Keown Tif 06 FINAL

CHAPTER 6
Risk and Rates of Return
True/False
1. By investing in different securities, an investor can lower his exposure to risk.

ANSWER: True
DIFFICULTY: Easy
KEYWORDS: diversification
2. Total risk equals unique security risk times systematic risk.

ANSWER: False
DIFFICULTY: Moderate
KEYWORDS: total risk
3. A security with a beta of zero has a required rate of return equal to the overall market rate of return.
ANSWER: False
KEYWORDS: security market line
4. The term structure of interest rates measures the relationship between a stock’s rate of return and length
of time to maturity.
ANSWER: False
KEYWORDS: term structure of interest rates
5. The market value of an asset is determined by the demand and supply forces working together in the
market.
ANSWER: True
KEYWORDS: market vale of an asset
6. The required rate of return for an asset is equal to the risk-free rate plus a risk premium.
ANSWER: True
KEYWORDS: required rate of return
7. Beta is a measurement of the relationship between a security’s returns and the general market’s returns.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: beta
8. 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
9. The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in terms of
1
beta.
ANSWER: True
KEYWORDS: CAPM
10. The relevant risk to an investor is that portion of the variability of returns that cannot be diversified
away.
ANSWER: True
KEYWORDS: relevant risk
11. The expected cash flow of an investment takes the condition of the economy into consideration.
ANSWER: True
KEYWORDS: expected cash flow
12. Stocks with higher betas are usually more stable than stocks with lower betas.
ANSWER: False
KEYWORDS: beta
13. A stock with a beta of 1.0 would earn the risk-free rate.
ANSWER: False
DIFFICULTY: Easy
KEYWORDS: risk-free rate, beta
14. Unsystematic risk can be eliminated through diversification.

ANSWER: True
DIFFICULTY: Easy
KEYWORDS: unsystematic risk
15. Beta is a measure of systematic risk.

ANSWER: True
DIFFICULTY: Easy
KEYWORDS: beta, systematic risk
16. The real rate of interest represents the nominal rate of interest plus the expected rate of inflation over
the maturity of a fixed income security.
ANSWER: False
KEYWORDS: real rate of interest
17. Cash flows should be used to measure returns for preferred stock and common stock; however,
accounting profits should be used to measure returns for debt.
ANSWER: False
KEYWORDS: cash flows versus accounting profits
18. The greater the dispersion of possible returns, the riskier is the investment.
2
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: standard deviation, risk
19. The market rewards assuming additional unsystematic risk with additional returns.
ANSWER: False
KEYWORDS: market reward, unsystematic risk
20. The market rewards assuming additional systematic risk with additional returns.
ANSWER: True
KEYWORDS: market reward, systematic risk
21. The slope of the characteristic line indicates the average movement in the stock price of a particular
firm in response to a movement in the general market.
ANSWER: True
KEYWORDS: characteristic line, beta
22. Betas for individual stocks tend to be stable.

ANSWER: False
KEYWORDS: beta
23. The minimum rate of return necessary to attract an investor to purchase a security is the investor’s
required rate of return.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: minimum rate of return
24. A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.
ANSWER: False
KEYWORDS: beta and risk
25. For the most part, there has been a positive relation between risk and return historically.
ANSWER: True
KEYWORDS: risk and return
26. Only investments in long-term corporate bonds have served as inflation hedges in the long run.
ANSWER: False
KEYWORDS: hedging inflation
27. The benefit from diversification is far greater when the diversification occurs across asset types.
ANSWER: True
3
28. Investing in foreign stocks is one way to improve diversification of a portfolio.
ANSWER: True
KEYWORDS: foreign securities and diversification
Multiple Choice
29. The capital asset pricing model:

a. provides a risk-return trade-off in which risk is measured in terms of the market returns.
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
KEYWORDS: CAPM
30. 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. beta.
d. probability of correlation.
ANSWER: c
DIFFICULTY: Easy
KEYWORDS: beta
31. The risk-return relationship for each financial asset is shown on:
a. the capital market line.
b. the New York Stock Exchange market line.
c. the security market line.
d. none of the above.
ANSWER: c
DIFFICULTY: Easy
32. You have invested in a project that has the following payoff schedule:
Probability of
Payoff Occurrence
$40 .15
$50 .20
$60 .30
$70 .30
$80 .05
What is the expected value of the investment’s payoff? (Round to the nearest $1.)
a. $60
b. $65
c. $58
d. $70
4
ANSWER: c
KEYWORDS: expected value
33. Which of the following investments is clearly preferred to the others?

Return Risk
A 18% 20%
B 20% 20%
C 20% 18%
a. Investment A
b. Investment B
c. Investment C
d. Cannot be determined
ANSWER: d
34. Which of the following investments is clearly preferred to the others?

Return Risk
A 14% 12%
B 22% 20%
C 18% 16%
a. Investment A
b. Investment B
c. Investment C
d. Cannot be determined
ANSWER: d
35. You are considering investing in Ford Motor Company. Which of the following is an example of
diversifiable risk?
a. Risk resulting from the possibility of a stock market crash
b. Risk resulting from uncertainty regarding a possible strike
against Ford
c. Risk resulting from an expected recession
d. Risk resulting from interest rates decreasing
ANSWER: b
KEYWORDS: diversifiable risk
36. You are considering investing in U.S. Steel. Which of the following is an example of nondiversifiable
risk?
a. Risk resulting from foreign expropriation of U.S. Steel property
b. Risk resulting from oil exploration by Marathan Oil (a U.S. Steel
subsidy)
c. Risk resulting from a strike against U.S. Steel
d. None of the above
5
ANSWER: d
KEYWORDS: nondiversifiable risk
37. You are considering buying some stock in Continental Grain. Which of the following is an example of
nondiversifiable risk?
a. Risk resulting from a general decline in the stock market
b. Risk resulting from a news release that several of Continental’s
grain silos were tainted
c. Risk resulting from an explosion in a grain elevator owned by
Continental
d. Risk resulting from an impending lawsuit against Continental
ANSWER: a
KEYWORDS: non-diversifiable risk
38. Sterling Incorporated has a beta of 1.0. If the expected return on the market is 12%, what is the
expected return on Sterling Incorporated’s stock?
a. 9%
b. 10%
c. 12%
d. Insufficient information is provided
ANSWER: c
KEYWORDS: expected return, CAPM
39. Siebling Manufacturing Company’s common stock has a beta of .8. If the expected risk-free return is
7% and the market offers a premium of 8% over the risk-free rate, what is the expected return on
Siebling’s common stock?
a. 7.8%
b. 13.4%
c. 14.4%
d. 8.7%
ANSWER: b
40. Huit Industries’ common stock has an expected return of 14.4% and a beta of 1.2. If the expected risk-
free return is 8%, what is the expected return for the market (round your answerwer to the nearest .
1%)?
a. 7.7%
b. 9.6%
c. 12.0%
d. 13.3%
ANSWER: d
6
41. Tanzlin Manufacturing’s common stock has a beta of 1.5. If the expected risk-free return is 9% and the
expected return on the market is 14%, what is the expected return on the stock?
a. 13.5%
b. 21.0%
c. 16.5%
d. 21.5%
ANSWER: c
42. Which of the following has a beta of zero?

a. A risk-free asset
b. The market
c. A high-risk asset
d. Both a & b
ANSWER: a
DIFFICULTY: Easy
KEYWORDS: beta, risk-free rate
43. If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a 40% chance
of getting a 12% return, and a 10% chance of getting an 8% return, what is the expected rate of return?
a. 12%
b. 13%
c. 14%
d. 15%
ANSWER: b
KEYWORDS: expected rate of return
44. The standard deviation for the above investment would be:
a. 2.24.
b. 2.56.
c. 2.83.
d. 2.98.
ANSWER: a
KEYWORDS: standard deviation
45. Beta is a statistical measure of:

a. hyperbolic.
b. total risk.
c. the standard deviation.
d. the relationship between an investment’s returns and the market return.
ANSWER: d
DIFFICULTY: Easy
KEYWORDS: beta
7
46. Given the capital asset pricing model, a security with a beta of 1.5 should return _____________, if the
risk-free rate is 6% and the market return is 11%.
a. 13.5%
b. 14.0%
c. 14.5%
d. 15.0%
ANSWER: a
KEYWORDS: required rate of return, CAPM
47. You are considering investing in a project with the following possible outcomes:
Probability of Investment
States Occurrence Returns
State 1: Economic boom 15% 16%
State 2: Economic growth 45% 12%
State 3: Economic decline 25% 5%
State 4: Depression 15% -5%
Calculate the expected rate of return and standard deviation of returns for this investment.
a. 9.8%, 7.0%
b. 7.0%, 43.6%
c. 8.3%, 6.6%
d. 8.3%, 16.1%
ANSWER: c
KEYWORDS: expected rate of return, standard deviation
48. A stock’s beta is a measure of its:

a. systematic risk.
b. unsystematic risk.
c. company-specific risk.
d. diversifiable risk.
ANSWER: a
DIFFICULTY: Easy
KEYWORDS: systematic risk, beta
49. If you hold a portfolio made up of the following stocks:

Investment Value Beta
Stock A $2,000 1.5
Stock B $5,000 1.2
Stock C $3,000 .8
What is the beta of the portfolio?
a. 1.17
b. 1.14
c. 1.32
d. Can’t be determined from information given
ANSWER: b
KEYWORDS: portfolio beta
8
50. 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 Deviation 12% Standard Deviation 19.5%
Probability Return Probability Return
50% Chance 20% 30% Chance 30%
50% Chance -4% 40% Chance 10%
30% Chance -20%
Project 3
Standard Deviation 12%
Probability Return
10% Chance 30%
40% Chance 15%
40% Chance 10%
10% Chance -21%
If you are a risk-averse investor, which one should you choose?
a. Project 1
b. Project 2
c. Project 3
ANSWER: c
KEYWORDS: choosing between investment alternatives
51. The security market line (SML) relates risk to return, for a given set of market conditions. If expected
inflation increases, which of the following would most likely occur?
a. The market risk premium would increase.
b. Beta would increase.
c. The slope of the SML would increase.
d. The SML line would shift up.
ANSWER: d
DIFFICULTY: Hard
KEYWORDS: shifts in the security market line, expected inflation
52. Changes in the general economy, such as changes in interest rates or tax laws, represent what type of
risk?
a. Firm-specific risk
b. Market risk
c. Unsystematic risk
d. Diversifiable risk
ANSWER: b
DIFFICULTY: Easy
KEYWORDS: market risk
53. The security market line (SML) relates risk to return, for a given set of market conditions. If risk
aversion increases, which of the following would most likely occur?
a. The market risk premium would increase.
b. Beta would increase.
c. The slope of the SML would increase.
9
d. The SML line would shift up.
ANSWER: a
DIFFICULTY: Hard
KEYWORDS: Shifts in the security market line, risk aversion
54. The Elvis Alive Corporation, makers of Elvis memorabilia, has a beta of 2.35. The return on the market
portfolio is 13%, and the risk-free rate is 7%. According to CAPM, what is the risk premium on a stock
with a beta of 1.0?
a. 11.75%
b. 18.75%
c. 6%
d. 13%
ANSWER: c
KEYWORDS: CAPM, risk premium
55. Bell Weather, Inc. has a beta of 1.25. The return on the market portfolio is 12.5%, and the risk-free rate
is 5%. According to CAPM, what is the required return on this stock?
a. 20.62%
b. 9.37%
c. 14.37%
d. 15.62%
ANSWER: c
56. A stock with a beta greater than 1.0 has returns that are __________ volatile than the market, and a
stock with a beta of less than 1.0 exhibits returns which are ____________ volatile than those of the
market portfolio.
a. more, more
b. more, less
c. less, more
d. less, less
ANSWER: b
KEYWORDS: beta, volatility of returns
57. You hold a portfolio with the following securities:

Percent
Security of Portfolio Beta Return
X Corporation 20% 1.35 14%
Y Corporation 35% .95 10%
Z Corporation 45% .75 8%
Compute the expected return and beta for the portfolio.
a. 10.67%, 1.02
b. 9.9%, 1.02
c. 34.4%, .94
d. 9.9%, .94
10
ANSWER: d
KEYWORDS: portfolio expected return, portfolio beta
58. The prices for the Guns and Hoses Corporation for the first quarter of 1992 are given below. Find the
holding period return for February.
Month End Price
January $135.28
February $119.40
March $141.57
a. 18.56%
b. 13.30%
c. -11.73%
d. 8.83%
ANSWER: c
KEYWORDS: holding period return
59. 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
KEYWORDS: security market line slope, beta
60. The rate on six-month T-bills is currently 5%. Andvark Company stock has a beta of 1.69 and a
required rate of return of 15.4%. According to CAPM, determine the return on the market portfolio.
a. 11.15%
b. 6.15%
c. 17.07%
d. 14.11%
ANSWER: a
KEYWORDS: return on market portfolio, CAPM
61. The return on the market portfolio is currently 13%. Battmobile Corporation stockholders require a rate
of return of 21%, and the stock has a beta of 3.5. According to CAPM, determine the risk-free rate.
a. 7%
b. 14.7%
c. 9.8%
d. 24.2%
11
ANSWER: c
DIFFICULTY: Hard
KEYWORDS: risk-free rate, CAPM
62. You are thinking of adding one of two investments to an already well diversified portfolio.
Security A Security B
Expected return = 12% Expected return = 12%
Standard deviation of returns = 20.9% Standard deviation of returns = 10.1%
Beta = .8 Beta = 2
If you are a risk-averse investor:
a. security A is the better choice.
b. security B is the better choice.
c. either security would be acceptable.
d. cannot be determined with information given.
ANSWER: a
KEYWORDS: choosing between investment alternatives, asset allocation
63. The market (systematic) risk associated with an individual stock is most closely identified with the:
a. variance of the returns of the stock.
b. variance of the returns of the market.
c. beta of the stock.
d. standard deviation of the stock.
ANSWER: c
KEYWORDS: beta, market risk
64. Of the following 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. U.S. Treasury bills
ANSWER: c
DIFFICULTY: Easy
KEYWORDS: risk and historical returns
65. Of the following alternative investments, which would be expected to have the highest return?
a. U.S. Treasury bonds
b. Common stocks of small firms
c. U.S. Treasury bills
d. Long-term corporate bonds
ANSWER: b
DIFFICULTY: Easy
KEYWORDS: historical returns
12
66. Of the following alternative investments, which would be expected to have the lowest return?
a. U.S. Treasury bonds
c. U.S. Treasury bills
ANSWER: c
DIFFICULTY: Easy
KEYWORDS: historical returns
67. Of the following alternative investments, which would be expected to have the lowest risk?
a. U.S. Treasury bills
c. U.S. Treasury bonds
ANSWER: a
DIFFICULTY: Easy
KEYWORDS: risk and historical returns
68. Which of the following is NOT an example of systematic risk?

a. Inflation
b. Recession
c. Management risk
d. Interest rate risk
ANSWER: c
DIFFICULTY: Easy
KEYWORDS: types of systematic risk
69. Wilson, Inc. is expecting the following returns on their stock and related probabilities. Calculate
Wilson’s expected return.
State Probability Return
Boom 30% 30%
Normal 70% 10%
a. 16%
b. 14%
c. 12%
d. 10%
ANSWER: a
KEYWORDS: expected return
83. Hefty stock has a beta of 1.2. If the risk-free rate is 7% and the market risk premium is 6.5%, what is
the required rate of return on Hefty?
a. 14.8%
b. 14.4%
c. 12.4%
d. 13.5%
13
ANSWER: a
70. What type of risk can investors reduce through diversification?

a. All risk
b. Systematic risk only
c. Unsystematic risk only
d. Uncertainty
ANSWER: c
KEYWORDS: unsystematic risk, diversification of risk
71. The market risk premium is measured by:

a. beta.
b. market return less risk-free rate.
c. T-bill rate.
d. standard deviation.
ANSWER: b
KEYWORDS: market risk premium, CAPM
Use the following information, which describes the possible outcomes from investing in a particular asset, to
answer questions 86 and 87.
State of the Economy Probability of the States Percentage Returns
Economic recession 25% 5%
Moderate economic growth 55% 10%
Strong economic growth 20% 13%
72. The expected return from investing in the asset is:

a. 9.00%.
b. 9.35%.
c. 10.00%.
d. 10.55%.
ANSWER: b
73. The standard deviation of returns is:

a. 8.00%.
b. 7.63%.
c. 4.68%.
d. 2.76%.
ANSWER: d
14
74. What is the expected rate of return for an investment that has the following expected scenario? If there
is an 18% probability of a recession, 2.0% return; if there is a 65% probability of a moderate economy,
9.5% return; if there is a 17% probability of a strong economy, 14.2% return.
a. 11.25%
b. 7.33%
c. 8.95%
d. 9.59%
ANSWER: c
75. What is the expected return on an investment that has the following expected scenario? If there is a
10% probability of a booming economy, $250 return; if there is a 70% probability of a moderate
economy, $154 return; if there is a 20% probability of a declining economy, $50 return.
a. $154.00
b. $142.80
c. $ 65.00
d. $ 15.12
ANSWER: b
Use the following information, which describes the expected return and standard deviation for three different
assets, to answer questions 90 and 91.
Asset X Asset Y Asset Z
Expected return 9.5% 8.8% 9.5%
Standard deviation 4.9% 5.5% 5.5%
76. If an investor must choose between investing in either Asset X or Asset Y, then:
a. she will always choose Asset X over Asset Y.
b. she will always choose Asset Y over Asset X.
c. she will be indifferent between investing in Asset X and Asset Y.
ANSWER: a
KEYWORDS: choosing between alternatives, risk and return
77. If an investor must choose between investing in either Asset X or Asset Z, then:
a. he will always choose Asset X over Asset Z.
b. he will always choose Asset Z over Asset X.
c. he will be indifferent between investing in Asset X and Asset Z.
ANSWER: a
KEYWORDS: choosing between alternatives, risk and return
15
78. Marjen stock has a required return of 20%. The expected market return is 15%, and the beta of
Marjen’s stock is 1.5. Calculate the risk-free rate.
a. 4%
b. 5%
c. 6%
d. 7%
ANSWER: b
79. Which of the following is not an example of factors that affect systematic risk?
a. Changes in general interest rates
b. A firm wins a lawsuit dealing with patent infringement
c. Our country declares war in the Persian Gulf
d. Environmental awareness increases throughout the country
ANSWER: b
KEYWORDS: systematic risk
80. Which of the following statements is true?

a. A stock with a beta of zero has a very low level of systematic risk.
b. A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.
c. A stock with a beta less than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.
d. A stock with a beta less than 1.0 has higher nondiversifiable risk than a stock with a beta of 1.0.
ANSWER: c
KEYWORDS: beta
81. You are thinking about purchasing 1,000 shares of stock in the following firms:
Number of Shares Firm’s Beta
Firm A 100 0.75
Firm B 200 1.47
Firm C 200 0.82
Firm D 600 1.60
If you purchase the number of shares specified, then the beta of your portfolio will be:
a. 1.16.
b. 1.35.
c. 1.00.
d. .85.
e. Cannot be determined with information given.
ANSWER: e
16
Use the following information to answer questions 97 to 100.
Beta
Market 1
Firm A 1.25
Firm B 0.6
Market Return 10% Risk Free Rate 2%
82. The market risk premium is:

a. 2%.
b. 4%.
c. 6%.
d. 8%.
ANSWER: d
KEYWORDS: market risk premium
83. Firm A’s risk premium is:

a. 2%.
b. 4%.
c. 6%.
d. 8%.
e. 10%.
ANSWER: e
KEYWORDS: risk premium
84. Firm B’s risk premium is:

a. 2.66%.
b. 4.8%.
c. 6.3%.
d. 8.1%.
ANSWER: b
KEYWORDS: risk premium
85. The required rate of return for Firm A is:

a. 4%.
b. 8%.
c. 12%.
d. 16%.
e. Cannot be determined with information given.
ANSWER: c
17
86. Currently, the expected return on the market is 12.5% and the required rate of return for Alpha, Inc. is
12.5%. Therefore, Alpha’s beta must be:
a. less than 1.0.
b. greater than 1.0.
c. equal to 1.0.
d. unknown based on the information provided.
ANSWER: c
KEYWORDS: beta, CAPM
87. Which of the following best measures the risk of holding an asset in isolation (i.e., stand-alone risk)?
a. The mean co-variance
b. The standard deviation
c. The coefficient of optimization
d. The standard asset pricing model
e. The omegatron
ANSWER: b
88. What is a practical measure that is used to quantify the risk of a single investment?
a. The systematic variation
b. The Fisher effect
c. The IRP
d. The standard deviation
ANSWER: d
89. What is the standard deviation of an investment that has the following expected scenario? If there is an
18% probability of a recession, 2.0% return; if there is a 65% probability of a moderate economy, 9.5%
return; if there is a 17% probability of a strong economy, 14.2% return.
a. 3.68%
b. 1.23%
c. 8.47%
d. 6.66%
ANSWER: a
90. You are considering investing in a firm that has the following possible outcomes:
18
Economic boom: probability of 25%; return of 25%
Economic growth: probability of 60%; return of 15%
Economic decline: probability of 15%; return of -5%
What is the expected rate of return on the investment?
a. 15.0%
b. 11.7%
c. 14.5%
d. 25.0%
ANSWER: c
KEYWORDS: expected rate of return
91. Investment risk is:

a. the probability of achieving a return that is greater than what was expected.
b. the probability of achieving a beta coefficient that is less than what was expected.
c. the probability of achieving a return that is less than what was expected.
d. the probability of achieving a standard deviation that is less than what was expected.
ANSWER: c
KEYWORDS: investment risk
92. Which of the following best measures the risk of holding an asset as part of a properly diversified
portfolio?
a. The mean co-variance
b. The standard asset pricing model
c. The coefficient of optimization
d. The beta coefficient
ANSWER: d
KEYWORDS: beta
93. Calculate the current beta for Mercury, Inc. The rate on 30-year U.S. Treasury bonds is currently 8%.
The market risk premium is 5%. Mercury returned 18% to its stockholders in the latest year.
a. 1.00
b. 1.75
c. 1.25
d. 2.00
e. 1.50
ANSWER: d
KEYWORDS: beta, CAPM
94. Which of the following is an adequate method of achieving portfolio diversification?
19
a. Invest in various bonds and stocks.
b. Invest in stocks of different industries.
c. Invest internationally.
d. All of the above.
e. None of the above.
ANSWER: d
DIFFICULTY: Easy
95. You have been employed by Telemetry Medical Instruments (TMI) for seven years and participate in
their 401 (k) plan by having 5% of your paycheck invested in the plan. You have been so impressed
with the performance of the company’s stock that you currently have all of your 401 (k) money
invested in TMI’s common stock. What does prudent investment management suggest that you do
about risk?
a. Close out your 401 (k) and put the money in the bank.
b. Increase your payroll deduction from 5% to 10% but keep all funds invested in TMI.
c. Close out your 401 (k) and invest in T-bills.
d. Take some of your investment out of TMI’s common stock and invest it in the stocks and bonds of
other firms.
ANSWER: d
96. You bought Chemtron stock for $45 a year ago. It is selling for $54 today. What is your holding period
return?
a. 9%
b. 11%
c. 6%
d. 20%
ANSWER: d
KEYWORDS: holding period return
97. You purchased the stock of Sargent Motors at a price of $75.75 one year ago today. If you sell the stock
today for $89.00, what is your holding period return?
a. 35.00%
b. 12.50%
c. 17.50%
d. 25.00%
ANSWER: c
98. The rate of return on the S&P 500 is 16.2%. Epsilon has a beta of 1.85. If the T-bond rate is 5.9%, what
20
should investors expect as a rate of return on Epsilon’s stock?
a. 16.2%
b. 22.1%
c. 18.5%
d. 25.0%
ANSWER: d
99. Which of the following statements is correct?

a. Portfolio diversification reduces the variability of the returns on the individual stocks held in a
portfolio.
b. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification,
we would expect Portfolio B to have lower risk.
c. If an investor buys enough stocks, he or she can, through diversification, eliminate all market risk.
d. Diversification can be achieved by purchasing stocks that are perfectly positively correlated.
ANSWER: b
KEYWORDS: portfolio diversification

a. Systematic, or market, risk can be reduced through diversification.
b. Both systematic and unsystematic risk can be reduced through diversification.
c. Unsystematic, or company, risk can be reduced through diversification.
d. Neither systematic nor unsystematic risk can be reduced through diversification.
ANSWER: c
KEYWORDS: unsystematic risk, company-specific risk

a. An average stock has a beta of 1.0.
b. A stock having a beta of greater than 1.0 is a higher-than-average-risk stock.
c. A stock having a beta of less than 1.0 is a lower-than-average-risk stock.
d. All of the above.
e. None of the above.
ANSWER: d
KEYWORDS: beta
102. Which of the following is a good measure of the relationship between an investment’s returns and the
market’s returns?
a. The beta coefficient
b. The standard variation
c. The CPI
d. The S&P 500 Index
ANSWER: a
21
KEYWORDS: beta
103. Which of the following is generally used to measure the market when calculating betas?
a. The Dow Jones Transportations
b. The Standard & Poors 500
c. The Value Line Quantam Index
d. The Lehman Brothers Bond Index
ANSWER: b
KEYWORDS: market return
104. Your broker mailed you your year-end statement. You have $25,000 invested in Dow Chemical,
$18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The annualized returns for
these stocks is 16.5% for Dow, 12.0% for GM, 18.5% for Microsoft, and 15.3% for Nike. What is the
return of your entire portfolio?
a. 15.60%
b. 18.55%
c. 16.25%
d. 9.00%
ANSWER: c
KEYWORDS: portfolio return
105. Your broker mailed you your year-end statement. You have $25,000 invested in Dow Chemical,
$18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The betas for each of your
stocks are 1.55 for Dow, 1.12 for GM, 2.39 for Microsoft, and .76 for Nike. What is the beta of your
portfolio?
a. 1.46
b. 1.70
c. 2.60
d. 0.41
ANSWER: b
106. You are considering a portfolio of three stocks with 30% of your money invested in company X, 45%
of your money invested in company Y, and 25% of your money invested in company Z. If the betas for
each stock are 1.22 for company X, 1.46 for company Y, and 1.03 for company Z, what is the portfolio
beta?
a. 1.24
b. 1.00
c. 1.28
d. 1.33
ANSWER: c
107. The risk-free rate is currently 6.5%. Acid Battery Company stockholders require a rate of return of
27.5%, and the stock has a beta of 2.1. What is the current market risk premium?
22
a. 6.90%
b. 21.00%
c. 13.65%
d. 10.00%
ANSWER: d
KEYWORDS: market risk premium
108. U.S. Treasury bonds currently yield 6%. Consolidated Industries stock has a beta of 1.5. The rate of
return on the S&P 500 is presently 18%. What is the rate of return that Consolidated Industries
stockholders require?
a. 6%
b. 24%
c. 18%
d. 27%
ANSWER: b
109. Amalgamated Aluminum stock has a beta of 1.2. Today’s market risk premium is 13%. Amalgamated
Aluminum stockholders require a rate of return of 22%. What is the present risk-free rate?
a. 6.40%
b. 22.00%
c. 4.60%
d. 15.60%
ANSWER: a
110. If investors expected inflation to increase in the future, what would happen to the security market line
(SML)?
a. The slope of the SML would rise.
b. The SML would shift downward, but the slope would remain the same.
c. The slope of the SML would fall.
d. The SML would shift up, but the slope would remain the same.
ANSWER: d
111. What would happen if investors became more risk averse?

a. The slope of the SML would rise.
b. The SML would shift downward but the slope would remain the same.
c. The slope of the SML would fall.
d. The SML would shift downward and the slope of the SML would fall.
ANSWER: a
23
112. According to the experts, a model portfolio should consist of a mix of securities that over the long run
should look something like this: cash or money market accounts, 5%; bonds, 25%; domestic stocks,
35%; international stocks, 35%. What is the determination of the proportions of various securities
within a portfolio referred to as?
a. Risk assessment
b. Capital asset modeling
c. Beta selection
d. Portfolio regression
e. Asset allocation
ANSWER: e
KEYWORDS: asset allocation
Short Answer
113. Briefly discuss why there is no reason to believe that the market will reward investors with additional
returns for assuming unsystematic risk.
ANSWER:
Through diversification, risk can be lowered without sacrificing returns. The market rewards investors
for the systematic risk that cannot be eliminated through proper asset allocation in a diversified
portfolio.
114. Provide an intuitive discussion of beta and its importance for measuring risk.
ANSWER: Beta is an important measure that indicates the systematic risk of a given investment. Since
systematic risk cannot be diversified away, investors are compensated for taking this risk.
KEYWORDS: beta as a measure of risk
115. You are considering a security with the following possible rates of return:
Probability Return (%)
0.20 9.6
0.30 12.0
0.30 14.4
0.20 16.8
a. Calculate the expected rate of return.
b. Calculate the standard deviation of the returns.
ANSWER:
a. R = (0.2)(9.6) + (0.3)(12.0) + (0.3)(14.4) + (0.2 )(16.8) = 13.2%
24
b. s(R) = [(9.6 - 13.2)2 (0.2) + (12 - 13.2)2(0.3)
+ (14.4 - 13.2)2(0.3) + (16.8 - 13.2)2(0.2)]1/2 = 2.459%
KEYWORDS: expected return and standard deviation
116. The return for the market during the next period is expected to be 16%; the risk-free rate is 10%.
Calculate the required rate of return for a stock with a beta of 1.5.
ANSWER: K = 10% + 1.5(16% - 10%) = 19%

KEYWORDS: required return, CAPM
117. Asset A has a required return of 18% and a beta of 1.4. The expected market return is 14%. What is the
risk-free rate? Plot the security market line.
ANSWER:
K = Krf + (Km-Krf)b
18% = X + (14% - X)1.4
18% - X =19.6% - 1.4X
.4X = 1.6%
X = 4% = Risk-free Rate = Krf
DIFFICULTY: Hard
KEYWORDS: risk-free rate, CAPM, SML
118. The stock of the Preston Corporation is expected to pay a dividend of $6 during the coming year.
Dividends are expected to grow far into the future at 8%. Investors have recently evaluated future
market return variance to be 0.0016 and the covariance of returns for Preston and the market as
0.00352. Assuming a required market return of 14% and a risk-free rate of 6%, at what price should the
stock of Preston sell?
ANSWER:
Beta = 0.00352/0.0016 = 2.2
K = 0.06 + 2.2(0.14 - 0.06)
K = 0.236
P = $6/(0.236 - 0.08) = $6/0.156 = $38.46
DIFFICULTY: Hard
KEYWORDS: stock price and beta
119. Security A has an expected rate of return of 22% and a beta of 2.5. Security B has a beta of 1.20. If the
Treasury bill rate is 10%, what is the expected rate of return for security B?
ANSWER:
RA = RF + BA(Rm - Rf)
.22 = .10 + 2.5 (Rm - .10)
.12 = 2.5 (Rm - .10) = 2.5 Rm - .25
.37 = 2.5 Rm
.148 = Rm
RB = Rf + BB(Rm - Rf)
RB = .10 + 1.20(.148 - .10)
RB = .1576
25
KEYWORDS: expected rate of return, CAPM
120. Using the following information for McDonovan, Inc.’s stock, calculate their expected return and
standard deviation.
State Probability Return
Boom 20% 40%
Normal 60% 15%
Recession 20% (20%)
ANSWER: Ki = (Ki)(Pi) = (.20)(40%) + (.60)(15%) + (.20)(-20%)

= 8% + 9% - 4% = 13%
i = ( (Ki – K )2Pi).5
i = ((40%-13%)2(.2) + (15%-13%)2 (.6) + (-20%-13%)2 (.2)).5 = 19.13%
KEYWORDS: expected return, standard deviation
121. AA & Co. has a beta of .656. If the expected market return is 13.2% and the risk-free rate is 5.7%, what
is the appropriate required return of AA & Co. using the CAPM model?
ANSWER:
Required Rate of Return = Risk-Free Rate + (Market Return - Risk-Free Rate) × Beta = 5.7% + (13.2%
- 5.7%) × 0.656 = 10.62%
KEYWORDS: required return, CAPM
122. Given the anticipated rate of inflation (i) of 6.3% and the real rate of interest (R) of 4.7%, find the
nominal rate of interest (r).
ANSWER:
r = R + i + iR
r = .047 + 0.63 + (.063)(.047)
r = 11.3%
KEYWORDS: anticipate rate of inflation
123. If provided the nominal rate of interest (r) of 14.2% and the anticipated rate of inflation (i) of 5.5%,
what is the real rate of interest (R)?
ANSWER:
r = R + i + iR
.142 = R + .055 + (.055)(R)
.142 - .055 = 1.055R + .055 - .055
.087 = 1.055R
R = 8.2%
KEYWORDS: real rate of interest
124. Given the anticipated rate of inflation (i) of 6.13% and the real rate of interest (R) of 7.56%, what is the
true inflation premium?
26
ANSWER: We know the inflation premium to equal i + iR or = 0.613 + (.0613)(.0756) = 6.59%
KEYWORDS: inflation premium
27

Keown Tif 06 FINAL

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Keown Tif 06 FINAL

Uploaded by

Copyright:

Available Formats

CHAPTER 6

Risk and Rates of Return

1. By investing in different securities, an investor can lower his exposure to risk.

2. Total risk equals unique security risk times systematic risk.

14. Unsystematic risk can be eliminated through diversification.

15. Beta is a measure of systematic risk.

22. Betas for individual stocks tend to be stable.

29. The capital asset pricing model:

33. Which of the following investments is clearly preferred to the others?

34. Which of the following investments is clearly preferred to the others?

42. Which of the following has a beta of zero?

45. Beta is a statistical measure of:

48. A stock’s beta is a measure of its:

49. If you hold a portfolio made up of the following stocks:

57. You hold a portfolio with the following securities:

59. The beta of ABC Co. stock is the slope of:

68. Which of the following is NOT an example of systematic risk?

70. What type of risk can investors reduce through diversification?

71. The market risk premium is measured by:

72. The expected return from investing in the asset is:

73. The standard deviation of returns is:

80. Which of the following statements is true?

Market Return 10% Risk Free Rate 2%

82. The market risk premium is:

83. Firm A’s risk premium is:

84. Firm B’s risk premium is:

85. The required rate of return for Firm A is:

91. Investment risk is:

94. Which of the following is an adequate method of achieving portfolio diversification?

99. Which of the following statements is correct?

100. Which of the following statements is true?

101. Which of the following statements is true?

111. What would happen if investors became more risk averse?

ANSWER: K = 10% + 1.5(16% - 10%) = 19%

ANSWER: Ki = (Ki)(Pi) = (.20)(40%) + (.60)(15%) + (.20)(-20%)

You might also like