Question 1

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, it means they move perfectly in sync with each other. Therefore, combining them in any proportion will not reduce the portfolio's risk compared to holding either security alone, as their returns are perfectly positively correlated, leading to no diversification benefit.

Question 2

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, which represents the market risk premium.

Question 3

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 4

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

Accepted Answer

The answer of If the returns of two firms are...

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 not measured by the weighted average of the standard deviations of the securities in the portfolio, but rather by the portfolio's overall standard deviation, which takes into account the correlation between the returns of the securities in the portfolio. Diversification reduces risk when the returns of the securities are not perfectly correlated.

Question 6

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

Accepted Answer

A firm's beta can be changed through managerial decisions such as changing the capital structure or investing in different projects which might have different risk profiles.

Question 7

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 is company-specific and can be eliminated by diversifying the portfolio. Systematic risk can't be diversified away as it is related to the overall market conditions.

Question 8

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 commonly accepted principle in finance theory. As investors become more risk-averse, they require higher returns to compensate them for taking on additional risk. This results in a steeper SML reflecting the higher expected return for higher risk investments.

Question 9

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 diversified portfolio is typically more stable over time than the beta of a single security because diversification helps to reduce the impact of company-specific events and news on the overall portfolio.

Question 10

If you plotted the returns of a company against those of the market and found that the slope of your line was negative,the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor,assuming that the observed relationship is expected to continue in the future.

Accepted Answer

The answer of If you plotted the returns of a...

Question 11

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

If the single security in Portfolio A has a lower risk than any of the 100 securities in Portfolio B, then Portfolio A could have lower risk overall despite lacking diversification. It is important to note, however, that this scenario would be unusual and not a typical result of diversified portfolios.

Question 12

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 diversification can reduce overall risk, it does not eliminate all risk. The market as a whole can still have systematic risk that affects all stocks in Portfolio B. Therefore, Portfolio B is not completely riskless.

Question 13

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

The statement is false. Betas used in the CAPM are calculated based on past data, not expected future data. However, future expected returns and market risk premium are used in applying the CAPM. The CAPM is subject to criticisms for its reliance on historical data and assumptions that may not hold in the future.

Question 14

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 return...

Question 15

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, implying its systematic risk. For an investor holding a well-diversified portfolio, beta remains relevant as it indicates the portfolio's sensitivity to market movements. However, for an investor holding only one stock, beta is less relevant since unsystematic (specific) risk, which can be diversified away, significantly impacts that stock's total risk.

Question 16

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 systematic risk of a stock in relation to the market. It is possible for a firm to have a positive beta if it is more volatile than the market, even if the correlation between its returns and those of another firm is negative. Correlation measures the degree to which two variables move together, while beta measures the magnitude and direction of the relationship between a stock and the market.

Question 17

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

Company-specific events are not related to market-wide factors and can be diversified away through a portfolio strategy.

Question 18

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

This statement is true as beta is one of the important components in the calculation of required rate of return using the Capital Asset Pricing Model (CAPM). A higher beta implies higher risk and hence a higher required rate of return, which would lead to a lower stock price. Conversely, a lower beta would lead to a lower required rate of return and a higher stock price.

Question 19

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 20

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.

Quiz 6: Risk and Return