Question 1

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

Market risk is measured by beta, which compares a stock's volatility to that of the overall market. A stock with a beta greater than 1 will tend to be more volatile than the market, and therefore has above-average market risk.

Question 2

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 is true. The coefficient of variation is a measure of risk-adjusted return that takes into account the expected return of an investment and its standard deviation, allowing investors to compare the stand-alone risk of different investments.

Question 3

If 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 overall risk of the portfolio is not solely determined by the standard deviation of individual stocks. Correlation between stocks also plays a role in determining portfolio risk. Therefore, it is possible for a stock with a lower standard deviation to still result in a higher required return if it positively contributes to reducing the overall risk of the portfolio.

Question 4

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

According to the Capital Asset Pricing Model, investors are primarily concerned with the systematic risk of a stock, which is the stock's contribution to the riskiness of a well-diversified portfolio, and not with its unsystematic risk or idiosyncratic risk, which can be diversified away by holding a diversified portfolio. Therefore, the relevant risk of a stock is its contribution to the riskiness of a portfolio, not its own individual risk in isolation.

Question 5

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.

Accepted Answer

This statement is true. The coefficient of variation is a way to measure risk-adjusted returns and helps investors compare investments with different levels of risk. It is calculated as the standard deviation of the expected returns divided by the expected return, and is expressed as a percentage. The higher the coefficient of variation, the greater the level of risk per unit of expected return.

Question 6

When 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

Adding a stock that has a high degree of positive correlation with the existing portfolio does not significantly diversify the portfolio's risk, as the stocks will tend to move in the same direction under the same market conditions. Diversification benefits are maximized when adding stocks with low or negative correlation, as this spreads and reduces overall risk.

Question 7

The 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

The tighter the probability distribution of expected future returns, the lower the risk of the investment as measured by its standard deviation. This is because a tighter distribution indicates that the returns are more predictable and there is less chance of large deviations from the expected value.

Question 8

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

Accepted Answer

Diversification involves investing in a variety of different stocks and assets, rather than putting all of one's money into a single stock or asset. By doing this, the risk of the portfolio is spread out among different companies and industries, reducing the riskiness of the portfolio as a whole. This means that if one stock or asset performs poorly, the impact on the overall portfolio is minimized.

Question 9

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

This is true because the variance involves squaring the deviations, which always results in a larger number than taking the square root (i.e. calculating the standard deviation).

Question 10

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

Accepted Answer

If investors become less averse to risk, the slope of the Security Market Line (SML), which represents the relationship between risk and expected return, will decrease because they will require a lower return for taking on additional risk.

Question 11

One 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 assumes that investors hold diversified portfolios, and therefore, the relevant risk of an asset is its contribution to the risk of the overall portfolio. The CAPM measures this risk through the asset's beta, which represents the asset's correlation with the market. The expected return of an asset is also a function of its beta and the market risk premium, which represents the return that investors require for bearing market risk. Therefore, the value of an asset under the CAPM depends on both its risk and expected return, assuming that the asset is held in a well-diversified portfolio.

Question 12

In 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

This is true, as we can only use historical data to make predictions about the future. While ex ante data would be ideal, it is not available until after the fact. Therefore, we use historical returns and standard deviations as approximations for future expectations.

Question 13

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

Managers must balance risk and return to create value for their shareholders. Sometimes, taking actions that increase risk relative to the market can lead to higher returns and value creation. However, this needs to be done in a managed and controlled way that aligns with the company’s overall strategy and risk appetite.

Question 14

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

This statement accurately describes the concept of risk aversion and its impact on investment preferences and returns.

Question 15

The 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 on a stock portfolio is the actual return earned on the portfolio over a certain period of time. It is not the weighted average of the expected returns, which are only estimates of what the returns are likely to be.

Question 16

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

Accepted Answer

This statement is true as risk-averse investors prefer investments with lower levels of uncertainty and require a higher return to compensate for the risk involved. Most investors are risk-averse, which makes this statement accurate.

Question 17

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.

Accepted Answer

The coefficient of variation is a better measure of risk when comparing securities with significantly different expected returns because it standardizes the risk per unit of return, allowing for a more meaningful comparison across different scales of expected returns.

Question 18

An 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 a stock's volatility relative to the overall market, not its diversifiable risk. Diversifiable risk is reduced through portfolio diversification, but beta reflects systematic risk, which cannot be diversified away.

Question 19

Most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets. The relevant risk of each such asset should be measured in terms of its effect on the risk of the firm's stockholders.

Accepted Answer

The statement is true. The risk of each asset should be evaluated in terms of its impact on the overall risk of the firm's stockholders. This involves assessing the level of risk for each asset and how it fits within the company's overall portfolio.

Question 20

"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 more risk only if they can expect to receive higher returns. Therefore, they require higher expected returns on riskier securities as compared to less risky ones.

Quiz 8: Risk and Rates of Return