Question 1

A theoretically ideal way to eliminate market risk is to diversify into the stocks of companies that make products investors buy when the stock market is depressed.

Accepted Answer

Diversification can help reduce market risk and if the investor chooses companies that make products in demand during a market downturn, the portfolio may be more resilient to market fluctuations.

Question 2

When a new stock is introduced into a portfolio and the ups and downs of its return appear to coincide with those of the portfolio's return, the stock's return is said to be perfectly positively correlated with the portfolio's, and its addition will reduce portfolio risk.

Accepted Answer

Perfect positive correlation means the stock moves exactly in tandem with the portfolio, but adding such a stock does not reduce portfolio risk; diversification, which involves adding assets with low or negative correlation, is what typically reduces risk.

Question 3

The beta coefficient, representing the relationship between the performance of the market and the performance of the stock, is theoretically not sensitive to business-specific risk factors.

Accepted Answer

The beta coefficient only measures the relationship between the market performance and the performance of the stock, not the specific risks associated with that particular business. Therefore, it is not sensitive to business-specific risk factors.

Question 4

Because events causing business-specific risks are random, their effects simply cancel out when added together over a substantial number of stocks. This canceling effect enables us to say that business-specific can be "diversified away."

Accepted Answer

This statement is true. Diversification is a strategy that involves spreading investments across different companies or sectors to reduce the impact of individual company risks on the overall portfolio. Random events that affect one company may not affect others, and therefore diversification can help to minimize the impact of business-specific risks.

Question 5

A portfolio's beta coefficient is the weighted average of the betas of the individual stocks, where the weights are the relative amounts invested in each stock.

Accepted Answer

This statement is true. Beta coefficient of a portfolio is calculated as the weighted average of the betas of the individual stocks in the portfolio.

Question 6

Stocks with equal stand-alone risk can have opposite risk impacts on a portfolio because of the timing of the variations in their returns.

Accepted Answer

Two stocks with the same standalone risk can have different risk impacts on a portfolio if their returns vary at different times. This is because the timing and pattern of returns affect the overall risk and return of a portfolio. For example, if two stocks have the same risk but one tends to perform well during economic downturns while the other performs well during upturns, a portfolio that combines both stocks could benefit from diversification and reduce overall risk.

Question 7

A well-diversified portfolio will act to reduce the variability of the returns on the stocks within itself.

Accepted Answer

The answer of A well-diversified portfolio will act to reduce...

Question 8

For a portfolio made up of three stocks in equal proportion, if stock A's expected return is 12%, stock B's expected return is 16%, and stock C's expected return is 17%, the expected return of the portfolio should be 15.0%.

Accepted Answer

The expected return of the portfolio is the weighted average of the expected returns of the individual stocks, which in this case is (12% + 16% + 17%) / 3 = 15%.

Question 9

If the expected return on a stock exceeds the return required by investors, the market will generate enough demand for the security to elevate the price to the point at which required and expected returns become equal.

Accepted Answer

This statement is consistent with the basic principles of supply and demand in financial markets. If the expected return on a stock is greater than the return required by investors, the stock is considered undervalued and investors will be willing to buy it at a higher price than its current market price. This increased demand will push the price of the stock up until its expected return is equal to the return required by investors.

Question 10

Market risk is caused by events that tend to affect the returns on all stocks.

Accepted Answer

Market risk, also known as systematic risk, is the risk that all stocks in the market will decline in value due to events such as economic downturns, political instability, natural disasters, or changes in interest rates. This type of risk cannot be diversified away through portfolio diversification, as it affects the entire market.

Question 11

The return on a portfolio of stocks is the average of the returns on the stocks in the portfolio weighted by the percentage of the portfolio's value invested in each stock.

Accepted Answer

This is the correct definition of portfolio return. The weights assigned to each stock in the portfolio determine their impact on the overall portfolio return.

Question 12

Changes in the rate of inflation is an element of unsystematic risk.

Accepted Answer

Changes in the rate of inflation are typically considered a systematic risk factor as they affect the overall economy and most, if not all, companies within it. Unsystematic risk refers to risks that are specific to an individual company or industry.

Question 13

Risk associated with specific industries or companies is referred to as business-specific risk. It is also known as unsystematic risk and cannot eliminated through diversification.

Accepted Answer

The answer of Risk associated with specific industries or companies...

Question 14

Risk aversion does not mean that investors avoid risk entirely. Rather, they will accept risk if they are adequately compensated by additional expected return.

Accepted Answer

Risk aversion means that investors are cautious about taking on risks but they may still choose to accept some level of risk if it is balanced by the potential for higher returns. So, if they are compensated with additional expected returns, they may be willing to take on more risk.

Question 15

A stock's beta coefficient is developed by plotting the historical relationship between the stock's return and the market's return.

Accepted Answer

The beta coefficient is a measure of a stock's volatility in relation to the market's volatility. It is calculated by plotting the historical returns of the stock and the market and analyzing the relationship between them.

Question 16

When a new stock is introduced into a portfolio and the "peaks" in its return occur with the "valleys" in the portfolio's return, the stock's return is said to be perfectly negatively correlated with the portfolio's, and its addition will reduce the portfolio's risk.

Accepted Answer

This is true because when two assets have perfect negative correlation, their returns move in opposite directions which can reduce the overall risk of the portfolio. When one goes up, the other goes down, and vice versa. This means that the addition of a negatively correlated asset can potentially reduce the volatility of the portfolio.

Question 17

If two portfolios are formed, one with only one stock and another with 20 stocks, the portfolio with more stocks will always be the less risky.

Accepted Answer

The risk of a portfolio depends on the individual stocks' risk and their correlation with each other. A portfolio with only one stock can be very risky if that particular stock is highly volatile. On the other hand, a portfolio with 20 stocks may have lower risk if those stocks have low correlation with each other and are diversified across different industries and sectors. Therefore, it is not always true that a portfolio with more stocks will be less risky.

Question 18

The beta coefficient of a stock is reflected in the slope of its characteristic line.

Accepted Answer

The beta coefficient of a stock is indeed reflected in the slope of its characteristic line. The characteristic line is a linear regression line that shows the relationship between a security's return and the return of a market index. The slope of the line represents the beta of the stock, which measures the stock's volatility in relation to the market. A high beta stock will have a steeper characteristic line, while a low beta stock will have a flatter line.

Question 19

Very risky stocks will not have a market because investors are risk averse.

Accepted Answer

While some investors may be risk averse, there are also investors who are willing to take on high-risk investments in exchange for potentially high returns. However, the market for very risky stocks may be smaller and more volatile compared to more stable investments.

Question 20

Portfolio risk is best reduced through diversification into stocks in fundamentally different industries.

Accepted Answer

Portfolio risk can be reduced by diversifying investments across different types of assets or securities, but it is also important to diversify within asset classes or sectors. Investing in stocks from a variety of industries that are not closely correlated with each other can help to reduce the overall risk of the portfolio.

Quiz 9: Risk and Return