

Question 13

We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

Accepted Answer

The beta of a diversified portfolio is generally more stable over time than the beta of a single security because diversification reduces the impact of individual security volatility on the portfolio.

Question 14

Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.

Accepted Answer

If the correlation between the returns on two securities is +1.0, combining them in any proportion will not reduce risk because their returns move perfectly in tandem, meaning there's no diversification benefit.

Question 15

The slope of the SML is determined by investors' aversion to risk.The greater the average investor's risk aversion, the steeper the SML.

Accepted Answer

This is a true statement. The slope of the SML is determined by the risk aversion of investors. Higher risk aversion will result in a steeper SML, while lower risk aversion will result in a flatter SML.

Question 16

Bad managerial judgments 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 away.

Accepted Answer

This statement is true. Company-specific events can be diversified away by investing in a portfolio of different companies with different risk profiles, which helps to reduce the impact of negative events on any one company. However, systemic or market-wide events that affect all companies cannot be diversified away.

Question 17

Portfolio A has but one security, while Portfolio B has 100 securities.Because of diversification effects, we would expect Portfolio B to have the lower risk.However, it is possible for Portfolio A to be less risky.

Accepted Answer

While diversification generally reduces risk, the specific security held in Portfolio A could be less risky than any of the 100 securities held in Portfolio B, potentially resulting in a lower overall risk for Portfolio A.

Question 18

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

Accepted Answer

A stock's beta measures its systematic risk relative to the systematic risks of other firms, not its diversifiable risk. Diversifiable risk, also known as unsystematic risk, can be reduced through diversification of a well-diversified portfolio.

Question 19

The distributions of rates of return for Companies AA and BB are given below:
  
We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.

Accepted Answer

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.

Question 20

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

Accepted Answer

A change in beta will affect the required rate of return on a stock according to the Capital Asset Pricing Model (CAPM), which in turn will affect the stock's price.

Quiz 6: Risk and return