Test Bank For Principles of Corporate Finance 13th by Brealey

Test Bank for Principles of Corporate Finance 13th by Brealey
Test Bank for Principles of Corporate Finance 13th

by Brealey
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Principles of Corporate Finance, 13e (Brealey)
Chapter 7 Introduction to Risk and Return
1) Which of the following portfolios has the least risk?

A) A portfolio of Treasury bills
B) A portfolio of long-term U.S. government bonds
C) A portfolio of U.S. common stocks of small firms
D) A portfolio of U.S. common stocks of large firms
Answer: A
Difficulty: 1 Easy
Topic: Capital Markets
Learning Objective: 07-01 Over a Century of Capital Market History in One Easy Lesson
Bloom's: Understand
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
2) For long-term U.S. government bonds, which risk concerns investors the most?
A) Interest rate risk
B) Default risk
C) Market risk
D) Liquidity risk
Answer: A
Difficulty: 1 Easy
Bloom's: Understand
3) What has been the average annual real rate of interest on Treasury bills over the past 117 years
(from 1900 to 2017)?
A) Less than 2%
B) Between 2% and 3%
C) Between 3% and 4%
D) Greater than 4%
Answer: A
Difficulty: 1 Easy
Bloom's: Understand
1
Copyright 2020 © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior
written consent of McGraw-Hill Education.
4) What has been the average annual nominal rate of interest on Treasury bills over the past 117
years (1900-2017)?
A) Less than 1%
D) Greater than 3%
Answer: D
Difficulty: 1 Easy
Bloom's: Remember
5) What has been the average annual nominal rate of return on a portfolio of U.S. common stocks
over the past 117 years (from 1900 to 2017)?
A) Less than 2%
D) Greater than 11%
Answer: D
Difficulty: 1 Easy
Bloom's: Remember
6) One dollar invested in a portfolio of long-term U.S. government bonds in 1900 would have
grown in nominal value by the end of year 2017 to:
A) $719.
B) $66.
C) $74.
D) $293.
Answer: D
Difficulty: 2 Medium
Bloom's: Remember
2
7) One dollar invested in a portfolio of U.S. common stocks in 1900 would have grown in nominal
value by the end of year 2017 to
A) $47,661.
B) $245.
C) $74.
D) $6.
Answer: A
Bloom's: Remember
8) What has been the average annual rate of return in real terms for a portfolio of U.S. common
stocks between 1900 and 2017?
A) Less than 2%
D) Greater than 8%
Answer: D
Bloom's: Remember
9) Which portfolio has had the lowest average annual nominal rate of return during the 1900-2017
periods?
A) Portfolio of small U.S. common stocks
B) Portfolio of U.S. government bonds
C) Portfolio of Treasury bills
D) Portfolio of large U.S. common stocks
Answer: C
Bloom's: Remember
3
10) Which portfolio had the highest average annual return in real terms between 1900 and 2017?
A) Portfolio of U.S. common stocks
C) Portfolio of Treasury bills
D) None of the answers
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
11) A standard error measures

A) nominal annual rate of return on a portfolio.
B) risk of a portfolio.
C) reliability of an estimate.
D) real annual rate of return on a portfolio.
Answer: C
Difficulty: 1 Easy
Topic: Standard Deviation and Variance
Learning Objective: 07-02 Diversification and Portfolio Risk
Bloom's: Understand
12) Which of the following is an estimate of the standard error of the mean?
A) The average annual rate of return divided by the square root of the number of observations
B) The variance divided by the number of observations
C) The standard deviation of returns divided by the square root of the number of observations
D) The variance of returns divided by the square root of the number of observations
Answer: C
Difficulty: 1 Easy
Bloom's: Understand
4
13) Which portfolio has had the highest average risk premium during the period 1900-2017?
A) Common stocks
B) Government bonds
C) Treasury bills
D) None of the answers
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
14) If the standard deviation of annual returns is 19.8 percent and the number of years of
observation is 107, what is the standard error?
A) 4.23 percent
B) 1.91 percent
C) 0.47 percent
D) 19.8 percent
Answer: B
Explanation: Standard error = 19.8/ = 1.91%.
Difficulty: 1 Easy
Bloom's: Understand
15) If the average annual rate of return for common stocks is 11.7 percent, and 4.0 percent for U.S.
Treasury bills, what is the average market risk premium?
A) 15.7 percent
B) 4.0 percent
C) 7.7 percent
D) Not enough information is provided.
Answer: C
Explanation: Average risk premium: 11.7 - 4.0 = 7.7%.
Difficulty: 1 Easy
Topic: Risk Premium
Bloom's: Understand
5
16) Spill Drink Company's stocks had -8 percent, 11 percent, and 24 percent rates of return,
respectively, during the last three years; calculate the (arithmetic) average rate of return for the
stock.
A) 8 percent per year
B) 9 percent per year
C) 10 percent per year
D) 11 percent per year
Answer: B
Explanation: Average rate of return = (-8 + 11 + 24)/3 = 9%.
Difficulty: 1 Easy
Topic: Risk Premium
Bloom's: Understand
17) For log normally distributed returns, annual compound returns equal
A) the arithmetic average return minus half the variance.
B) the arithmetic average return plus half the variance.
C) the arithmetic average return minus half the standard deviation.
D) the arithmetic average return plus half the standard deviation.
Answer: A
Difficulty: 1 Easy
Topic: Cost of Capital - General
Bloom's: Understand
18) Which of the following provides a correct measure of the opportunity cost of capital regardless
of the timing of cash flows?
A) Arithmetic average
B) Geometric average
C) Hyperbolic mean
D) Opportunistic mean
Answer: A
Difficulty: 1 Easy
Bloom's: Understand
6
19) Assume the following data: Risk-free rate = 4.0 percent; average risk premium = 7.7 percent.
Calculate the required rate of return for the risky asset.
A) 5.6 percent
B) 7.6 percent
C) 11.7 percent
D) 30.8 percent
Answer: C
Explanation: Required rate of return = 4.0 + 7.7 = 11.7%.
Difficulty: 1 Easy
Bloom's: Remember
20) Which of the following countries has had the lowest risk premium?
A) United States
B) Denmark
C) Italy
D) Germany
Answer: B
Difficulty: 1 Easy
Bloom's: Remember
21) Which of the following countries has had the highest risk premium?
A) Germany
B) Denmark
C) United States
D) Switzerland
Answer: A
Bloom's: Understand
7
22) Mega Corporation has the following returns for the past three years: 7 percent, 13 percent, and
10 percent. Use the following formulas to calculate the variance of the returns and the standard
deviation of the returns:
Variance ( m) = expected value of ( m - rm)2
Standard deviation of m = .
A) 64.00 and 8.00 percent
B) 124.00 and 11.10 percent
C) 6.00 and 2.45 percent
D) 30.00 and 10.00 percent
Answer: C
Explanation: Mean = (7 + 13 + 10)/3 = 10%; Variance = [(7 – 10)^2 + (13 – 10)^2 +
(10 – 10)^2]/3 = 6;
Standard deviation = 6^(1/2) = 2.45%

Bloom's: Understand
8
23) Macro Corporation has had the following returns for the past three years: -10 percent, 10
percent, and 30 percent. Use the following formulas to calculate the standard deviation of the
returns:
Variance ( m) = expected value of ( m - rm)2
Standard deviation of m = .
A) 10.00 percent
B) 16.33 percent
C) 18.21 percent
D) 30.00 percent
Answer: B
Explanation: Mean = (-10 + 10 + 30)/3 = 10%.
Variance = [(-10 - 10)^2 + (10 - 10)^2 + (30 - 10)^2]/3 = 266.67.
Standard deviation = 16.33.

Bloom's: Understand
9
24) Sun Corporation has had returns of -6 percent, 16 percent, 18 percent, and 28 percent for the
past four years. Calculate the standard deviation of the returns using the correction for the loss of a
degree of freedom shown below.
When variance is estimated from a sample of observed returns, we add the squared deviations and
divide by N -1, where N is the number of observations. We divide by N -1 rather than N to correct
for a loss of a degree of freedom. The formula is
Variance( m ) =
Where m is the market return in period t and rm is the mean of the values of rmt.
A) 11.6 percent
B) 14.3 percent
C) 13.4 percent
D) 14.0 percent
Answer: B
Explanation: (-6 + 16 + 18 + 28)/4 = 14%.
Variance = [(-6 - 14)^2 + (16 - 14)^2 + (18 - 14)^2 + (28 - 14)^2]/(4 - 1) = 205.33.
Standard deviation = 205.33^(1/2) = 14.3%.

Difficulty: 1 Easy
Bloom's: Remember
25) Which portfolio had the highest standard deviation during the period between 1900 and 2014?
A) Common stocks
B) Government bonds
C) Treasury bills
D) None of the answers is correct.
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
10
26) What has been the approximate standard deviation of returns of U.S. common stocks during
the period between 1900 and 2017?
A) 19.7 percent
B) 33.4 percent
C) 8.9 percent
D) 2.8 percent
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
27) The standard deviation of U.S. returns, from 1995 to the financial crisis years later had
increased (approximately) by:
A) 20%.
B) 30%.
C) 40%.
D) 60%.
Answer: C
Difficulty: 1 Easy
Bloom's: Remember
28) A statistical measure of the degree to which securities' returns move together is called a
A) variance.
B) correlation coefficient.
C) standard deviation.
D) geometric average.
Answer: B
Difficulty: 1 Easy
Topic: Diversification
Bloom's: Remember
11
29) The type of the risk that can be eliminated by diversification is called
A) market risk.
B) unique risk.
C) interest rate risk.
D) default risk.
Answer: B
Difficulty: 1 Easy
Bloom's: Remember
30) Unique risk is also called

A) systematic risk.
B) non-diversifiable risk.
C) firm-specific risk.
D) market risk.
Answer: C
Difficulty: 1 Easy
Bloom's: Remember
31) Market risk is also called

A) systematic risk.
B) undiversifiable risk.
C) firm-specific risk.
D) systematic risk and undiversifiable risk.
Answer: D
Topic: Portfolio Return
Learning Objective: 07-03 Calculating Portfolio Risk
Bloom's: Understand
12
32) Stock A has an expected return of 10 percent per year and stock B has an expected return of 20
percent. If 40 percent of a portfolio's funds are invested in stock A and the rest in stock B, what is
the expected return on the portfolio of stock A and stock B?
A) 10 percent
B) 20 percent
C) 16 percent
D) 14 percent
Answer: C
Explanation: 0.40(10) + 0.60(20) = 16%.
Bloom's: Understand
33) As the number of stocks in a portfolio is increased,

A) unique risk decreases and approaches zero.
B) market risk decreases.
C) unique risk decreases and becomes equal to market risk.
D) total risk approaches zero.
Answer: A
Bloom's: Understand
13
34) Stock M and Stock N have had the following returns for the past three years: 12 percent, -10
percent, 32 percent; and 15 percent, 6 percent, 24 percent, respectively. Calculate the covariance
between the two securities. (Ignore the correction for the loss of a degree of freedom set out in the
text.)
A) -99
B) 126
C) +250
D) -250
Answer: B
Explanation: E(RM) = (12 - 10 + 32)/3 = 11.33%.
E(RN) = (15 + 6 + 24)/3 = 15%.
Cov(RM, RN) = [(12 - 11.33)(15 - 15) + (-10 - 11.33)(6 - 15) + (32 - 11.33)(24 - 15)]/3 = 126.
Bloom's: Understand
35) Stock P and Stock Q have had annual returns of -10 percent, 12 percent, 28 percent; and 8
percent, 13 percent, 24 percent, respectively. Calculate the covariance of return between the
securities. (Ignore the correction for the loss of a degree of freedom set out in the text.)
A) -149.00
B) +149.00
C) +99.33
D) -100.00
Answer: C
Explanation: E(P) = (-10 + 12 + 28)/3 = 10%; E(Q) = (8 + 13 + 24)/3 = 15%.
Cov(P,Q) = [(-10 - 10)(8 - 15) + (12 - 10) (13 - 15) + (28 - 10)(24 - 15)]/3 = 99.33.
Bloom's: Understand
14
36) Stock X has a standard deviation of return of 10 percent. Stock Y has a standard deviation of
return of 20 percent. The correlation coefficient between the two stocks is 0.5. If you invest 60
percent of your funds in stock X and 40 percent in stock Y, what is the standard deviation of your
portfolio?
A) 10.3 percent
B) 21.0 percent
C) 12.2 percent
D) 14.8 percent
Answer: C
Explanation: (0.6^2)(10^2) + (0.4^2) (20^2) + (2)(0.6)(0.4)(0.5)(10)(20) = 148; Standard
deviation = (148^0.5) = 12.2%.
Bloom's: Understand
37) If the correlation coefficient between the returns on stock C and stock D is +1.0, the standard
deviation of return for stock C is 15 percent, and that for stock D is 30 percent, calculate the
covariance between stock C and stock D.
A) +45
B) -450
C) +450
D) -45
Answer: C
Explanation: By definition, Cov(RC, RD) = (+1)(30)(15) = +450.
Bloom's: Understand
15
38) What range of values can correlation coefficients take?
A) Zero to + 1
B) -1 to + 1
C) -Infinity to + infinity
D) Zero to + infinity
Answer: B
Bloom's: Understand
39) If the covariance between stock A and stock B is 100, the standard deviation of stock A is 10
percent and that of stock B is 20 percent, calculate the correlation coefficient between the two
securities.
A) -0.5
B) +1.0
C) +0.5
D) 0.0
Answer: C
Explanation: By definition, Corr(RA, RB) = 100/(10 × 20) = +0.5.
Bloom's: Understand
40) For a two-stock portfolio, the maximum reduction in risk occurs when the correlation
coefficient between the two stocks equals
A) +1.0.
B) -0.5.
C) -1.0.
D) 0.0.
Answer: C
Topic: Risk and Diversification
Bloom's: Understand
16
41) For a portfolio of N-stocks, the formula for portfolio variance contains
A) N variance terms.
B) N(N - 1)/2 variance terms.
C) N2 variance terms.
D) N - 1 variance terms.
Answer: A
Bloom's: Understand
42) For a portfolio of N-stocks, the formula for portfolio variance contains
A) N covariance terms.
B) N(N - 1)/2 different covariance terms.
C) N2 covariance terms.
D) N - 1 covariance terms.
Answer: B
Topic: Beta
Learning Objective: 07-04 How Individual Securities Affect Portfolio Risk
Bloom's: Understand
43) Beta is a measure of

A) unique risk.
B) total risk.
C) market risk.
D) liquidity risk.
Answer: C
Topic: Beta
Bloom's: Understand
17
44) The beta of the market portfolio is
A) +1.0.
B) +0.5.
C) 0.0.
D) -1.0.
Answer: A
Topic: Beta
Bloom's: Understand
45) For each additional 1 percent change in market return, the return on a stock having a beta of 2.2
changes, on average, by
A) 1.00 percent.
B) 0.55 percent.
C) 2.20 percent.
D) 1.10 percent.
Answer: C
Topic: Beta
Bloom's: Understand
46) Which of the following portfolios will have the highest beta?
A) Portfolio of U.S. Treasury bills
C) Portfolio containing 50 percent U.S. Treasury bills and 50 percent U.S. government bonds
D) Portfolio of U.S. common stocks
Answer: D
Topic: Beta
Bloom's: Understand
18
47) If the standard deviation of returns on the market is 20 percent, and the beta of a
well-diversified portfolio is 1.5, calculate the standard deviation of this portfolio.
A) 30 percent.
B) 20 percent.
C) 15 percent.
D) 10 percent.
Answer: A
Explanation: All unique risk has been eliminated through diversification. Beta will measure the
remaining market risk. Standard deviation of the portfolio = (1.5) × (20) = 30%.
Difficulty: 3 Hard
Topic: Beta
Bloom's: Apply
48) The correlation coefficient between a stock and the market portfolio is +0.6. The standard
deviation of return of the stock is 30 percent and that of the market portfolio is 20 percent.
Calculate the beta of the stock.
A) 1.1
B) 1.0
C) 0.9
D) 0.6
Answer: C
Explanation: Cov(Rs, Rm) = (0.6)(20)(30) = 360; var(Rm) = 20^2 = 400.
Beta = [Cov(Rs, Rm)]/var(Rm) = 360/400 = 0.9.

Difficulty: 3 Hard
Topic: Beta
Bloom's: Understand
19
49) The historical nominal returns for stock A were -8 percent, +10 percent, and +22 percent. The
nominal returns for the market portfolio were +6 percent, +18 percent, and 24 percent during this
same time. Calculate the beta for stock A.
A) 1.64
B) 0.61
C) 1.00
D) 0.50
Answer: A
Explanation: Mean A = 8%; Mean M = 16%; Cov(Ra, Rm) = 138; Var(Rm) = 84.
Beta = 138/84 = 1.64.

Difficulty: 3 Hard
Topic: Beta
Bloom's: Understand
50) The annual returns for three years for stock B were 0 percent, 10 percent, and 26 percent.
Annual returns for three years for the market portfolio were +6 percent, 18 percent, and 24 percent.
Calculate the beta for the stock.
A) 0.75
B) 1.36
C) 1.00
D) 0.74
Answer: B
Explanation: Mean B = 12%, Mean M = 16%, Cov(Ra, Rm) = 114; Var(Rm) = 84.
Beta = 114/84 = 1.36.

Difficulty: 3 Hard
Topic: Beta
Bloom's: Understand
20
51) The correlation coefficient between stock B and the market portfolio is 0.8. The standard
deviation of stock B is 35 percent and that of the market is 20 percent. Calculate the beta of the
stock.
A) 1.0
B) 1.4
C) 0.8
D) 0.7
Answer: B
Explanation: Cov(Rb, Rm) = (0.8)(20)(35) = 560.
Beta = 560/400 = 1.4.

Topic: Beta
Bloom's: Understand
52) The covariance between Amazon stock and the S&P 500 is 0.05. The standard deviation of the
stock market is 20%. What is the beta of Amazon?
A) 0.00
B) 1.00
C) 1.25
D) 1.42
Answer: C
Explanation: Beta = .05/0.2^2 = 1.25.
Topic: Beta
Bloom's: Understand
21
53) What is the beta of a security where the expected return is double that of the stock market, there
is no correlation coefficient relative to the U.S. stock market, and the standard deviation of the
stock market is 0.18?
A) 0.00
B) 1.00
C) 1.25
D) 2.00
Answer: A
Explanation: No correlation means no covariance, thus no beta.
Topic: Beta
Bloom's: Understand
54) Treasury bills typically provide higher average returns, both in nominal terms and in real
terms, than long-term government bonds.
Answer: FALSE
Bloom's: Understand
55) A risk premium is the difference between a security's return and the Treasury bill return.
Answer: TRUE
Bloom's: Understand
22
56) For log normally distributed returns, the annual geometric average return is greater than the
arithmetic average return.
Answer: FALSE
Bloom's: Understand
57) According to the authors, a reasonable range for the risk premium in the United States is 5
percent to 8 percent.
Answer: TRUE
Bloom's: Understand
58) The standard statistical measures of the variability of stock returns are beta and covariance.
Answer: FALSE
Topic: Beta
Bloom's: Understand
59) Diversification reduces the risk of a portfolio because the prices of different securities do not
move exactly together.
Answer: TRUE
Bloom's: Understand
23
60) The portfolio risk that cannot be eliminated by diversification is called unique risk.
Answer: FALSE
Bloom's: Understand
61) The portfolio risk that cannot be eliminated by diversification is called market risk.
Answer: TRUE
Bloom's: Understand
62) The beta of a well-diversified portfolio is equal to the value weighted average beta of the
securities included in the portfolio.
Answer: TRUE
Topic: Beta
Bloom's: Understand
63) The average beta of all stocks in the market is zero.
Answer: FALSE
Topic: Beta
Bloom's: Understand
24
64) A portfolio with a beta of one offers an expected return equal to the market risk premium.
Answer: FALSE
Topic: Beta
Bloom's: Understand
65) Stocks with high standard deviations will necessarily also have high betas.
Answer: FALSE
Topic: Beta
Bloom's: Understand
66) Low standard deviation stocks always have low betas.
Answer: FALSE
Topic: Beta
Bloom's: Understand
67) A stock having a covariance with the market that is higher than the variance of the market will
always have a beta above 1.0.
Answer: TRUE
Topic: Beta
Bloom's: Understand
25
68) By purchasing U.S. government bonds, an investor can achieve both a risk-free nominal rate of
return and a risk-free real rate of return.
Answer: FALSE
Topic: Beta
Bloom's: Understand
69) A risk premium generated by comparing stocks to 10-year U.S. Treasury bonds will be smaller
than a risk premium generated by comparing stocks to U.S. Treasury bills.
Answer: TRUE
Bloom's: Understand
70) One can easily calculate the estimated risk premium on stocks via the statistical analysis of
historical stock returns.
Answer: FALSE
Bloom's: Understand
71) The standard deviation of a two-stock portfolio generally equals the value-weighted average of
the standard deviations of the two stocks.
Answer: FALSE
Bloom's: Understand
26
72) The covariance between the returns on two stocks equals the correlation coefficient multiplied
by the standard deviations of the two stocks.
Answer: TRUE
Bloom's: Understand
73) For the most part, stock returns tend to move together. Thus, pairs of stocks tend to have both
positive covariances and correlations.
Answer: TRUE
Bloom's: Understand
74) If returns on two stocks tended to move in opposite directions, then the covariances and
correlations on the two stocks would be negative.
Answer: TRUE
Bloom's: Understand
75) Diversification can reduce portfolio risk even in the case when correlations across stock
returns equal zero.
Answer: TRUE
Bloom's: Understand
27
76) The variability of a well-diversified portfolio mostly reflects the contributions to risk from the
standard deviations of the stocks within that portfolio.
Answer: FALSE
Bloom's: Understand
77) The risk of a well-diversified portfolio depends on the market risk of the securities included in
the portfolio.
Answer: TRUE
Bloom's: Understand
78) Define the term risk premium.
Answer: The difference between the security return and the risk-free rate, such as a Treasury bill
return, is called the risk premium. This denotes the additional return on the security to additional
risk.
Topic: Risk Premium
Bloom's: Understand
79) Regarding stock returns, briefly explain the term variance.
Answer: Variance is a standard statistical measure of spread. The variance is the expected
squared deviation from the expected return. From a finance point of view, this measures the total
risk of a portfolio: The higher the variance, the higher the risk of the portfolio. This is also called a
measure of total risk.
Bloom's: Understand
28
80) Briefly explain how diversification reduces risk.
Answer: Diversification reduces risk because prices of different securities do not move exactly
together. When you form portfolios using a large number of stocks, the variability of the portfolio
is much less than the average variability of individual stocks.
Bloom's: Understand
81) In the formula for calculating the variance of an N-stock portfolio, how many covariance and
variance terms are there?
Answer: In the formula for calculating the variance of an N-stock portfolio, there are [N(N – 1)]/2
different covariance terms and N variance terms.
Difficulty: 1 Easy
Bloom's: Understand
82) Briefly explain how the beta of a stock is estimated.
Answer: One can estimate the beta of a stock by plotting the market returns on the x-axis and the
corresponding stock returns on the y-axis. The slope of the resulting line of best fit is the beta
estimate for the stock. [βi = Cov(Ri, Rm)/Var(Rm)]
Topic: Beta
Bloom's: Understand
29
83) Briefly explain what the beta of a stock means.
Answer: For each additional 1 percent change in the market return, the return on the stock on
average changes by beta times 1 percent. For example, if the beta of IBM is 1.59, then for an
additional 1 percent change in the market return, the expected change in the return of IBM stock
will equal 1.59 percent.
Difficulty: 3 Hard
Topic: Beta
Bloom's: Understand
84) Discuss the importance of beta as a measure of risk.
Answer: Beta is a measure of market risk. It is also called the relative measure of risk as it
measures risk relative to the market portfolio. Beta is useful as a measure of risk in the context of
well-diversified portfolios. It measures the risk contribution of a single security to the portfolio.
Topic: Beta
Bloom's: Understand
85) Briefly explain the difference between beta as a measure of risk and variance as a measure of
risk.
Answer: Variance measures the total risk of a security and is a measure of stand-alone risk. Total
risk has both unique risk and market risk. In a well-diversified portfolio, unique risks tend to
cancel each other out and only market risk remains. Beta is a measure of market risk and is useful
in the context of a well-diversified portfolio. Beta measures the sensitivity of the security returns to
changes in market returns. The market portfolio has a beta of one and thus has average risk.
Topic: Beta
Bloom's: Understand
30
86) Briefly explain how individual securities affect portfolio risk.
Answer: The risk of a well-diversified portfolio depends on the market risk of the securities
included in the portfolio. Portfolio beta is the weighted average of individual security betas
included in the portfolio. Individual securities affect portfolio risk to the extent that they change
the beta of the portfolio.
Bloom's: Understand
87) What is the beta of a portfolio with a large number of randomly selected stocks?
Answer: The beta of a portfolio with a large number of randomly selected stocks equals one. The
standard deviation of such a portfolio is equal to the standard deviation of the market.
Topic: Beta
Bloom's: Understand
88) How can individual investors diversify?
Answer: A very simple way for an individual investor to diversify is to buy shares in a mutual
fund that holds a diversified portfolio.
Bloom's: Understand
31
Test Bank for Principles of Corporate Finance 13th by Brealey
89) Briefly explain the concept of value additivity.
Answer: If the capital market establishes a value PV(A) for asset A and PV(B) for asset B, the
market value of a firm that holds both these assets is given by PV(AB) = PV(A) + PV(B). This logic
can be extended for any number of assets.
Value additivity is also applicable to cash flows. We can add the present values of two separate
cash flows and get the present value of the combined cash flows. It can be stated as follows:
PV(A + B) = PV(A) + PV(B) and PV(A + B + C) = PV(A) + PV(B) + PV(C).
This idea can be extended for any number of cash flows.

Bloom's: Understand
90) Explain why international stocks may have high standard deviations but low betas.
Answer: Beta is traditionally measured relative to the S&P 500 index. As such, there may be a
weaker statistical relationship between the S&P 500 and an international stock. If these two assets
are mostly independent of one another, there is little chance they will have a statistically
significant covariance. With a low covariance, by definition, the stock will have a low beta. This
could occur even if the standard deviation of the beta is very high. This answer assumes that the
market risk in domestic stocks is largely independent of the market risk in international stocks.
Difficulty: 3 Hard
Topic: Beta
Bloom's: Understand
32
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1) Which of the following portfolios has the least risk?

11) A standard error measures

Variance ( m) = expected value of ( m - rm)2

Standard deviation = 6^(1/2) = 2.45%

Variance ( m) = expected value of ( m - rm)2

Standard deviation = 16.33.

Standard deviation = 205.33^(1/2) = 14.3%.

30) Unique risk is also called

31) Market risk is also called

33) As the number of stocks in a portfolio is increased,

E(RN) = (15 + 6 + 24)/3 = 15%.

43) Beta is a measure of

Beta = [Cov(Rs, Rm)]/var(Rm) = 360/400 = 0.9.

Beta = 138/84 = 1.64.

Beta = 114/84 = 1.36.

Beta = 560/400 = 1.4.

63) The average beta of all stocks in the market is zero.

66) Low standard deviation stocks always have low betas.

78) Define the term risk premium.

79) Regarding stock returns, briefly explain the term variance.

82) Briefly explain how the beta of a stock is estimated.

84) Discuss the importance of beta as a measure of risk.

88) How can individual investors diversify?

89) Briefly explain the concept of value additivity.

PV(A + B) = PV(A) + PV(B) and PV(A + B + C) = PV(A) + PV(B) + PV(C).

This idea can be extended for any number of cash flows.

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