Question 1

Systematic risk is measured by _____ and represents risk which _____ be eliminated by diversiﬁcation.

Accepted Answer

Systematic risk is measured by beta and it represents risk which cannot be eliminated by diversification. Standard deviation measures total risk, not just systematic risk.

Question 2

The principle of diversiﬁcation tells us that:

Accepted Answer

The principle of diversification tells us that spreading an investment across many diverse assets will eliminate some of the risk. It is not possible to eliminate all risks, but having a portfolio with diverse assets helps to reduce the overall risk. This is because different assets tend to perform differently under various economic conditions or events. By spreading out our investments, we can reduce the impact of any one asset underperforming or experiencing a significant loss.

Question 3

The reward-to-risk ratio can be deﬁned as the:

Accepted Answer

The reward-to-risk ratio is defined as the slope of the security market line, which represents the relationship between the expected return of a security and its beta.

Question 4

Based upon the capital asset pricing model, an asset which has more systematic risk than the market:

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), all assets should earn a rate of return that places them on the Security Market Line (SML) if the market is in equilibrium. The SML represents the expected return of a security based on its systematic risk (beta). An asset with more systematic risk than the market will have a beta greater than 1, and its expected return will be higher than the market return, but it will still lie on the SML.

Question 5

Risk that affects a large number of assets, each to a greater or lesser degree, is called:

Accepted Answer

Systematic risk affects a large number of assets in a similar way, such as economic factors or changes in the overall market. This type of risk cannot be diversified away and affects the entire market.

Question 6

Systematic risks are deﬁned as:

Accepted Answer

Systematic risks pertain to unexpected events which impact almost all assets. Such risks cannot be diversified away as they affect the overall economy or market. Examples of such risks include wars, natural disasters, economic recessions, and global pandemics.

Question 7

Which one of the following measures is relevant to the systematic risk principle?

Accepted Answer

Beta is the measure of systematic risk, which refers to the portion of total risk that cannot be diversifiable through diversification of the portfolio. Beta measures the sensitivity of an asset or portfolio's returns to the market returns, which is considered as systematic risk. The higher the beta, the higher the systematic risk. Therefore, beta is the relevant measure to the systematic risk principle. Variance, alpha, standard deviation, and theta are all measures of total risk or specific risk, which can be diversifiable through diversification of the portfolio.

Question 8

The reward-to-risk ratio for Stock X exceeds that of Stock Y. Stock X has a beta of 1.37 and Stock Y has a beta of .98. Given this, you know for certain that:

Accepted Answer

The answer of The reward-to-risk ratio for Stock X exceeds...

Question 9

Which one of the following will necessarily decrease the risk of a portfolio that consists of stocks, Treasury bills, and gold?

Accepted Answer

Treasury bills are considered to be a risk-free asset, so increasing their allocation in a portfolio will decrease the overall risk of the portfolio. Selling stocks and replacing them with Treasury bills will also decrease the portfolio's exposure to the stock market, further reducing risk. Selling a .90 beta stock and buying a 1.1 beta stock will actually increase the portfolio's risk. Selling the gold and buying more diversified stocks may or may not decrease risk depending on the specific stocks chosen. Selling the large-company stocks and buying small-company stocks may increase risk as small-company stocks are considered more volatile than large-company stocks. Decreasing the number of securities in the portfolio may or may not decrease risk, depending on the specific securities removed.

Question 10

The risk-free rate of return subtracted from the expected market rate of return is called the:

Accepted Answer

The risk premium is the excess return an investor expects to receive from an investment in a risky market portfolio compared to the risk-free rate. It represents the compensation an investor requires for bearing the additional risk of investing in the stock market.

Question 11

Which one of the following statements is correct concerning the standard deviation of a portfolio?

Accepted Answer

The standard deviation of a portfolio can be lowered by changing the weights of the securities in the portfolio. This is because the standard deviation of a portfolio is affected not only by the standard deviation of each security held within the portfolio, but also by the correlation between those securities. By adjusting the weights of the securities in the portfolio, an investor can reduce the overall correlation and therefore lower the portfolio's standard deviation. The greater the diversification of a portfolio, the lower the standard deviation, not the greater. Standard deviation is not used to determine the amount of risk premium that should apply to a portfolio. Standard deviation measures both systematic and unsystematic risk, not just systematic risk. Finally, while the standard deviation of a portfolio is affected by the standard deviations of the individual securities held within it, it is not a simple weighted average of those standard deviations. The interplay between the securities and their correlations within the portfolio make the calculation more complicated.

Question 12

The market risk premium is computed by:

Accepted Answer

The market risk premium is the additional return that an investor expects to receive from investing in a risky asset, such as stocks, over and above the risk-free rate of return. It is calculated by subtracting the risk-free rate of return from the market rate of return. Therefore, the correct answer is D.

Question 13

Unsystematic risk is deﬁned as the risk that:

Accepted Answer

Unsystematic risk, also known as company-specific risk, is the risk that is derived from an event that affects a single firm or a limited number of assets. This type of risk can be mitigated through diversification. The other options describe systemic or macroeconomic risks.

Question 14

Ted believes that he currently owns a portfolio which is adequately diversiﬁed. If he is correct, the addition of a _____ asset to the portfolio will have minimal, if any, effect on the portfolio's _____.

Accepted Answer

The answer of Ted believes that he currently owns a...

Question 15

The excess return earned by an asset that has a beta of 1.0 over that earned by a risk-free asset is referred to as the:

Accepted Answer

The excess return earned by an asset with a beta of 1.0 over a risk-free asset is referred to as the market risk premium. The market risk premium is the additional compensation an investor expects to receive for taking on the risk of investing in the overall market instead of a risk-free asset.

Question 16

If investors can freely trade assets in ﬁnancial markets, then the impact of trading activity on expected returns insures that ________________________.

Accepted Answer

In efficient markets, assets are priced such that they offer the same reward to risk ratio, as per the Capital Market Line (CML) and Security Market Line (SML) in the Capital Asset Pricing Model (CAPM).

Question 17

Total risk equals _________________.

Accepted Answer

Total risk consists of both market risk and firm-specific risk. Market risk is the risk that affects the overall market and cannot be diversified away while firm-specific risk is the risk that is specific to a particular company and can be diversified away. Therefore, the sum of these two risks will give us the total risk.

Question 18

Which of the following is correct?

Accepted Answer

Standard deviation measures total risk, including both systematic and unsystematic risk. Therefore, the security with the largest standard deviation has the greatest total risk.

Question 19

Which one of the following stocks will have the highest risk premium?

Accepted Answer

The answer of Which one of the following stocks will...

Question 20

Standard deviation measures the _____ risk of a security.

Accepted Answer

Standard deviation measures the total risk of a security, which includes both systematic and diversifiable risk. Unique and asset-specific risk refer to the risk inherent to a specific security, while systematic risk refers to the overall market risk that cannot be diversified away. Diversifiable risk refers to the risk that can be eliminated by diversifying a portfolio.

Quiz 13: Return, Risk, and the Security Market Line

Systematic risk is measured by _ and represents risk which _ be eliminated by diversiﬁcation.