Ch 13: Return, Risk, and the Security Market Line

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1. 2 components of unexpected *unsystematic portion 9. Asset X: E=5.8%, β=.8 (E(R∨A)-R∨f) / β∨A =

return (U) in the total return *systematic portion Asset Y: E=14.2%,
equation? β=1.8 (14.2%-1%) / 1.8 = 7.3%
2. *ABC has a beta(β) of 2.5 22%
*XYZ has a beta(β) of 1.5 If the risk free rate is
*The risk-free rate is 4% and 1%, what is the
the market premium is 9% reward-to-risk ratio
for Asset Y?
What is the expected return on 10. A stock has a beta of *E(Ri) = Rf + (E(R∨M) - Rf) x βi
a portfolio that is equally 1.28, the expected
invested in ABC and XYZ? return on the market is E(Ri) = .045 + (.12-.045)(1.28)
3. According to the CAPM, event *a change in the yield 12 percent, and the = .141 or 14.1%
that would affect the return on on T-bills risk-free rate is 4.5
a risky asset? *Federal reserve percent. What must the
actions that affect the expected return on this
economy stock be?
*A strengthening of the 11. A stock has an *E(R) = Rf =+ (Mrp) x
country's currency expected return of 12 Beta
4. An investment will have a less than what the percent, the risk-free
negative NPV when its financial markets offer rate is 3.5 percent, and .12 = .035 + (.05) x Beta
expected return is for the same risk the market risk Beta = .085 / .05
premium is 5 percent. Beta = 1.7
5. An uncertain or risky return The portion of the What must the beta of
return that depends on this stock be?
information that is
12. Capital Asset Pricing *The equation of the SML
currently unknown
Model (CAPM) (E(R∨f + [E(R∨M) - R∨f] x β∨i)
6. A security has, CAPM: E(R) = Rf + showing the relationship
Beta: 1 (Mrp) x Beta between expected return and
Market risk prem (Mrp): 8% beta.
Risk-free rate (Rf): 3% E(R) = .03 + (.08) x 1 =
.11 1. The pure time value of
What will happen to the money: As measured by the
expected return if the beta E(R) = .03 + (.08) x 2 = risk-free rate, Rf, this is the
doubles? .19 reward for merely waiting for
your money, without taking
The expected return any risk.
will increase to 19%
from 11% 2. The reward for bearing
7. As more securities are added *It may eventually be systematic risk: As measured
to a portfolio, the portfolio's almost totally by the market risk premium,
unsystematic risk is affected eliminated E(R∨M) − R∨f, this component
in what way? *It is likely to decrease is the reward the market offers
for bearing an average amount
8. *Asseta A and B each have an Asset A of systematic risk in addition
expected return of 10%. to waiting.
*Asset A has a standard *Asset A offers the
deviation of 12% same return at a lower 3. The amount of systematic
*Asset B has standard level of risk risk: As measured by βi, this is
deviation of 13%. the amount of systematic risk
present in a particular asset or
Which asset would a rational portfolio, relative to that in an
investor choose? average asset.
13. Capital Asset E(R) = Rf =+ (Mrp) x 19. Examples of unsystematic Affects a single asset or a
Pricing Model Beta risks faced by a firm? small group of assets.
(CAPM) for
Beta Risks that are unique to
14. Capital Asset E(Ri) = Rf + (E(R∨M) - Rf) x βi individual companies or
Pricing Model assets are sometimes
(CAPM) for called unique or asset-
the Expected specifi risks.
return on the
stock i.e.,
*Announcement of an oil
15. Cost of The minimum required return on a new strike by a company will
Capital project when its risk is similar to that of primarily affect that
projects the firm currently owns is known company and, perhaps, a
as the: few others (such as primary
16. Diverisifiable, more securities are added to the competitors and suppliers).
Uniqu, or protfolio *A hostile takeover attempt
Unsystematic by a competitor
risk is *The death of the CEO
reduced as 20. Expected Return The return on a risky asset
17. Examples of Affected by information that will be expected in the future
information revealed in the near future (NOT 21. Factors that determine a *Expected return and
that may historical information) stock's total return Unexpected return
impact the
risky return *The outcome of an application currently Total return = Expected
of a stock pending with the Food and Drug return + Unexpected return
Administration
*News about Flyers research R = E(R)+U
*The results from the latest arms control
talks 22. Historical return data declines
*The news that Flyers sales figures are indicates that as the
higher than expected number of securities in a
*A sudden, unexpected drop in interest portfolio increases, the
rates standard deviation of
returns for the portfolio:
18. Examples of *Uncertainties about general economic
23. How can a positive The difference between the
systematic conditions including GDP, interest rates,
risks faced or inflation relationship between the return on the market and
by a firm? expected return on a the risk-free rate is likely
*An unanticipated increase, or surprise, security and its beta be to be positive
in inflation, for example, affects wages justified?
and the costs of the supplies that 24. If a security's expected 1
companies buy; it affects the value of the return is equal to the
assets that companies own; and it affects expected return on the
the prices at which companies sell their market, its beta must be
products. Forces such as these, to which 25. If the variance of a Increase
all companies are susceptible, are the portfolio increases, then
essence of systematic risk. the portfolio standard
deviation will
26. If you want to create a You must invest in stocks
portfolio of stocks, what of more than one
is the required miniumum corporation
of stocks?
27. John's portfolio consists of 75% 33. systemactic risk matters When an investor is
$1,200 worth of Chi Corp devisified only
common stock and $400 worth
of Lambda Corp common stock. *affects almosts all asets
in the economy to some
Lambda's portfolio weight is defree
25%.
i.e.,
What is Chi's portfolio weight? *an increase in the
28. Portfolio *when investors own corporate tax rate
more than a single *an increase in the
stock, bond, or Federal funds rate
other asset 34. Systematic risk Unaffected by adding
securities to a portfolio
*investing $100,000 35. Systematic Risk Principal The expected return on
in a combination of a risky asset depends
stocks and bonds only on that asset's
systematic risk
*investing $100,000
in a combination of 36. The calculation of a portfolio a portfolio expected
US and Asian stocks beta is similar to the return
calculation of:
*investing $100,000 37. The equation for the capital Expected return on
in the stocks of 50 asset pricing model (CAPM) security (E(Ri)) = Risk-
publicly traded free rate (Rf) + Beta (βi)
corporations x (Return on market
29. Portfolio Weight The percentage of a (E(R∨M)) - Risk-free
portfolio's total rate(Rf))
value that is 38. The risk of owning an asset *surprises
invested in a comes from: *unanticipated events
particular asset.
39. The size of the risk premium how a risky asset is
30. Risk premium =Expected return - is useful for understanding: determined .
Risk-free rate
40. The systematic risk principal that are borne
The additional argues that the market does unnecessarily
compensation for not reward risks:
taking risk, over and 41. The weighted average of the 12.9% = .50 x 12.9(2)
above the risk-free standard deviations of the = 50 x .258
rate assets in Portfolio C is
31. Security Market Line (SML) Relationship 12.9%. What is the possible or 10.9%
between risk and value for the standard
return deviation of the portfolio? *The standard deviation
of a portfolio is less
32. Standard Deviation *the square root of than or equal to the
the variance weighted average of the
standard deviations of
the assets in the
portfolio.
42. The weighted average of 10.9% or 12.9% 49. Variance and Standard *measures the volatility of
the standard deviations of Deviation returns
the assets in Portfolio C is The standdard deviation
12.9%. What is the value for of a portfolio is less than *uses unequal probabilities
the standard deviation of or equal to the weighted for the entire range of
the portfolio? average of the standard possible outcomes
deviations of the assets
in the portfolio *Weighted average of
43. To calculate variance for multiply each possible squared deviations
two stocks, after squared deviation by its
determining the squared probability *Variance= σ² = ∑(X-µ)² / N
deviation from the expected 50. What does the security *Describes the relationship
returns one needs to market line depict? between systematic risk and
44. Two components of the *the risk-free rate (R∨F) expected return in financial
expected return on the *The risk premium markets
market (R⁻∨M)?
*Graphical depiction of the
45. Type of correlation between None capital asset pricing model. It
the unsystematic risk of shows the relationship
two companies from between expected return and
different industries beta.
46. Type of risk that is not Systematic or market risk 51. What is the beta of a By definition, a risk-free
reduced by diversification risk-free asset? asset has no systematic risk
47. unsystematic risk *affects few assets (unsystematic risk), so a risk-
free asset has a beta of zero
*highly diversified 52. What is the expected .05 + 1.5 (.09 - .05) = 11%
portfolios tend to have return for a security if
very little risk *the risk-free rate is 5%
48. Variance *A measure of the *the expected return is
squared deviations of a 9%
security's return from its *the security's beta is
expected retrun 1.5
53. What is the expected 4% + 1.2 (12% - 4%) =36%
*Standard deviation is the return of a security
square root of variance with,
*a beta of 1.2
**the sum of the squared *if the risk-free rate is
distances of each term in 4% and
the distribution from the *the expected return on
mean (μ), divided by the the market is 12%?
number of terms in the
54. What is the slope of the The market-risk premium
distribution (N).
security market line
*Variance= σ² = ∑(X-µ)² / (SML)?
N 55. When 100 securities are 19.69 %
included, the standard
deviation of a portfolio *Standard deviation declines
of risky assets fall to: as the number of securities is
increased
56. When a dollar in the future is discounted to the present it is worth less because of the time already knew about
value of money, but when a news item is discounted, it means that the market: most of the news item
57. When securities are added to a portfolio, systematic risk will: not change