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

This is because beta measures the sensitivity of a stock's returns to the returns of the overall market, and a beta greater than 1.0 indicates a stock that is more volatile than the market as a whole.

Question 2

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 statement is incorrect. A tighter probability distribution of expected future returns actually indicates lower risk, as it means there is less uncertainty and a more predictable outcome. The greater the standard deviation, the higher the risk as it reflects a wider range of possible outcomes.

Question 3

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) will decrease because the SML slope represents the market's risk premium, and a decrease in risk aversion would lower the premium demanded for taking on additional risk.

Question 4

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. While we cannot predict the future, historical returns and standard deviations can provide insight and guidance in portfolio analysis. However, it is important to recognize the limitations of relying solely on past data and to also consider other factors when making investment decisions.

Question 5

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

Accepted Answer

This is a fundamental principle of finance - investors are risk averse and demand higher expected returns on riskier securities to compensate for the additional risk.

Question 6

For a stock to be in equilibrium, two conditions are necessary: (1)The stock's market price must equal its intrinsic value as seen by the marginal investor and (2)the expected return as seen by the marginal investor must equal this investor's required return.

Accepted Answer

These are the two necessary conditions for a stock to be in equilibrium according to the theory of efficient markets. If either of these conditions is not met, the stock is said to be mispriced and may offer an opportunity for investors to buy or sell for a profit.

Question 7

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

The statement correctly defines risk aversion and the impact it has on investor behavior in the market.

Question 8

Two conditions are used to determine whether or not a stock is in equilibrium: (1)Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2)does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

Accepted Answer

If one condition holds, then the other must also hold.

Question 9

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

Accepted Answer

Diversification helps to spread risk across different assets, reducing the impact of any single stock or market on the overall portfolio. This generally results in a reduction in portfolio riskiness.

Question 10

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 by adding more stocks to a portfolio, but beta reflects market risk, which cannot be diversified away.

Question 11

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

This statement is not entirely true. Managers are expected to take calculated risks in order to increase a firm's rate of return and remain competitive in the market. However, these risks should be measured and managed effectively to minimize potential losses. It is the responsibility of the managers to strike a balance between risk and return, ensuring the company is not exposed to excessive risks that could negatively affect the company's financial position.

Question 12

If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

Accepted Answer

This statement is known as the equilibrium pricing principle, which suggests that the market will adjust the price of a stock until its expected return is equal to the required return of the marginal investor. If the expected return exceeds the required return, investors will demand more of the stock, driving up the price until the expected return is reduced. Thus, the statement is true.

Question 13

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

Accepted Answer

This statement is in line with the principle of the efficient market hypothesis, which suggests that the market price of a stock will be determined by the available information and the expectations of the marginal investor. If the market price exceeds the investor's estimate of the intrinsic value, then they will sell to capitalize on the perceived overvaluation, which will bring the price down to a level that reflects the true value of the stock.

Question 14

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 not the weighted average of the expected returns on the stocks in the portfolio, as it takes into account the actual returns earned on each stock, which may differ from their expected returns. The formula for realized return is:
Realized return = ∑(weight of stock i x return on stock i) for all stocks in the portfolio.

Question 15

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

The statement is true because when the correlation between a new stock and existing stocks in a portfolio is high, it means that the new stock moves in a similar direction with the existing stocks. Therefore, the portfolio's overall risk is not significantly affected because the portfolio already has stocks with similar risk characteristics. On the other hand, if the correlation is low or negative, the new stock can provide diversification benefits that can help lower the portfolio's overall risk.

Question 16

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

CAPM posits that the risk and return of an asset should be evaluated based on its contribution to the risk and return of a diversified portfolio, not on its standalone characteristics. It emphasizes the importance of systematic risk (market risk) over unsystematic risk (individual asset risk), which can be diversified away.

Question 17

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 investors hold only one stock, they typically require a higher rate of return to compensate for the higher risk associated with stocks with higher standard deviation. However, when stocks are held in portfolios, the correlation among stocks may reduce the overall risk of the portfolio, so the required return on a stock with a low standard deviation may be higher if it helps to diversify the portfolio.

Question 18

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. Risk-averse investors prefer investments with more certain returns and therefore require higher rates of return on investments that are more uncertain to compensate for the added risk. Most investors tend to be risk averse to some degree, leading them to seek similar compensating returns for higher-risk investments.

Question 19

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

This statement is true. According to the Capital Asset Pricing Model, investors are concerned with the overall risk of their portfolio, rather than the risk of individual stocks in isolation. The relevant risk of a stock is its contribution to the overall riskiness of a well-diversified portfolio.

Question 20

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, resulting in a larger value than its standard deviation, which is the square root of variance. Therefore, variance is always larger than its square root, the standard deviation.

Quiz 6: Risk and return