Question 1

If the expected rate of return for a particular stock,as seen by the marginal investor,exceeds its required rate of return,we should soon observe an increase in demand for the stock,and the price will likely increase until a price is established that equates the expected return with the required return.The sooner this equilibrium is reached,the more efficient the market is judged to be.

Accepted Answer

This statement describes the efficient market hypothesis, which states that in an efficient market, prices will adjust rapidly to reflect all available information. If the expected rate of return for a stock is higher than its required rate of return, investors will be willing to pay a higher price to purchase the stock, which will increase demand and eventually drive up the price until the expected return equals the required return. The speed at which this adjustment occurs is a measure of the market's efficiency.

Question 2

Efficient portfolio has the best risk and expected return combination for any given level of risk or return.

Accepted Answer

This statement accurately describes the concept of efficient portfolio theory, which is based on the idea of finding the optimal balance between risk and expected return in a portfolio, given a set of investment constraints or objectives. By analyzing the historical returns and risks of different asset classes or securities, a portfolio manager or investor can identify the combinations of assets that offer the highest returns for a given level of risk, or the lowest risk for a given level of return. The resulting efficient frontier curve represents the set of all efficient portfolios, and helps investors make more informed decisions about how to allocate their assets based on their risk tolerance and investment goals.

Question 3

If any two assets are perfectly negatively correlated,an equal weighted portfolio of these two assets will result in a portfolio return of zero.

Accepted Answer

Perfect negative correlation between two assets means that when one asset's price goes up, the other's goes down in a perfectly inverse manner. However, this does not automatically result in a portfolio return of zero. The actual return would depend on the individual returns of the assets, not just their correlation.

Question 4

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

The statement is true. The coefficient of variation provides a standardized measure of risk relative to the level of expected return. It is calculated by dividing the standard deviation of expected returns by the expected return.

Question 5

Diversification can reduce the riskiness of a portfolio of stocks.

Accepted Answer

Diversification spreads the portfolio across multiple stocks and reduces the exposure to any single company or industry, thus reducing the overall riskiness of the portfolio.

Question 6

Under no conditions should companies take actions that increase their risk relative to the market,regardless of how much those actions would increase the firm's expected rate of return.

Accepted Answer

This statement is not necessarily true. Companies may take actions to increase their risk if they believe it will also increase their expected rate of return, especially if they have a higher risk tolerance than the overall market. However, companies should always carefully evaluate and manage their risk, rather than taking reckless or uninformed actions.

Question 7

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

It is possible for Portfolio A to have selected a low-risk security, while one or more of the securities in Portfolio B could be high-risk. Therefore, the number of securities alone does not determine the risk of a portfolio.

Question 8

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

Variance involves squaring the deviation of each actual return from the expected return, making it always larger than its square root (standard deviation).

Question 9

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 concerned with the risk of a well-diversified portfolio, not the risks of individual stocks held in isolation. Therefore, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

Question 10

Risk aversion implies that investors require higher expected returns on risky securities if they are to be induced to purchase them.

Accepted Answer

Risk aversion means investors are less willing to take on risk, and therefore they require higher expected returns to compensate them for taking on that risk. This is because they expect to be compensated for the possibility of losing money on those investments.

Question 11

Diversifiable risk is the only risk that affects the required rate of return because nondiversifiable risk can be eliminated.

Accepted Answer

Nondiversifiable risk, also known as systematic risk, cannot be eliminated through diversification. It is a risk that affects the overall market or economy and cannot be diversified away. Therefore, it does affect the required rate of return. Diversifiable risk, also known as unsystematic risk, can be eliminated through diversification and does not affect the required rate of return.

Question 12

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 by the investor, which is not necessarily the same as the expected return. The expected return is a forecast of what the return might be based on mathematical models and historical data. The realized return reflects the actual performance of the portfolio and takes into consideration factors such as unexpected events and changes in market conditions. Therefore, the realized return on a stock portfolio is not necessarily the weighted average of the expected returns on the stocks in the portfolio.

Question 13

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 (the difference between the expected return on the market portfolio and the risk-free rate), not by the value of beta. Beta measures the sensitivity of a security's returns to the returns of the market portfolio, and it determines a security's position on the SML, not the slope of the SML itself.

Question 14

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 15

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, it will result in an increase in the expected return of risky assets, but the risk premium will remain constant. Therefore, the slope of the SML will remain unchanged.

Question 16

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 overall market. For an investor who holds only one stock, the stock's beta can give an indication of how much risk is associated with that specific stock. However, for an investor who holds a well-diversified portfolio, beta becomes less relevant because the overall risk of the portfolio is already spread across multiple stocks with varying betas. In this case, the investor would be more concerned with the portfolio's overall beta or the risk of the portfolio as a whole rather than the beta of any one individual stock.

Question 17

Because of differences in the expected returns of 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 correctly explains the limitations of using standard deviation as a measure of risk and how coefficient of variation can address those limitations.

Question 18

Risk aversion is 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 lower-risk (and therefore lower-expected-return) securities than investors who have more tolerance for risk.

Accepted Answer

This statement accurately describes the concept of risk aversion and how it affects investment decisions. Investors with higher risk aversion tend to prefer lower-risk securities with lower expected returns, while those with lower risk aversion may be more comfortable taking on riskier investments with potentially higher returns.

Question 19

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

Accepted Answer

A firm's beta is influenced by its capital structure, which includes its use of debt and equity. By adjusting its capital structure and investment decisions, a firm can change its beta.

Question 20

One key conclusion of the capital asset pricing model is that the value an asset should be measured by considers 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 emphasizes that the relevant risk of an asset is its contribution to the risk of a well-diversified portfolio. Therefore, the risk of an asset held in isolation is not considered in the CAPM. Instead, the CAPM considers the systematic risk, measured by beta, which indicates the relationship between the asset and the market portfolio. The expected return of an asset is determined by its beta, the market risk premium, and the risk-free rate.

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