Foundations of Finance 8th Edition Keown Test Bank 1

Foundations of Finance, 8e (Keown/Martin/Petty)
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Chapter 6 The Meaning and Measurement of Risk and Return
Learning Objective 1
1) Accounting profits is the most relevant variable the financial manager uses to measure returns.
Answer: FALSE
Diff: 1
Keywords: Accounting Profits, Cash Flows, Returns
AACSB: Reflective thinking skills
2) Cash flows is the most relevant variable to measure the returns on debt instruments, while GAAP net
income is the most relevant variable to measure the returns on common stock.
Answer: FALSE
Diff: 1
Keywords: Return, Cash Flow, Net Income
3) The expected rate of return from an investment is equal to the expected cash flows divided by the
initial investment.
Answer: TRUE
Diff: 1
Keywords: Expected Rate of Return, Expected Cash Flows
AACSB: Analytic skills
4) Actual returns are always less than expected returns because actual returns are determined at the end
of the period and must be discounted back to present value.
Answer: FALSE
Diff: 1
Keywords: Actual Returns, Expected Returns
5) Another name for an asset's expected rate of return is holding-period return.
1
Copyright © 2014 Pearson Education, Inc.
Answer: FALSE
Diff: 1
Keywords: Holding Period Return, Expected Return
6) The realized rate of return, or holding period return, is equal to the holding period dollar gain divided
by the price at the beginning of the period.
Answer: TRUE
Diff: 1
Keywords: Holding Period Return, Holding Period Dollar Gain
2
7) The risk-return tradeoff that investors face on a day-to-day basis is based on realized rates of return
because expected returns involve too much uncertainty.
Answer: FALSE
Diff: 2
Keywords: Realized Rate of Return, Expected Rate of Return
8) Stock A has the following returns for various states of the economy:
State of
the Economy Probability Stock A's Return
Recession 10% -30%
Below Average 20% -2%
Average 40% 10%
Above Average 20% 18%
Boom 10% 40%
Stock A's expected return is

A) 5.4%.
B) 7.2%.
C) 8.2%.
D) 9.6%
Answer: C
Diff: 1
Keywords: Expected Return, Probability
9) Stock A has the following returns for various states of the economy:
State of
the Economy Probability Stock A's Return
Recession 9% -72%
Average 51% 16%
Boom 10% 85%
Stock A's expected return is

A) 9.9%.
B) 12.7%.
C) 13.8%.
D) 16.5%.
Answer: B
Diff: 1
Keywords: Expected Return
3
10) You are considering a sales job that pays you on a commission basis or a salaried position that pays
you $50,000 per year. Historical data suggests the following probability distribution for your commission
income. Which job has the higher expected income?
Probability of
Commission Occurrence
$15,000 .15
$35,000 .20
$48,000 .35
$67,000 .22
$80,000 .18
A) The salary of $50,000 is greater than the expected commission of $49,630.
B) The salary of $50,000 is greater than the expected commission of $48,400.
C) The salary of $50,000 is less than the expected commission of $50,050.
D) The salary of $50,000 is less than the expected commission of $52,720.
Answer: A
Diff: 2
Keywords: Expected Value
11) Use the following data:

Market risk premium = 10%
Risk free rate = 2%
Beta of XYZ stock = 1.6
Beta of PDQ stock = 2.4
Investment in XYZ stock = $15,000
Investment in PDQ stock = $60,000
You have no assets other than your investments in XYZ and PDQ stock.
What is the expected return of your portfolio? Show all work.

Answer: Portfolio Beta method:
Bp = (15/75 × 1.6) + (60/75 × 2.4) = 2.24
Rp = .02 + (2.24 × .10) = .244 = 24.4%
Weighting individual stock return method:

RXYZ = .02 + (1.6 × .10) = .18
RPDQ = .02 + (2.4 × .10) = .26
WXYZ = $15,000/($15,000 + $60,000) = .2
WPDQ = $50,000/($15,000 + $50,000) = .8
RP = (.2 × .18) + (.8X .26) = .244 = 24.4%
Both approaches are equivalent.

Diff: 2
Keywords: Beta, Portfolio, Security Market Line
4
1) Variation in the rate of return of an investment is a measure of the riskiness of that investment.
Answer: TRUE
Diff: 1
Keywords: Rate of Return, Risk, Variability
2) A rational investor will always prefer an investment with a lower standard deviation of returns,
because such investments are less risky.
Answer: FALSE
Diff: 1
Keywords: Standard Deviation of Returns, Risk, Risk-Return Trade Off
3) For a well-diversified investor, an investment with an expected return of 10% with a standard
deviation of 3% dominates an investment with an expected return of 10% with a standard deviation of
5%.
Answer: FALSE
Diff: 2
Keywords: Expected Return, Standard Deviation, Risk-Return Trade Off, Well-diversified
4) Due to strict stock market controls, the most a stock's value can drop in one trading day is 5%.
Answer: FALSE
Diff: 1
Keywords: Stock Price Volatility
5) Stock W has the following returns for various states of the economy:
State of the Economy Probability Stock W's Return

Recession 10% -30%
Average 40% 10%
Boom 10% 40%
Stock W's standard deviation of returns is

A) 10%.
B) 14%.
C) 17%.
D) 20%
Answer: C
Diff: 2
Keywords: Standard Deviation
5
6) Stock W has the following returns for various states of the economy:
State of the Economy Probability Stock W's Return

Recession 9% -72%
Average 51% 16%
Boom 10% 85%
Stock W's standard deviation of returns is

A) 12%.
B) 29%.
C) 37%.
D) 43%.
Answer: C
Diff: 2
7) Stock W has an expected return of 12% with a standard deviation of 8%. If returns are normally
distributed, then approximately two-thirds of the time the return on stock W will be
A) between 12% and 20%.
B) between 8% and 12%.
C) between -4% and 28%.
D) between 4% and 20%.
Answer: D
Diff: 2
Keywords: Normal Distribution, Expected Return, Standard Deviation
8) Which of the following investments is clearly preferred to the others for an investor who is not holding
a well-diversified portfolio?
Investment σ
A 18% 20%
B 20% 20%
C 20% 22%
A) Investment A
B) Investment B
C) Investment C
D) Cannot be determined without information regarding the risk-free rate of return.
Answer: B
Diff: 2
Keywords: Expected Return, Standard Deviation, Risk-Return Trade Off
6
9) Assume that you have $330,000 invested in a stock that is returning 11.50%, $170,000 invested in a
stock that is returning 22.75%, and $470,000 invested in a stock that is returning 10.25%. What is the
expected return of your portfolio?
A) 15.6%
B) 12.9%
C) 18.3%
D) 14.8%
Answer: B
Diff: 2
Keywords: Expected Return, Portfolio
10) Assume that you have $100,000 invested in a stock that is returning 14%, $150,000 invested in a stock
that is returning 18%, and $200,000 invested in a stock that is returning 15%. What is the expected return
of your portfolio?
A) 13.25%
B) 14.97%
C) 15.67%
D) 15.78%
Answer: D
Diff: 2
7
11) You are given the following probability distribution for XYZ common stock's returns during the next
year, which are assumed to be normally distributed. Show all work below, and complete the following:
Return Probability
12% 20%
16% 60%
20% 20%
a. Calculate the standard deviation of the returns, and round to the nearest one-half percent.
b. Draw a graphical representation of XYZ's normal distribution below (ye old bell-shaped curve). LABEL
THE AXES OF THE GRAPH OR THE FOLLOWING RESULTS WILL BE MEANINGLESS. Using your
result in part A for the standard deviation (rounded to the nearest one-half percent) explain and indicate
on the graph, the probability that XYZ will return more than 13.5%, assuming a normal distribution.
Answer: GRAPH:
a. Exp. Return = (.12 × .2) + (.16 × .6) + (.2 × .2) = .16
Std. Dev. = [(.12 - .16)2(0.2) + (.16 - .16)2(0.6)
+ (.20 - .16)2(0.2)]1/2 = .0253 = 2.53% rounded to 2.5%
b. The graph should have probability as the vertical axis and return (outcome, value of the variable, etc.)
as the horizontal axis. It should be bell-shaped and centered at the 16% mean.
13.5% is one standard deviation below the mean. The text indicates that 2/3 of outcomes fall within one
standard deviation of the mean for a normal probability distribution, so 2/3 of outcomes fall within 13.5%
and 18.5%. Since one-half of the remaining 1/3 would be in the upper tail more than one standard
deviation above the mean, 1/6 would fall above 16% + 2.5% = 18.5%. Thus, 2/3 + 1/6 = 5/6, or roughly 83%
lie above 13.5%. Note, some students may have learned 68% fall within one standard deviation of the
mean.
Diff: 3
Keywords: Expected Return, Standard Deviation, Normal Deviation
12) Discuss whether the standard deviation of a portfolio is, or is not, a weighted average of the standard
deviations of the assets in the portfolio. Fully explain your answer.
Answer: The standard deviation of a portfolio is not a weighted average of the standard deviations of the
assets in the portfolio. If the portfolio is well-diversified then it should have a standard deviation that is
lower than most or all of the assets placed in that portfolio. Betas can be averaged, but standard
deviations cannot, due to the diversifiable risk that is contained in the standard deviation but not
reflected by beta.
Diff: 2
Keywords: Standard Deviation, Portfolio, Diversification
8
13) Bay Land, Inc. has the following distribution of returns:
State Return Probability

Boom 0.3 0.25
Normal 0.4 0.15
Bust 0.3 0.30
Assuming that these returns are normally distributed, what is the probability that Bay Land, Inc. will
return less than 7.25%? Show all work, and clearly explain and state your answer.
Answer: Exp. Return = (.3 × .25) + (.4 × .15) + (.3 × .05) = .15
std. Dev. = [(.25 - .15)2(0.3) + (.15 - .15)2(0.4) + (.05 - .15)2(0.3)]1/2 = .0775 = 7.75%
Because 2/3 of the returns fall within one standard deviation of the mean (for a normal probability
distribution), 1/3 do not. One-half of that one third (or 1/6) falls in the tail below one standard deviation
below the mean (below 15% - 7.75% = 7.25%), thus the answer is 1/6, or 16.7%. Note, some students may
have learned 68% fall within one standard deviation of the mean.
Diff: 3
Keywords: Expected Return, Standard Deviation, Normal Distribution
1) Historically, investments with the highest returns have the lowest standard deviations because
investors do not like risk.
Answer: FALSE
Diff: 1
Keywords: Risk-Return Trade Off
2) An investor with a required return of 8% for stock A will purchase stock A if the expected return for
stock A is less than or equal to 8%.
Answer: FALSE
Diff: 1
Keywords: Required Return, Expected Return
3) In general, the required rate of return is a function of (1) the time value of money, (2) the risk of an
asset, and (3) the investor's attitude toward risk.
Answer: TRUE
Diff: 1
Keywords: Required Rate of Return
4) As the required rate of return of an investment decreases, the market price of the investment decreases.
Answer: FALSE
Diff: 1
9
5) In an efficient market, a stock with a standard deviation of returns of 12% could have a higher expected
return than a stock with a standard deviation of 10% because the beta for the higher standard deviation
stock could be lower than the beta for the lower standard deviation stock.
Answer: TRUE
Diff: 2
Keywords: Risk-Return Trade Off, Beta, Standard Deviation
6) Small company stocks have historically had higher average annual returns than large company stocks,
and also a higher risk premium.
Answer: TRUE
Diff: 2
Keywords: Small Company Stocks, Risk Premium
7) Investment A and Investment B both have the same expected return, but Investment A is more risky
than Investment B. In the technical jargon of modern portfolio theory, Investment A is said to "dominate"
Investment B.
Answer: FALSE
Diff: 2
Keywords: Risk-Return Trade Off
8) Negative historical returns are not possible during periods of high volatility (high standard deviations
of returns) due to the risk-return tradeoff.
Answer: FALSE
Diff: 2
Keywords: Risk-Return Tradeoff, Historical Returns, Standard Deviation
9) Investment A has an expected return of 15% per year, while investment B has an expected return of
12% per year. A rational investor will choose
A) investment A because of the higher expected return.
B) investment B because a lower return means lower risk.
C) investment A if A and B are of equal risk.
D) investment A only if the standard deviation of returns for A is higher than the standard deviation of
returns for B.
Answer: C
Diff: 2
Keywords: Expected Rate of Return, Standard Deviation, Risk-Return Trade Off
10
10) Investment A has an expected return of 14% with a standard deviation of 4%, while investment B has
an expected return of 20% with a standard deviation of 9%. Therefore
A) a risk averse investor will definitely select investment A because the standard deviation is lower.
B) a rational investor will pick investment B because the return adjusted for risk (20% - 9%) is higher than
the return adjusted for risk for investment A ($14% - 4%).
C) it is irrational for a risk-averse investor to select investment B because its standard deviation is more
than twice as big as investment A's, but the return is not twice as big.
D) rational investors could pick either A or B, depending on their level of risk aversion.
Answer: D
Diff: 2
11) Which of the following investments is clearly preferred to the others for a risk-averse investor?
Investment σ
A 14% 12%
B 22% 20%
C 18% 16%
A) Investment A
B) Investment B
C) Investment C
D) cannot be determined without additional information
Answer: D
Diff: 2
12) Rogue Recreation, Inc. has normally distributed returns with an expected return of 15% and a
standard deviation of 5%, while Lake Tours, Inc. has normally distributed returns with an expected
return of 15% and a standard deviation of 15%. Which of the following is true?
A) Lake Tours' investors are not being adequately compensated for relevant risk.
B) Rogue Rec is likely to experience returns larger than those of Lake Tours.
C) Lake Tours is more likely to have negative returns than Rogue Rec.
D) Rational investors will prefer Lake Tours, Inc. over Rogue Recreation, Inc.
Answer: C
Diff: 2
Keywords: Expected Return, Standard Deviation
11
13) You are considering investing in a project with the following possible outcomes:
Probability of Investment
States Occurrence Returns
State 1: Economic boom 18% 20%
State 2: Economic growth 42% 16%
State 3: Economic decline 30% 3%
State 4: Depression 10% -25%
Calculate the expected rate of return and standard deviation of returns for this investment, respectively.
A) 8.72%, 12.99%
B) 7.35%, 12.99%
C) 3.50%, 1.69%
D) 2.18%, 1.69%
Answer: A
Diff: 2
Keywords: Expected Return, Standard Deviation
14) Changes in the general economy, like changes in interest rates or tax laws represent what type of risk?
A) company-unique risk
B) market risk
C) unsystematic risk
D) diversifiable risk
Answer: B
Diff: 1
Keywords: Market Risk
15) The minimum rate of return necessary to attract an investor to purchase or hold a security is referred
to as the
A) stock's beta.
B) investor's risk premium.
C) investor's required rate of return.
D) risk-free rate.
Answer: C
Diff: 1
16) The relevant variable a financial manager uses to measure returns is

A) net income determined using generally accepted accounting principles.
B) earnings per share minus dividends per share.
C) cash flows.
D) dividends.
Answer: C
Diff: 1
Keywords: Returns
12
17) Of the following different types of securities, which is typically considered most risky?
A) long-term corporate bonds
B) long-term government bonds
C) common stocks of large companies
D) common stocks of small companies
Answer: D
Diff: 1
Keywords: Risk, Stocks, Bonds
18) Assume that an investment is forecasted to produce the following returns: a 10% probability of a
$1,400 return; a 50% probability of a $6,600 return; and a 40% probability of a $1,500 return. What is the
expected amount of return this investment will produce?
A) $4,040
B) $7,640
C) $12140
D) $1,540
Answer: A
Diff: 2
19) Assume that an investment is forecasted to produce the following returns: a 30% probability of a 12%
return; a 50% probability of a 16% return; and a 20% probability of a 19% return. What is the expected
percentage return this investment will produce?
A) 33.3%
B) 16.1%
C) 9.5%
D) 15.4%
Answer: D
Diff: 2
20) Assume that an investment is forecasted to produce the following returns: a 20% probability of a 12%
return; a 50% probability of a 16% return; and a 30% probability of a 19% return. What is the standard
deviation of return for this investment?
A) 5.89%
B) 16.1%
C) 2.43%
D) 15.7%
Answer: C
Diff: 2
13
21) The category of securities with the highest historical risk premium is
A) large company stocks.
B) small company stocks.
C) government bonds.
D) small company corporate bonds.
Answer: B
Diff: 1
Keywords: Risk Premium
22) If you were to use the standard deviation as a measure of investment risk, which of the following has
historically been the least risky investment?
A) common stock of large firms
B) U.S. Treasury bills
C) common stock of small firms
D) long-term government bonds
Answer: B
Diff: 1
Keywords: Standard Deviation, Risk, U.S. Treasury Bills
23) If you were to use the standard deviation as a measure of investment risk, which of the following has
historically been the highest risk investment?
A) common stock of large firms
B) U.S. Treasury bills
C) common stock of small firms
D) long-term government bonds
Answer: C
Diff: 1
Keywords: Standard Deviation, Risk, Small Cap Common Stocks
14
24) You are considering a security with the following possible rates of return:
Probability Return (%)

0.15 9.5
0.25 13.6
0.50 14.9
0.10 25.3
a. Calculate the expected rate of return.

b. Calculate the standard deviation of the returns.
Answer:
a. Expected Return = (0.15)(9.5)+(0.25)(13.6)+(0.50)(14.9)+(0.1)(25.3) = 14.81%
b. Std. Dev. = [(9.5 - 14.81)2(0.15) + (13.6 - 14.81)2(0.25)

+ (14.9 - 14.81)2(0.5) + (25.3 - 14.81)2(0.1)]1/2 = 3.95%
Diff: 2
Keywords: Expected Rate of Return, Standard Deviation of Returns
25) You are considering the three securities listed below.

Returns
Probability Stock A Stock B Stock C
20% 2% -3% 5%
50% 10% 8% 8%
30% 15% 20% 12%
a. Calculate the expected return for each security.

b. Calculate the standard deviation of returns for each security.
c. Compare Stock A with Stocks B and C. Is Stock A preferred over the others?
Answer:
a.
RA = (.2)(2%)+(.5)(10%)+(.3)(15%) = 9.9%
RB = (.2)(-3%)+(.5)(8%)+(.3)(20%) = 9.4%
RC = (.2)(5%)+(.5)(8%)+(.3)(12%) = 8.6%
b.
Std.Dev.A = (2%-9.9%)2(.2)+(10%-9.9%)2(.5)+(15%-9.9%)2(.3) = 4.5%
Std.Dev.B = (-3%-9.4%)2(.2)+(8%-9.4%)2(.5)+(20%-9.4%)2(.3) = 8.1%
Std.Dev.C = (5%-8.6%)2(.2)+(8%-8.6%)2(.5)+(12%-8.6%)2(.3) = 2.5%
c.
Stock A dominates stock B because A has a higher expected return and a lower standard deviation. Stock
A has a higher expected return than stock C, but also a higher standard deviation, so the choice between
A and C depends on the level of risk aversion.
Diff: 2
15
1) The benefits of diversification occur as long as the investments in a portfolio are not perfectly
positively correlated.
Answer: TRUE
Diff: 1
Keywords: Diversification, Correlation
2) Proper diversification generally results in the elimination of risk.

Answer: FALSE
Diff: 1
Keywords: Diversification, Risk
3) A stock with a beta of 1 has systematic or market risk equal to the "typical" stock in the marketplace.
Answer: TRUE
Diff: 1
Keywords: Beta, Systematic Risk
4) Diversifying among different kinds of assets is called asset allocation.

Answer: TRUE
Diff: 1
Keywords: Asset Allocation, Diversification
5) Asset allocation is not recommended by financial planners because mixing different types of assets,
such as stocks with bonds, makes it more difficult to track performance and adjust portfolios to changing
market conditions.
Answer: FALSE
Diff: 1
Keywords: Asset Allocation
6) A stock with a beta of 1.4 has 40% more variability in returns than the average stock.
Answer: TRUE
Diff: 1
Keywords: Beta, Variability
7) Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks have higher
standard deviations of returns than bonds.
Answer: FALSE
Diff: 1
Keywords: Diversification, Portfolio Risk
16
8) An all-stock portfolio is more risky than a portfolio consisting of all bonds.
Answer: TRUE
Diff: 1
Keywords: Diversification, Portfolio Risk
9) Company unique risk can be virtually eliminated with a portfolio consisting of approximately 20
securities.
Answer: TRUE
Diff: 1
Keywords: Company Unique Risk, Diversification
10) Total risk equals systematic risk plus unsystematic risk.

Answer: TRUE
Diff: 1
Keywords: Systematic Risk, Unsystematic Risk, Total Risk
11) A well-diversified portfolio typically has systematic risk equal to about 40% of the portfolio's total
risk.
Answer: TRUE
Diff: 1
Keywords: Systematic Risk, Diversification
12) A security with a beta of one has a required rate of return equal to the overall market rate of return.
Answer: TRUE
Diff: 1
Keywords: Beta
13) Unique security risk can be eliminated from an investor's portfolio through diversification.
Answer: TRUE
Diff: 1
Keywords: Diversification, Portfolio
14) The Beta of a T-bill is zero.

Answer: TRUE
Diff: 1
Keywords: Beta, T-bill
15) The Beta of a T-bill is one.

Answer: FALSE
Diff: 1
Keywords: Beta, T-bill
17
16) Portfolio performance is determined mainly by stock selection and market timing, with less emphasis
on asset allocation.
Answer: FALSE
Diff: 1
Keywords: Asset Allocation, Portfolio Performance
17) Beta is a measurement of the relationship between a security's returns and the general market's
returns.
Answer: TRUE
Diff: 1
Keywords: Beta
18) The relevant risk to an investor is that portion of the variability of returns that cannot be diversified
away.
Answer: TRUE
Diff: 1
Keywords: Relevant Risk, Non-diversifiable Risk
19) The characteristic line for any well-diversified portfolio is horizontal.

Answer: FALSE
Diff: 1
Keywords: Characteristic Line, Well-diversified Portfolio
20) The slope of the characteristic line of a security is that security's Beta.
Answer: TRUE
Diff: 1
Keywords: Characteristic Line, Beta
21) Beta represents the average movement of a company's stock returns in response to a movement in the
market's returns.
Answer: TRUE
Diff: 1
Keywords: Beta
22) Because risk is measured by variability of returns, how long we hold our investments does not matter
very much when it comes to reducing risk.
Answer: FALSE
Diff: 1
Keywords: Diversification, Risk Reduction
18
23) The market rewards the patient investor, for between 1926 and 2008, there has never been a time
when an investor lost money if she held an all-stock portfolio for ten years.
Answer: TRUE
Diff: 1
Keywords: Diversification, Investment Horizon
24) The portfolio beta is simply the sum of the betas of the individual stocks in the portfolio.
Answer: FALSE
Diff: 1
Keywords: Beta, Portfolio Beta
25) Which of the following statements is MOST correct concerning diversification and risk?
A) Risk-averse investors often choose companies from different industries for their portfolios because the
correlation of returns is less than if all the companies came from the same industry.
B) Risk-averse investors often select portfolios that include only companies from the same industry group
because the familiarity reduces the risk.
C) Only wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks
to gain the benefits of diversification.
D) Proper diversification generally results in the elimination of risk.
Answer: A
Diff: 2
Keywords: Diversification, Risk, Correlation
26) Which of the following statements is MOST correct concerning diversification and risk?
A) Diversification is mainly achieved by the selection of individual securities for each type of asset held in
a portfolio.
B) Diversification is mainly achieved by the asset allocation decision, not the selection of individual
securities within each asset category.
C) Large company stocks and small company stocks together in a portfolio lead to dramatic reductions in
risk because their returns are negatively correlated.
D) Asset allocation is important for pension funds but not for individual investors.
Answer: B
Diff: 2
Keywords: Diversification, Asset Allocation, Risk
19
27) An investor currently holds the following portfolio:
Amount
Invested
8,000 shares of Stock A $16,000 Beta = 1.3
15,000 shares of Stock B $48,000 Beta = 1.8
25,000 shares of Stock C $96,000 Beta = 2.2
The investor is worried that the beta of his portfolio is too high, so he wants to sell some stock C and add
stock D, which has a beta of 1.0, to his portfolio. If the investor wants his portfolio to have a beta of 1.72,
how much stock C must he replace with stock D?
A) $18,000
B) $24,000
C) $31,000
D) $36,000
Answer: D
Diff: 3
Keywords: Beta, Portfolio
28) Wendy purchased 800 shares of Genetics Stock at $3 per share on 1/1/12. Wendy sold the shares on
12/31/12 for $3.45. Genetics stock has a beta of 1.9, the risk-free rate of return is 4%, and the market risk
premium is 9%. Wendy's holding period return is
A) 15.0%.
B) 16.5%.
C) 17.6%.
D) 21.1%.
Answer: A
Diff: 1
Keywords: Holding Period Return
29) You are thinking of adding one of two investments to an already well- diversified portfolio.
Security A Security B
Expected Return = 14% Expected Return = 16%
Standard Deviation of Standard Deviation of
Returns = 16% Returns = -20%
Beta = 1.2 Beta = 1.2
If you are a risk-averse investor, which one is the better choice?

A) Security A
B) Security B
C) Either security would be acceptable because they have the same beta.
D) Security B, but only if Security B's required return is greater than 12%
Answer: B
Diff: 2
Keywords: Risk-Aversion, Well-diversified Portfolio, Beta, Risk-Return Trade Off
20
30) You are going to invest all of your funds in one of three projects with the following distribution of
possible returns:
PROJECT 1 PROJECT 2
Standard Standard
Probability Return Deviation Beta Probability Return Deviation Beta
50% Chance 22% 12% 1.1 30% Chance 36% 19.5% 1.0
50% Chance -4% 40% Chance 10.5%
30% Chance -20%
PROJECT 3
Standard
Probability Return Deviation Beta
10% Chance 28% 12% 1.2
70% Chance 18%
20% Chance -8%
If you are a risk averse investor, which one should you choose?
A) Project 1
B) Project 2
C) Project 3
D) either Project 1 or Project 2 because they have the same expected return
Answer: C
Diff: 2
Keywords: Standard Deviation, Risk/Return Trade Off, Expected Return, Non-diversified Portfolio
31) You are considering investing in Ford Motor Company. Which of the following are examples of
diversifiable risk?
I. Risk resulting from possibility of a stock market crash.
II. Risk resulting from uncertainty regarding a possible strike against Ford.
III. Risk resulting from an expensive recall of a Ford product.
IV. Risk resulting from interest rates decreasing.
A) I only
B) I and IV
C) I, II, III, IV
D) II, III
Answer: D
Diff: 1
Keywords: Diversifiable Risk
21
32) You are considering buying some stock in Continental Grain. Which of the following are examples of
non-diversifiable risks?
I. Risk resulting from a general decline in the stock market.
II. Risk resulting from a possible increase in income taxes.
III. Risk resulting from an explosion in a grain elevator owned by Continental.
IV. Risk resulting from a pending lawsuit against Continental.
A) I and II
B) III and IV
C) I only
D) II, III, and IV
Answer: A
Diff: 2
Keywords: Non-Diversifiable Risk, Systematic Risk
33) Of the following, which differs in meaning from the other three?
A) systematic risk
B) market risk
C) undiversifiable risk
D) asset-unique risk
Answer: D
Diff: 2
Keywords: Systematic Risk, Market Risk, Undiversifiable Risk
34) Most stocks have betas between

A) -1.00 and 1.00.
B) 0.00 and 1.00.
C) 0.60 and 1.60.
D) 1.00 and 2.00.
Answer: C
Diff: 1
Keywords: Beta
35) A well-diversified portfolio includes investments in 50 securities. The portfolio's systematic risk is
likely to be about
A) 50% of the total risk.
B) 40% of the total risk.
C) 25% of the total risk.
D) zero because risk is eliminated with a portfolio of 50 securities or more.
Answer: B
Diff: 2
Keywords: Systematic Risk, Well-diversified Portfolio
22
36) Beta is a statistical measure of
A) unsystematic risk.
B) total risk.
C) the standard deviation.
D) the relationship between an investment's returns and the market return.
Answer: D
Diff: 1
Keywords: Beta
37) A stock's beta is a measure of its

A) unsystematic risk.
B) systematic risk.
C) company-unique risk.
D) diversifiable risk.
Answer: B
Diff: 1
Keywords: Beta, Systematic Risk
38) If you hold a portfolio made up of the following stocks:
Investment Value Beta

Stock X $4,000 1.5
Stock Y $5,000 1.0
Stock Z $1,000 .5
What is the beta of the portfolio?

A) 1.33
B) 1.24
C) 1.15
D) 1.00
Answer: C
Diff: 2
39) Which of the following is/are true?

A) Most of the unsystematic risk is removed by the time a portfolio contains 30 stocks.
B) Two points on the Characteristic Line are the T-bill and the market portfolio.
C) The greater the total risk of an asset, the greater the expected return.
D) All securities have a beta between 0 and 1.
Answer: A
Diff: 2
Keywords: Systematic Risk, Diversification
23
40) If we are able to fully diversify, what is the appropriate measure of risk to use?
A) expected return
B) standard deviation
C) beta
D) risk-free rate of return
Answer: C
Diff: 1
Keywords: Diversification, Beta
41) You hold a portfolio with the following securities:
Expected
Security Value Beta Return
Driscol Corporation 20% 3.20 36.0%
Evening Corporation 40% 1.60 20.0%
Frolic Corporation 40% .20 6.0%
What is the expected return for the portfolio?

A) 17.60%
B) 20.67%
C) 23.54%
D) 28.59%
Answer: A
Diff: 2
42) The prices for the National Gasworks Corporation for the second quarter of 2012 are given below. The
price of the stock on April 1, 2012 was $130. Find the holding period return for an investor who
purchased the stock on April 1, 2012 and sold it the last day of June 2012.
Month End Price

April $125.00
May 138.50
June 132.75
A) -4.2%
B) -3.7%
C) 2.1%
D) 3.7%
Answer: C
Diff: 2
Keywords: Holding Period Return
24
43) You must add one of two investments to an already well- diversified portfolio.
Returns = 15.8% Returns = 19.7%
Beta = 1.8 Beta = 1.5

A) Security A
B) Security B
C) Either security would be acceptable.
D) cannot be determined with information given
Answer: B
Diff: 2
Keywords: Well-diversified Portfolio, Risk-Return Trade Off, Beta
44) Beginning with an investment in one company's securities, as we add securities of other companies to
our portfolio, which type of risk declines?
A) systematic risk
B) market risk
C) non-diversifiable risk
D) unsystematic risk
Answer: D
Diff: 1
Keywords: Unsystematic Risk, Diversification
45) Assume that you expect to hold a $40,000 investment for one year. It is forecasted to have a year end
value of $42,000 with a 30% probability; a year end value of $48,000 with a 45% probability; and a year
end value of $60,000 with a 25% probability. What is the expected holding period return for this
investment?
A) 50%
B) 25%
C) 23%
D) 18%
Answer: C
Diff: 3
Keywords: Holding Period Return, Expected Return
25
46) Assume that you expect to hold a $20,000 investment for one year. It is forecasted to have a year end
value of $21,000 with a 30% probability; a year end value of $24,000 with a 45% probability; and a year
end value of $30,000 with a 25% probability. What is the standard deviation of the holding period return
for this investment?
A) 12.06%
B) 14.36%
C) 16.36%
D) 33.45%
Answer: C
Diff: 3
Keywords: Holding Period Return, Standard Deviation
47) You must add one of two investments to an already well- diversified portfolio.
Returns = 15.0% Returns = 11%
Beta = 1.5 Beta = 1.5

A) Security A
B) Security B
C) Either security would be acceptable.
D) cannot be determined with information given
Answer: A
Diff: 2
Keywords: Well-diversified Portfolio, Risk-Return Trade Off, Beta
48) Portfolio risk is typically measured by ________ while the risk of a single investment is measured by
________.
A) standard deviation; beta
B) security market line; standard deviation
C) beta; standard deviation
D) beta; slope of the characteristic line
Answer: C
Diff: 2
Keywords: Portfolio Risk, Beta, Standard Deviation
26
49) How can investors reduce the risk associated with an investment portfolio without having to accept a
lower expected return?
A) Wait until the stock market rises.
B) Increase the amount of money invested in the portfolio.
C) Purchase a variety of securities; i.e., diversify.
D) Purchase stocks that have exceptionally high standard deviations.
Answer: C
Diff: 1
Keywords: Diversification, Risk
50) Which of the following types of risk is diversifiable?

A) unsystematic, or company-unique risk
B) betagenic, or ecocentric risk
C) systematic risk
D) market risk
Answer: A
Diff: 1
Keywords: Diversifiable Risk, Unsystematic Risk
51) You purchased 500 shares of A.M.J. Inc. common stock one year ago for $50 per share. You received a
dividend of $2 per share today and decide to take your profits by selling at $54.50 per share. What is your
holding period return?
A) 13.0%
B) 9.0%
C) 6.5%
D) 4.0%
Answer: A
Diff: 2
Keywords: Holding Period Return, Dividends
52) Which of the following measures the average relationship between a stock's returns and the market's
returns?
A) coefficient of validation
B) standard deviation
C) geometric regression
D) beta coefficient
Answer: D
Diff: 1
Keywords: Beta
27
53) Assume that you have $165,000 invested in a stock whose beta is 1.25, $85,000 invested in a stock
whose beta is 2.35, and $235,000 invested in a stock whose beta is 1.11. What is the beta of your portfolio?
A) 1.37
B) 2.01
C) 1.85
D) 1.57
Answer: A
Diff: 2
54) Assume that you have $100,000 invested in a stock whose beta is .85, $200,000 invested in a stock
whose beta is 1.05, and $300,000 invested in a stock whose beta is 1.25. What is the beta of your portfolio?
A) 0.97
B) 1.02
C) 1.12
D) 1.21
Answer: C
Diff: 2
55) Which of the following statements is MOST correct regarding beta?

A) Beta must be calculated using at least 5 years of monthly returns data to be accurate.
B) Beta can only be measured properly using daily returns.
C) Beta for a particular company remains constant over time.
D) Even professionals may not agree on the measurement of beta.
Answer: D
Diff: 1
Keywords: Beta
56) What is diversifying among different kinds of assets known as?

A) portfolio funding
B) capital asset classification
C) asset allocation
D) multi-diversification
Answer: C
Diff: 2
Keywords: Asset Allocation, Diversification
28
1) The required rate of return for an asset is equal to the risk-free rate plus a risk premium.
Answer: TRUE
Diff: 1
Keywords: Required Rate of Return, Risk-free Rate, Risk Premium
2) The T-bill return is used in the CAPM model as the risk free rate.
Answer: TRUE
Diff: 1
Keywords: CAPM, T-bill, Risk-free Rate
3) The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in terms of
beta.
Answer: TRUE
Diff: 1
Keywords: CAPM, Risk-Return Trade Off, Beta
4) The S&P 500 index must be used as the measure of market return in the CAPM or the results are not
theoretically accurate.
Answer: FALSE
Diff: 1
Keywords: CAPM, S&P 500
5) According to the CAPM, for each unit of Beta an asset's required rate of return increases by the
market's return.
Answer: FALSE
Diff: 1
Keywords: CAPM, Beta, Required Return, Market Return
6) According to the CAPM, for each unit of Beta an asset's required rate of return increases by the
market's risk premium.
Answer: TRUE
Diff: 1
Keywords: CAPM, Beta, Required Return, Market Risk Premium
7) Stocks that plot above the security market line are underpriced because their expected returns exceed
their risk-adjusted required returns.
Answer: TRUE
Diff: 2
Keywords: Security Market Line
29
8) The capital asset pricing model
A) provides a risk-return trade off in which risk is measured in terms of the market volatility.
B) provides a risk-return trade off in which risk is measured in terms of beta.
C) measures risk as the coefficient of variation between security and market rates of return.
D) depicts the total risk of a security.
Answer: B
Diff: 2
Keywords: Capital Asset Pricing Model, Beta, Risk-Return Trade Off
9) A typical measure for the risk-free rate of return is the

A) U.S. Treasury Bill rate.
B) prime lending rate.
C) money market rate.
D) short-term AAA-rated bond rate.
Answer: A
Diff: 1
Keywords: Risk-Free Rate of Return, U.S. T-bill
10) If the Beta for stock A equals zero, then

A) stock A's required return is equal to the required return on the market portfolio.
B) stock A's required return is equal to the risk-free rate of return.
C) stock A has a guaranteed return.
D) stock A's required return is greater than the required return on the market portfolio.
Answer: B
Diff: 2
Keywords: Beta, Required Rate of Return, Security Market Line
11) The risk-free rate of interest is 4% and the market risk premium is 9%. Howard Corporation has a beta
of 2.0, and last year generated a return of 16% with a standard deviation of returns of 27%. The required
return on Howard Corporation stock is
A) 36%.
B) 34%.
C) 26%.
D) 22%.
Answer: D
Diff: 2
Keywords: Required Return, Beta, Security Market Line
30
12) Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta of 1.8 and a
standard deviation of returns of 18%. If the market risk premium increases, then
A) the required return on stock B will increase more than the required return on stock A.
B) the required returns on stocks A and B will both increase by the same amount.
C) the required returns on stocks A and B will remain the same.
D) the required return on stock A will increase more than the required return on stock B.
Answer: A
Diff: 2
Keywords: Beta, Security Market Line, Market Risk Premium
13) Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B has a beta of 1.8 and a
standard deviation of returns of 18%. If the risk-free rate of return increases and the market risk premium
remains constant, then
A) the required return on stock B will increase more than the required return on stock A.
B) the required returns on stocks A and B will both increase by the same amount.
C) the required returns on stocks A and B will not change.
D) the required return on stock A will increase more than the required return on stock B.
Answer: B
Diff: 2
Keywords: Beta, Security Market Line, Market Risk Premium, Risk-free Rate of Return

Amount
Invested
4,000 shares of Stock H $8,000 Beta = 1.3
7,500 shares of Stock I $24,000 Beta = 1.8
12,500 shares of Stock J $48,000 Beta = 2.2
The beta for the portfolio is

A) 1.99.
B) 1.77.
C) 1.45.
D) 1.27.
Answer: A
Diff: 1
Keywords: Beta, Portfolio, Security Market Line
31
Amount
Invested
8,000 shares of Stock A $16,000 Beta = 1.3
15,000 shares of Stock B $48,000 Beta = 1.8
25,000 shares of Stock C $96,000 Beta = 2.2
If the risk-free rate of return is 2% and the market risk premium is 7%, then the required return on the
portfolio is
A) 14.91%.
B) 15.93%.
C) 21.91%.
D) 23.93%.
Answer: B
Diff: 3
Keywords: Beta, Security Market Line, Portfolio, Required Return
16) Wendy purchased 800 shares of Robotics Stock at $3 per share on 1/1/09. Wendy sold the shares on
12/31/09 for $3.45. Genetics stock has a beta of 1.3, the risk-free rate of return is 3%, and the market risk
premium is 8%. The required return on Genetics Stock is
A) 13.4%.
B) 16.5%.
C) 17.6%.
D) 21.1%.
Answer: A
Diff: 1
Keywords: Required Return, Security Market Line, Beta, Market Risk Premium
17) Based on the security market line, Robo-Tech stock has a required return of 14% and Friendly
Insurance Company has a required return of 10%. Robo-Tech has a standard deviation of returns of 18%.
Therefore
A) Friendly must have a standard deviation of returns of less than 18% because Friendly is less risky than
Robo-Tech.
B) all rational investors will prefer Friendly over Robo-Tech.
C) for a well-diversified investor, Friendly is less risky than Robo-Tech.
D) the beta for Friendly must be greater than the beta for Robo-Tech because Friendly is the better buy for
a risk-averse investor.
Answer: C
Diff: 2
Keywords: Security Market Line, Well-diversified, Beta, Risk
32
18) Green Company stock has a beta of 2 and a required return of 23%, while Gold Company stock has a
beta of 1.0 and a required return of 14%. The standard deviation of returns for Green Company is 10%
more than the standard deviation for Gold Company. The expected return on the market portfolio
according to the CAPM is
A) 9%.
B) 10%.
C) 12%.
D) 14%.
Answer: D
Diff: 3
Keywords: CAPM, Security Market Line, Beta, Required Return
19) White Company stock has a beta of 2 and a required return of 23%, while Black Company stock has a
beta of 1.0 and a required return of 14%. The standard deviation of returns for White Company is 10%
more than the standard deviation for Black Company. The risk free rate of return according to the CAPM
is
A) 4%.
B) 5%.
C) 6%.
D) impossible to determine with the information given
Answer: B
Diff: 3
Keywords: CAPM, Security Market Line, Beta, Required Return
20) Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the
market risk premium is 7.5%, the risk-free rate of return is
A) 4.1%.
B) 3.4%.
C) 2.0%.
D) 1.5%.
Answer: D
Diff: 2
Keywords: CAPM, Security Market Line, Risk-free Rate of Return
21) Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the
risk free rate of return is 4.2%, the expected return on the market portfolio is
A) 21%.
B) 19.2%.
C) 13.4%.
D) 10.2%.
Answer: D
Diff: 2
Keywords: CAPM, Security Market Line, Risk-free Rate of Return, Market Portfolio
33
22) You are going to add one of the following three projects to your already well-diversified portfolio.
PROJECT 1 PROJECT 2
Standard Standard
Probability Return Deviation Beta Probability Return Deviation Beta
50% Chance 22% 12% 1.1 30% Chance 36% 19.5% 0.8
50% Chance -4% 40% Chance 10.5%
30% Chance -20%
PROJECT 3
Standard
Probability Return Deviation Beta
10% Chance 28% 12% 2.0
70% Chance 18%
20% Chance -8%
Assume the risk-free rate of return is 2% and the market risk premium is 8%. If you are a risk averse
investor, which project should you choose?
A) Project 1
B) Project 2
C) Project 3
D) Either Project 2 or Project 3 because the higher expected return on project 3 offsets its higher risk.
Answer: B
Diff: 3
Keywords: Beta, Risk-Return Trade Off, Expected Return, Security Market Line, Required Return
23) The appropriate measure for risk according to the capital asset pricing model is
A) the standard deviation of a firm's cash flows.
B) alpha.
C) the standard deviation of a firm's stock returns.
D) beta.
Answer: D
Diff: 1
Keywords: Beta, CAPM, Risk
24) Anchor Incorporated has a beta of 1.0. If the expected return on the market is 15%, what is the
expected return on Anchor Incorporated's stock?
A) 15%
B) 14%
C) 18%
D) cannot be determined without the risk free rate
Answer: A
Diff: 2
Keywords: Beta, Security Market Line
34
25) Decker Corp. common stock has a required return of 17.5% and a beta of 1.75. If the expected risk free
return is 3%, what is the expected return for the market based on the CAPM?
A) 11.29%
B) 14.29%
C) 13.35%
D) 15.27%
Answer: A
Diff: 2
Keywords: Beta, Security Market Line, Expected Return for the Market Portfolio
26) Wildings, Inc. common stock has a beta of 1.2. If the expected risk free return is 4% and the expected
market risk premium is 9%, what is the expected return on Wildings' stock?
A) 10.0%
B) 12.0%
C) 13.8%
D) 14.8%
Answer: D
Diff: 2
Keywords: Beta, Security Market Line, Market Risk Premium, Expected Return
27) You determine that LMN common stock has an expected return of 24%. LMN has a Beta of 1.5. The
risk-free rate is 5%, and the market expected return is 15%. Which of the following is most likely to
happen?
A) You and other investors will buy up LMN stock and its price will rise.
B) You and other investors will sell LMN stock and its return will fall.
C) You and other investors will buy up LMN stock and its return will rise.
D) You and other investors will sell LMN stock and its price will fall.
Answer: A
Diff: 2
Keywords: Security Market Line, Required Return, Expected Return
35
28) You hold a portfolio made up of the following stocks:
Investment Value Beta

Stock L $8,000 2.0
Stock M $18,000 1.5
Stock N $14,000 .4
If the market's expected return is 14%, and the risk free rate of return is 5%, what is the expected return of
the portfolio?
A) 17.010%
B) 16.700%
C) 15.935%
D) 14.698%
Answer: C
Diff: 2
Keywords: Security Market Line, Beta, Expected Return, Portfolio
29) Marble Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on the market
portfolio is 15% and the risk free rate is 4%. What is the risk premium on the market?
A) 5%
B) 6%
C) 9.00%
D) 11%
Answer: D
Diff: 1
Keywords: Security Market Line, Market Risk Premium
30) Marble Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on the market
portfolio is 15% and the risk free rate is 4%. According to CAPM, what is the required rate of return on
Collectible's stock?
A) 37.5%
B) 31.5%
C) 26.5%
D) 23.5%
Answer: B
Diff: 2
Keywords: Security Market Line, Beta, Required Rate of Return
36
31) You hold a portfolio with the following securities:
Percent Expected
Security of Portfolio Beta Return
Able Corporation 20% 3.20 36.0%
Baker Corporation 40% 1.60 20.0%
Charlie Corporation 40% .20 6.0%
What is the expected return for the market, according to the CAPM?
A) 14.0%
B) 13.8%
C) 12.0%
D) 10.0%
Answer: A
Diff: 3
Keywords: Expected Return on the Market, CAPM, Security Market Line, Beta
32) The beta of ABC Co. stock is the slope of

A) the security market line.
B) the characteristic line for a plot of returns on the S&P 500 versus returns on short-term Treasury bills.
C) the arbitrage pricing line.
D) the characteristic line for a plot of ABC Co. returns against the returns of the market portfolio for the
same period.
Answer: D
Diff: 2
Keywords: Beta, Characteristic Line
33) The rate on T-bills is currently 2%. Environment Help Company stock has a beta of 1.5 and a required
rate of return of 17%. According to CAPM, determine the return on the market portfolio.
A) 27.5%
B) 19.0%
C) 14.0%
D) 12.0%
Answer: D
Diff: 3
Keywords: T-bill, Beta, Security Market Line, CAPM
34) The return on the market portfolio is currently 12%. Mobile Phone Corporation stockholders require a
rate of return of 30% and the stock has a beta of 3.2. According to CAPM, determine the risk-free rate.
A) 9.80%
B) 6.50%
C) 4.64%
D) 3.82%
Answer: D
Diff: 3
Keywords: CAPM, Security Market Line, Risk-free Rate of Return
37
35) Which of the following is the slope of the security market line?
A) beta
B) one
C) It varies, and is steeper for riskier securities.
D) the market risk premium
Answer: D
Diff: 2
Keywords: Security Market Line, Market Risk Premium
36) What is the name given to the equation that financial managers use to measure an investor's required
rate of return?
A) the standard deviation
B) the capital asset pricing model
C) the coefficient of variation
D) the MIRR
Answer: B
Diff: 1
Keywords: CAPM
37) You are considering an investment in Citizens Bank Corp. The firm has a beta of 1.6. Currently, U.S.
Treasury bills are yielding 2.75% and the expected return for the S & P 500 is 14%. What rate of return
should you expect for your investment in Citizens Bank?
A) 11.15%
B) 15.39%
C) 16.75%
D) 20.75%
Answer: D
Diff: 2
Keywords: Security Market Line, Required Return
38
38) Answer the questions below using the following information on stocks A, B, and C.
A B C
Expected Return 20% 21% 10%
Standard Deviation 12% 10% 10%
Beta 1.8 2.2 0.8
Assume the risk-free rate of return is 3% and the expected market return is 12%
a. Calculate the required return for stocks A, B, and C.
b. Assuming an investor with a well-diversified portfolio, which stock would the investor want
to add to his portfolio?
c. Assuming an investor who will invest all of his money into one security, which stock will the investor
choose?
Answer:
a. Stock A: 3% + (12% - 3%)(1.8) = 19.2%
Stock B: 3% + (12% -3%)(2.2) = 22.8%
Stock C: 3% + (12% - 3%)(0.8) =10.2%
b. A well-diversified investor will select Stock A, which is the only stock with an expected return that
exceeds its required return.
c. Stock B is preferred because it has the highest expected return along with the lowest standard
deviation of returns.
Diff: 2
Keywords: Required Return, Security Market Line, Diversification, Risk-Return Trade Off
39) The expected return for the market portfolio is 13%, the expected return on U.S. Treasury Bills is 2%,
and the expected return on AAA-rated short-term corporate bonds is 7%. Calculate the required return
for a stock with a beta equal to 1.5.
Answer: 2% + (13% - 2%)(1.5) = 18.5%
Diff: 2
Keywords: Security Market Line, Beta, Required Return
40) Security A has an expected rate of return of 29.8 percent and a beta of 3.1. Security B has a beta of 1.70.
If the Treasury bill rate is 5 percent, what is the expected rate of return for Security B?
Answer: Use A to determine the market risk premium.
.298 = .05 + 3.1(market return - .05)
.248 = (3.1 × market return) - .155
.403/3.1 = .13 = market return
Return on B = .05 + 1.7(.13 - .05) = .186 = 18.6%
Diff: 3
Keywords: Security Market Line, Beta, Expected Return, Treasury Bill
39
41) Bankers Corp has a very conservative Beta of .7, while Biotech Corp has a Beta of 2.1. Given that the
T-bill rate is 5%, and the market is expected to return 15%, what is the expected return of Bankers Corp,
Biotech Corp, and a portfolio composed of 60% of Bankers Corp and 40% Biotech Corp?
a. Solve this problem first by weighting the Betas to calculate a portfolio Beta, and then using CAPM to
calculate the portfolio expected return.
b. Then solve the problem again by calculating the expected return of each asset and weighting those
returns to calculate the portfolio expected return.
c. Why is Biotech Corp's expected return NOT three times that of Bankers Corp?
Answer:
a.
Bp = .6 × .7 + .4 × 2.1) = 1.26
Kp = .05 + 1.26(.15 - .05) = .05 + .126 = .176
b.
KBankers = .05 + .7(.15 - .05) = .12
KBiotech = .05 + 2.1(.15-.05) = .26
Kp = (.6 × .12) + (.4 × .26) = .176
c. Beta is multiplied by the market risk premium only, so a stock with a beta three times that of another
stock will have three times the risk premium, not three times the total return.
Diff: 2
Keywords: Beta, Portfolio, Market Risk Premium, Security Market Line
42) Redesign Corp is considering a new strategy that would increase its expected return from 12% to
13.9%, but would also increase its beta from 1.2 to 1.8. If the risk free rate is 5% and the return on the
market is expected to be 10%, should Redesign change its strategy?
Answer: No. Currently the company's required return is 11% and the company is earning 12%. After the
changes, the company's required return would increase to 14%, but its expected return would increase to
only 13.9%. Thus, the increased return is not sufficient to justify the increase risk.
Diff: 2
Keywords: Risk-Return Tradeoff, CAPM, Security Market Line, Beta
40

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Chapter 6 The Meaning and Measurement of Risk and Return

5) Another name for an asset's expected rate of return is holding-period return.

Stock A's expected return is

Stock A's expected return is

11) Use the following data:

What is the expected return of your portfolio? Show all work.

Weighting individual stock return method:

Both approaches are equivalent.

State of the Economy Probability Stock W's Return

Stock W's standard deviation of returns is

State of the Economy Probability Stock W's Return

Stock W's standard deviation of returns is

State Return Probability

16) The relevant variable a financial manager uses to measure returns is

Probability Return (%)

a. Calculate the expected rate of return.

b. Std. Dev. = [(9.5 - 14.81)2(0.15) + (13.6 - 14.81)2(0.25)

25) You are considering the three securities listed below.

a. Calculate the expected return for each security.

2) Proper diversification generally results in the elimination of risk.

4) Diversifying among different kinds of assets is called asset allocation.

10) Total risk equals systematic risk plus unsystematic risk.

14) The Beta of a T-bill is zero.

15) The Beta of a T-bill is one.

19) The characteristic line for any well-diversified portfolio is horizontal.

If you are a risk-averse investor, which one is the better choice?

34) Most stocks have betas between

37) A stock's beta is a measure of its

38) If you hold a portfolio made up of the following stocks:

Investment Value Beta

What is the beta of the portfolio?

39) Which of the following is/are true?

41) You hold a portfolio with the following securities:

What is the expected return for the portfolio?

Month End Price

If you are a risk-averse investor, which one is the better choice?

If you are a risk-averse investor, which one is the better choice?

50) Which of the following types of risk is diversifiable?

55) Which of the following statements is MOST correct regarding beta?

56) What is diversifying among different kinds of assets known as?

9) A typical measure for the risk-free rate of return is the

10) If the Beta for stock A equals zero, then

14) An investor currently holds the following portfolio:

The beta for the portfolio is

Investment Value Beta

32) The beta of ABC Co. stock is the slope of

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