Chapter 013 Return Risk and the Security Market Line
Multiple Choice Questions
1. The return on a risky asset which is anticipated being earned in the future is called the
_____ return.
a. average
b. historical
C. expected
d. geometric
e. required
SECTION: 13.1
TOPIC: EXPECTED RETURN
TYPE: DEFINITIONS
2. A group of assets, such as stocks and bonds, held by an investor is called a(n):
a. index.
B. portfolio.
c. collection.
d. grouping.
e. tranche.
SECTION: 13.2
TOPIC: PORTFOLIOS
TYPE: DEFINITIONS
3. The percentage of a portfolio's total value invested in a particular asset is called that
asset's:
a. portfolio return.
B. portfolio weight.
c. degree of risk.
d. composite value.
e. index value.
SECTION: 13.2
TOPIC: PORTFOLIO WEIGHTS
TYPE: DEFINITIONS
13-1
Chapter 013 Return Risk and the Security Market Line
4. Risk that affects a large number of assets is called _____ risk.
a. idiosyncratic
b. diversifiable
C. systematic
d. asset-specific
e. total
SECTION: 13.4
TOPIC: SYSTEMATIC RISK
TYPE: DEFINITIONS
5. Risk that affects at most a small number of assets is called _____ risk.
a. portfolio
b. nondiversifiable
c. market
D. unsystematic
e. total
SECTION: 13.4
TOPIC: UNSYSTEMATIC RISK
TYPE: DEFINITIONS
6. The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will eliminate all of the
unsystematic risk.
b. concentrating an investment in three companies all within the same industry will greatly
reduce the systematic risk.
c. spreading an investment across five diverse companies will not lower the total risk.
d. spreading an investment across many diverse assets will eliminate all of the systematic risk.
E. spreading an investment across many diverse assets will eliminate some of the total risk.
SECTION: 13.5
TOPIC: PRINCIPLE OF DIVERSIFICATION
TYPE: DEFINITIONS
13-2
Chapter 013 Return Risk and the Security Market Line
7. The _____ tells us that the expected return on a risky asset depends only on that asset's
nondiversifiable risk.
a. efficient markets hypothesis
B. systematic risk principle
c. open markets theorem
d. law of one price
e. principle of diversification
SECTION: 13.6
TOPIC: SYSTEMATIC RISK PRINCIPLE
TYPE: DEFINITIONS
8. The amount of systematic risk present in a particular risky asset relative to the systematic
risk present in an average risky asset, is called the:
A. beta coefficient.
b. reward-to-risk ratio.
c. risk ratio.
d. diversifiable risk.
e. Treynor index.
SECTION: 13.6
TOPIC: BETA COEFFICIENT
TYPE: DEFINITIONS
9. The positively sloped linear function which illustrates the relationship between an asset's
expected return and its beta coefficient is the:
a. reward-to-risk ratio.
b. portfolio weight.
c. portfolio risk.
D. security market line.
e. market risk premium.
SECTION: 13.7
TOPIC: SECURITY MARKET LINE
TYPE: DEFINITIONS
13-3
Chapter 013 Return Risk and the Security Market Line
10. Which one of the following is the slope of the security market line?
a. reward-to-risk ratio
b. portfolio weight
c. beta coefficient
d. risk-free interest rate
E. market risk premium
SECTION: 13.7
TOPIC: MARKET RISK PREMIUM
TYPE: DEFINITIONS
11. The equation of the SML which defines the relationship between the expected return and
beta is the:
A. capital asset pricing model.
b. time value of money equation.
c. risk-return model.
d. market equation.
e. expected risk formula.
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL
TYPE: DEFINITIONS
12. The minimum required return on a new risky investment is called the:
a. average arithmetic return.
b. expected return.
c. geometric average return.
d. time value of money.
E. cost of capital.
SECTION: 13.7
TOPIC: COST OF CAPITAL
TYPE: DEFINITIONS
13-4
Chapter 013 Return Risk and the Security Market Line
13. The expected return on a stock given various states of the economy is equal to the:
a. highest expected return given any economic state.
b. arithmetic average of the returns for each economic state.
c. summation of the individual expected rates of return.
D. weighted average of the returns for each economic state.
e. return for the economic state with the highest probability of occurrence.
SECTION: 13.1
TOPIC: EXPECTED RETURN
TYPE: CONCEPTS
14. The expected return on a stock computed using economic probabilities is:
a. guaranteed to equal the actual average return on the stock for the next five years.
b. guaranteed to be the minimal rate of return on the stock over the next two years.
c. guaranteed to equal the actual return for the immediate twelve month period.
D. a mathematical expectation based on a weighted average and not an actual anticipated
outcome.
e. the actual return you should anticipate as long as the economic forecast remains constant.
SECTION: 13.1
TOPIC: EXPECTED RETURN
TYPE: CONCEPTS
15. The expected risk premium on a stock is equal to the expected return on the stock minus
the:
a. expected market rate of return.
B. risk-free rate.
c. inflation rate.
d. standard deviation.
e. variance.
SECTION: 13.1
TOPIC: EXPECTED RISK PREMIUM
TYPE: CONCEPTS
13-5
Chapter 013 Return Risk and the Security Market Line
16. Standard deviation measures _____ risk.
A. total
b. nondiversifiable
c. unsystematic
d. systematic
e. economic
SECTION: 13.1
TOPIC: STANDARD DEVIATION
TYPE: CONCEPTS
17. The expected rate of return on a stock portfolio is a weighted average where the weights
are based on the:
a. number of shares owned of each stock.
b. market price per share of each stock.
C. market value of the investment in each stock.
d. original amount invested in each stock.
e. cost per share of each stock held.
SECTION: 13.2
TOPIC: PORTFOLIO WEIGHT
TYPE: CONCEPTS
18. The portfolio expected return considers which of the following factors?
I. percentage of the portfolio invested in each individual security
II. projected states of the economy
III. the performance of each security given various economic states
IV. probability of occurrence for each state of the economy
a. I and III only
b. II and IV only
c. I, III, and IV only
d. II, III, and IV only
E. I, II, III, and IV
SECTION: 13.2
TOPIC: PORTFOLIO EXPECTED RETURN
TYPE: CONCEPTS
13-6
Chapter 013 Return Risk and the Security Market Line
19. The expected return on a portfolio:
I. can never exceed the expected return of the best performing security in the portfolio.
II. must be equal to or greater than the expected return of the worst performing security in the
portfolio.
III. is independent of the performance of the overall economy.
IV. is independent of the allocation of the portfolio amongst individual securities.
a. I and III only
b. II and IV only
C. I and II only
d. I, II, and III only
e. I, II, III, and IV
SECTION: 13.2
TOPIC: PORTFOLIO EXPECTED RETURN
TYPE: CONCEPTS
20. If a stock portfolio is well diversified, then the portfolio variance:
a. will equal the variance of the most volatile stock in the portfolio.
B. may be less than the variance of the least risky stock in the portfolio.
c. must be equal to or greater than the variance of the least risky stock in the portfolio.
d. will be a weighted average of the variances of the individual securities in the portfolio.
e. will be an arithmetic average of the variance of the individual securities in the portfolio.
SECTION: 13.2
TOPIC: PORTFOLIO VARIANCE
TYPE: CONCEPTS
21. The standard deviation of a portfolio:
a. is a weighted average of the standard deviations of the individual securities which comprise
the portfolio.
b. can never be less than the standard deviation of the most risky security in the portfolio.
c. must be equal to or greater than the lowest standard deviation of any single security held in
the portfolio.
d. is an arithmetic average of the standard deviations of the individual securities which
comprise the portfolio.
E. can be less than the standard deviation of the least risky security in the portfolio.
SECTION: 13.2
TOPIC: PORTFOLIO STANDARD DEVIATION
TYPE: CONCEPTS
13-7
Chapter 013 Return Risk and the Security Market Line
22. Which of the following are included in the computation of a portfolio's standard
deviation?
I. weight assigned to each security comprising the portfolio
II. weighted average of the standard deviations of the individual securities held in the
portfolio
III. probability of occurrence for each economic state of the economy
IV. rate of return for each individual security held in the portfolio for each economic state
a. II only
b. III and IV only
C. I, III, and IV only
d. I, II, and IV only
e. I, II, III, and IV
SECTION: 13.2
TOPIC: PORTFOLIO STANDARD DEVIATION
TYPE: CONCEPTS
23. Which one of the following statements is correct concerning a portfolio of multiple
securities and multiple states of the economy when both the securities and the economic states
have unequal weights?
a. Given multiple economic states with unequal weights, it is impossible for the portfolio
standard deviation to be less than the lowest standard deviation for any one security contained
in the portfolio.
b. The weights of the individual securities have no effect on the expected return of a portfolio
when multiple states of the economy are involved.
c. Changing the probabilities of occurrence for the various economic states will not affect the
expected standard deviation of the portfolio.
d. The standard deviation of the portfolio can be greater than the standard deviation of any
single security in the portfolio given that the individual securities are well diversified.
E. Given both the unequal weights of the securities and the unequal weights of the economic
states, a portfolio can be created that has an expected standard deviation of zero.
SECTION: 13.2
TOPIC: PORTFOLIO STANDARD DEVIATION
TYPE: CONCEPTS
13-8
Chapter 013 Return Risk and the Security Market Line
24. Which one of the following events would be included in the expected return on Delta
stock?
a. The directors of Delta just fired the CEO because of remarks he made this morning to one
of the directors.
b. A fire just destroyed Delta's main distribution warehouse which will directly impact the
firm's sales for at least six months.
C. This morning, Delta confirmed that its CEO is retiring at the end of the year as anticipated.
d. The price of Delta stock suddenly dropped due to rumors concerning company fraud.
e. Delta's research department just announced that they accidentally discovered a new
substance which could replace plastic in a few years.
SECTION: 13.3
TOPIC: EXPECTED AND UNEXPECTED RETURNS
TYPE: CONCEPTS
25. Which one of the following statements is correct?
a. The unexpected return is always negative.
b. The expected return minus the unexpected return is equal to the total return.
c. Over time, the average return is equal to the unexpected return.
d. The expected return includes the surprise portion of news announcements.
E. Over time, the average unexpected return will be zero.
SECTION: 13.3
TOPIC: EXPECTED AND UNEXPECTED RETURNS
TYPE: CONCEPTS
26. Which one of the following is true concerning unexpected returns?
a. All announcements by a firm affect that firm's unexpected returns.
b. Unexpected returns over time have a negative effect on the total return of a firm.
c. Unexpected returns are relatively predictable in the short-term.
d. Unexpected returns generally cause the actual return to vary significantly from the expected
return over the long-term.
E. Unexpected returns can be either positive or negative in the short term but tend to be zero
over the long-term.
SECTION: 13.3
TOPIC: UNEXPECTED RETURNS
TYPE: CONCEPTS
13-9
Chapter 013 Return Risk and the Security Market Line
27. Which one of the following is an example of systematic risk?
a. coal miners go on strike against Deep Vein Coal Company
b. Baker's Dozen experiences a kitchen fire which halts operations
C. inflation unexpectedly increases by 1.5 percent in the U.S.
d. government inspectors stop production at a meat packing plant
e. localized flooding affects corn production
SECTION: 13.4
TOPIC: SYSTEMATIC RISK
TYPE: CONCEPTS
28. Unsystematic risk:
A. can be effectively eliminated by portfolio diversification.
b. is compensated for by the risk premium.
c. is measured by beta.
d. is measured by standard deviation.
e. is related to the overall economy.
SECTION: 13.4
TOPIC: UNSYSTEMATIC RISK
TYPE: CONCEPTS
29. Which one of the following is an example of unsystematic risk?
a. the exchange rate rises against the other major currencies
b. a national sales tax is adopted
C. an explosion occurs at a chemical plant
d. the Federal Reserve surprisingly raises interest rates by one quarter of a percent
e. consumer spending decreases on a nationwide basis
SECTION: 13.4
TOPIC: UNSYSTEMATIC RISK
TYPE: CONCEPTS
13-10
Chapter 013 Return Risk and the Security Market Line
30. Which one of the following is least apt to reduce the unsystematic risk of a portfolio?
A. adding additional shares of each stock in a portfolio to that portfolio
b. adding bonds to a stock portfolio
c. adding international securities into a portfolio of U.S. stocks
d. adding U.S. Treasury bills to a risky portfolio
e. adding technology stocks to a portfolio of utility stocks
SECTION: 13.4
TOPIC: UNSYSTEMATIC RISK
TYPE: CONCEPTS
31. Which one of the following statements is correct concerning unsystematic risk?
a. Assuming unsystematic risk is rewarded by the market place.
B. Eliminating unsystematic risk is the responsibility of the individual investor.
c. Unsystematic risk is rewarded when it exceeds the market level of unsystematic risk.
d. The Capital Asset Pricing Model specifically rewards investors for assuming unsystematic
risk via the application of beta in the formula.
e. The higher the beta, the higher the unsystematic risk.
SECTION: 13.5 AND 13.6
TOPIC: UNSYSTEMATIC RISK
TYPE: CONCEPTS
32. Which one of the following is another name for systematic risk?
a. diversifiable risk
b. unique risk
c. asset-specific risk
D. market risk
e. unrewarded risk
SECTION: 13.5
TOPIC: SYSTEMATIC RISK
TYPE: CONCEPTS
13-11
Chapter 013 Return Risk and the Security Market Line
33. Which one of the following risks is irrelevant to a well-diversified investor?
a. systematic risk
B. unsystematic risk
c. market risk
d. nondiversifiable risk
e. systematic portion of a surprise
SECTION: 13.5
TOPIC: SYSTEMATIC RISK
TYPE: CONCEPTS
34. Which of the following are examples of diversifiable risk?
I. tornado strikes an industrial park in Kansas
II. federal government imposes new workplace safety laws
III. local government increases property tax rates
IV. cost of worker's compensation insurance increases nationwide
A. I and III only
b. II and IV only
c. II and III only
d. I and IV only
e. I, III, and IV only
SECTION: 13.5
TOPIC: DIVERSIFIABLE RISK
TYPE: CONCEPTS
35. Which of the following statements are correct concerning diversifiable risks?
I. Diversifiable risks can be essentially eliminated by investing in thirty unrelated securities.
II. The market rewards investors for diversifiable risk by paying a risk premium.
III. Diversifiable risks are generally associated with an individual firm or industry.
IV. Beta measures diversifiable risk.
A. I and III only
b. II and IV only
c. I and IV only
d. II and III only
e. I, II, and III only
SECTION: 13.5
TOPIC: DIVERSIFIABLE RISKS
TYPE: CONCEPTS
13-12
Chapter 013 Return Risk and the Security Market Line
36. Which of the following are examples of diversifiable risks?
I. the inflation rate spikes suddenly
II. terrorists strike the United States
III. the price of corn increases due to a nationwide drought
IV. taxes are increased on hotel room rentals
a. I and III only
b. II and IV only
c. I and II only
D. III and IV only
e. I, II, and IV only
SECTION: 13.5
TOPIC: DIVERSIFIABLE RISKS
TYPE: CONCEPTS
37. Which of the following statements concerning risk are correct?
I. Nondiversifiable risk is measured by beta.
II. The risk premium increases as diversifiable risk increases.
III. Systematic risk is another name for nondiversifiable risk.
IV. Diversifiable risks are those risks you cannot avoid if you are invested in the financial
markets.
A. I and III only
b. II and IV only
c. I and II only
d. III and IV only
e. I, II, and III only
SECTION: 13.5
TOPIC: NONDIVERSIFIABLE RISKS
TYPE: CONCEPTS
13-13
Chapter 013 Return Risk and the Security Market Line
38. The primary purpose of portfolio diversification is to:
a. increase returns and risks.
b. eliminate all risks.
C. eliminate asset-specific risk.
d. eliminate systematic risk.
e. lower both returns and risks.
SECTION: 13.5
TOPIC: DIVERSIFICATION
TYPE: CONCEPTS
39. Which one of the following indicates a portfolio is being effectively diversified?
a. an increase in the portfolio beta
b. a decrease in the portfolio beta
c. an increase in the portfolio rate of return
d. an increase in the portfolio standard deviation
E. a decrease in the portfolio standard deviation
SECTION: 13.5
TOPIC: DIVERSIFICATION
TYPE: CONCEPTS
40. How many diverse securities are required to eliminate the majority of the diversifiable risk
from a portfolio?
a. 3
b. 5
C. 30
d. 40
e. 50
SECTION: 13.5
TOPIC: DIVERSIFICATION
TYPE: CONCEPTS
13-14
Chapter 013 Return Risk and the Security Market Line
41. Systematic risk is measured by:
a. the mean.
B. beta.
c. the geometric average.
d. the standard deviation.
e. the arithmetic average.
SECTION: 13.6
TOPIC: SYSTEMATIC RISK
TYPE: CONCEPTS
42. The systematic risk principle implies the _____ an asset depends on that asset's systematic
risk.
a. variance of the returns on
b. standard deviation of the returns on
C. expected return on
d. total risk assumed by owning
e. diversification benefits of
SECTION: 13.6
TOPIC: SYSTEMATIC RISK PRINCIPLE
TYPE: CONCEPTS
43. Which one of the following statements is correct concerning a portfolio beta?
a. Portfolio betas range between 1.0 and +1.0.
B. A portfolio beta is a weighted average of the betas of the individual securities contained in
the portfolio.
c. A portfolio beta cannot be computed from the betas of the individual securities comprising
the portfolio because some risk is eliminated via diversification.
d. A portfolio of U.S. Treasury bills will have a beta of +1.0.
e. The beta of a market portfolio is equal to zero.
SECTION: 13.6
TOPIC: PORTFOLIO BETA
TYPE: CONCEPTS
13-15
Chapter 013 Return Risk and the Security Market Line
44. The systematic risk of the market is measured by:
A. a beta of 1.0.
b. a beta of 0.0.
c. a standard deviation of 1.0.
d. a standard deviation of 0.0.
e. a variance of 1.0.
SECTION: 13.6
TOPIC: SYSTEMATIC RISK
TYPE: CONCEPTS
45. Which of the following variables do you need to know to estimate the amount of
additional reward you will receive for purchasing a risky asset instead of a risk-free asset?
I. asset standard deviation
II. asset beta
III. risk-free rate of return
IV. market risk premium
a. I and III only
B. II and IV only
c. III and IV only
d. I, III, and IV only
e. I, II, III, and IV
SECTION: 13.6
TOPIC: PORTFOLIO BETA
TYPE: CONCEPTS
46. Total risk is measured by _____ and systematic risk is measured by _____.
a. beta; epsilon
b. beta; standard deviation
c. epsilon; beta
D. standard deviation; beta
e. standard deviation; variance
SECTION: 13.6
TOPIC: MEASURING RISK
TYPE: CONCEPTS
13-16
Chapter 013 Return Risk and the Security Market Line
47. The intercept point of the security market line is the rate of return which corresponds to:
A. the risk-free rate.
b. the market rate.
c. a return of zero.
d. a return of 1.0 percent.
e. the market risk premium.
SECTION: 13.7
TOPIC: SECURITY MARKET LINE (SML)
TYPE: CONCEPTS
48. A stock with an actual return that lies above the security market line has:
a. more systematic risk than the overall market.
b. more risk than warranted based on the realized rate of return.
C. yielded a higher return than expected for the level of risk assumed.
d. less systematic risk than the overall market.
e. yielded a return equivalent to the level of risk assumed.
SECTION: 13.7
TOPIC: SECURITY MARKET LINE (SML)
TYPE: CONCEPTS
49. The market rate of return is eleven percent and the risk-free rate of return is four percent.
Treynak stock has three percent more risk than the market and has an actual return of eleven
percent. This stock:
a. is underpriced.
b. is correctly priced.
C. will plot below the security market line.
d. will plot on the security market line.
e. will plot to the left of the overall market on a security market line graph.
SECTION: 13.7
TOPIC: SECURITY MARKET LINE (SML)
TYPE: CONCEPTS
13-17
Chapter 013 Return Risk and the Security Market Line
50. If the market is efficient and securities are priced fairly then the _____ will be constant for
all securities.
a. systematic risk
b. standard deviation
C. reward-to-risk ratio
d. beta
e. risk premium
SECTION: 13.7
TOPIC: REWARD-TO-RISK RATIO
TYPE: CONCEPTS
51. The reward-to-risk ratio for stock A exceeds the reward-to-risk ratio of stock B. Stock A
has a beta of 1.4 and stock B has a beta of .90. This information implies that:
a. stock A is riskier than stock B and both stocks are fairly priced.
b. stock A is less risky than stock B and both stocks are fairly priced.
C. either stock A is underpriced or stock B is overpriced or both.
d. both stock A and stock B are correctly priced since stock A is riskier than stock B.
e. either stock A is overpriced or stock B is underpriced or both.
SECTION: 13.7
TOPIC: REWARD-TO-RISK RATIO
TYPE: CONCEPTS
52. The market risk premium is computed by:
a. adding the risk-free rate of return to the inflation rate.
b. adding the risk-free rate of return to the market rate of return.
c. subtracting the risk-free rate of return from the inflation rate.
D. subtracting the risk-free rate of return from the market rate of return.
e. multiplying the risk-free rate of return by a beta of 1.0.
SECTION: 13.7
TOPIC: MARKET RISK PREMIUM
TYPE: CONCEPTS
13-18
Chapter 013 Return Risk and the Security Market Line
53. The excess return earned by an asset that has a beta of 1.0 over that earned by a risk-free
asset is referred to as the:
a. market rate of return.
B. market risk premium.
c. systematic return.
d. total return.
e. real rate of return.
SECTION: 13.7
TOPIC: MARKET RISK PREMIUM
TYPE: CONCEPTS
54. The _____ of a security divided by the beta of that security is equal to the slope of the
security market line if the security is priced fairly.
a. real return
b. actual return
c. nominal return
D. risk premium
e. expected return
SECTION: 13.7
TOPIC: MARKET RISK PREMIUM
TYPE: CONCEPTS
55. The capital asset pricing model (CAPM) assumes:
I. a risk-free asset has no systematic risk.
II. beta is a reliable estimate of total risk.
III. the risk-to-reward ratio is constant.
IV. the market rate of return can be approximated.
a. I and III only
b. II and IV only
C. I, III, and IV only
d. II, III, and IV only
e. I, II, III, and IV
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: CONCEPTS
13-19
Chapter 013 Return Risk and the Security Market Line
56. According to CAPM, the amount of reward an investor receives for bearing the risk of an
individual security depends upon the:
a. amount of total risk assumed and the market risk premium.
B. market risk premium and the amount of systematic risk inherent in the security.
c. risk free rate, the market rate of return, and the standard deviation of the security.
d. beta of the security and the market rate of return.
e. beta of the security and the risk-free rate of return.
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: CONCEPTS
57. Which one of the following should earn the most risk premium based on CAPM?
a. diversified portfolio with returns similar to the overall market
B. stock with a beta of 1.23
c. stock with a beta of .98
d. U.S. Treasury bill
e. portfolio with a beta of 1.16
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: RISK PREMIUM
TYPE: PROBLEMS
13-20
Chapter 013 Return Risk and the Security Market Line
58. You want your portfolio beta to be 1.10. Currently, your portfolio consists of $3,000
invested in stock A with a beta of 1.65 and $2,000 in stock B with a beta of .72. You have
another $5,000 to invest and want to divide it between an asset with a beta of 1.48 and a riskfree asset. How much should you invest in the risk-free asset?
a. $0
b. $775
C. $1,885
d. $3,115
e. $5,000
BetaPortfolio = 1.10 = ($3,000 / $10,000 1.65) + ($2,000 / $10,000 .72) + (x / $10,000
1.48) + (($5,000 x) / $10,000 0) = .495 + .144 + .000148x + 0; .461 = .000148x; x =
$3,114.86; Risk-free asset = $5,000 $3,114.86 = $1,885.14
SECTION: 13.2 AND 13.6
TOPIC: ANALYZING A PORTFOLIO
TYPE: PROBLEMS
59. You have a $9,000 portfolio which is invested in stocks A, B, and a risk-free asset. $4,000
is invested in stock A. Stock A has a beta of 1.84 and stock B has a beta of 0.68. How much
needs to be invested in stock B if you want a portfolio beta of .95?
a. $0
B. $1,750
c. $3,279
d. $5,000
e. $7,279
BetaPortfolio = .95 = ($4,000 / $9,000 1.84) + (x / $9,000 .68) + [($9,000 $4,000 x) /
$9,000 0)]; .95 = .817777778 + .000075556x + 0; .00007556x = .132222222; x = $1,750
AACSB TOPIC: ANALYTIC
SECTION: 13.2 AND 13.6
TOPIC: ANALYZING A PORTFOLIO
TYPE: PROBLEMS
13-21
Chapter 013 Return Risk and the Security Market Line
60. You recently purchased a stock that is expected to earn 16 percent in a booming economy,
12 percent in a normal economy, and lose 8 percent in a recessionary economy. There is a 20
percent probability of a boom, a 70 percent chance of a normal economy, and a 10 percent
chance of a recession. What is your expected rate of return on this stock?
a. 6.00 percent
b. 6.67 percent
c. 8.60 percent
D. 10.80 percent
e. 12.40 percent
E(r) = (.20
.16) + (.70
.12) + (.10
.08) = .032 + .084
.008 = .108 = 10.8 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: EXPECTED RETURN
TYPE: PROBLEMS
61. The common stock of Low Cost Foods is expected to earn 15 percent in a recession, 7
percent in a normal economy, and lose 6 percent in a booming economy. The probability of a
boom is 5 percent, the probability of a normal economy is 80 percent, and the chance of a
recession is 15 percent. What is the expected rate of return on this stock?
a. 5.45 percent
b. 7.25 percent
C. 7.55 percent
d. 8.15 percent
e. 8.45 percent
E(r) = (.05
percent
.06) + (.80
.07) + (.15
.15) =
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: EXPECTED RETURN
TYPE: PROBLEMS
13-22
.003 + .056 + .0225 = .0755 = 7.55
Chapter 013 Return Risk and the Security Market Line
62. You are comparing stock A to stock B. Given the following information, which one of
these two stocks should you prefer and why?
a. Stock A; Stock A has a slightly lower expected return but appears to be significantly less
risky than stock B.
b. Stock A; Stock A has an expected return of 10.2 percent and appears to be less risky.
C. Stock A; Stock A has a higher expected return and appears to be less risky than stock B.
d. Stock B; Stock B has a higher expected return and appears to be just slightly more risky
than stock A.
e. Stock B; Stock B has a much higher return which compensates for the additional risk.
E(r)A = (.70 .11) + (.30 .07) = .077 + .021 = .098 = 9.8 percent
E(r)B = (.70 .19) + (.30
.12) = .133 .036 = .097 = 9.7 percentYou should select stock
A because it has a higher expected return and also appears to be less risky.
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: EXPECTED RETURN
TYPE: PROBLEMS
63. Winston Brothers stock has a beta of 1.36. The risk-free rate of return is 5.25 percent and
the market rate of return is 11.70 percent. What is the risk premium on this stock?
a. 6.45 percent
B. 8.77 percent
c. 10.99 percent
d. 14.37 percent
e. 16.95 percent
Risk premium = 1.36
(.117
.0525) = .08772 = 8.77 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: RISK PREMIUM
TYPE: PROBLEMS
13-23
Chapter 013 Return Risk and the Security Market Line
64. If the economy booms, Frank's Welding Supply stock is expected to return 19 percent. If
the economy falls into a recession, the stock's return is projected at 5 percent. The probability
of a boom is 80 percent while the probability of a recession is 20 percent. What is the variance
of the returns on this stock?
A. .003136
b. .006727
c. .009864
d. .010192
e. .013328
E(r) = (.80 .19) + (.20 .05) = .152 + .01 = .162
Var = .80 (.19 .162)2 + .20 (.05 .162)2 = .0006272 + .0025088 = .003136
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: VARIANCE
TYPE: PROBLEMS
65. The rate of return on the common stock of FIDF is expected to be 15 percent in a boom
economy, 12 percent in a normal economy, and only 7 percent in a recessionary economy.
The probabilities of these economic states are 15 percent for a boom, 80 percent for a normal
economy, and 5 percent for a recession. What is the variance of the returns on this common
stock?
a. .000118
B. .000256
c. .001876
d. .003492
e. .016000
E(r) = (.15 .15) + (.80 .12) + (.05
Var = .15 (.15 .122)2 + .80 (.12
+ .0001352 = .000256
.07) = .0225 + .096 + .0035 = .122
.122)2 + .05 (.07 .122)2 = .0001176 + .0000032
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: VARIANCE
TYPE: PROBLEMS
13-24
Chapter 013 Return Risk and the Security Market Line
66. The returns on the common stock of Cycles, Inc. are quite cyclical. In a boom economy,
the stock is expected to return 27 percent in comparison to 13 percent in a normal economy
and a negative 20 percent in a recessionary period. The probability of a recession is 30 percent
while the probability of a boom is 5 percent. The remainder of the time the economy will be at
normal levels. What is the standard deviation of the returns on this stock?
a. 11.40 percent
b. 14.79 percent
C. 15.87 percent
d. 18.27 percent
e. 22.46 percent
E(r) = (.05 .27) + (.65 .13) + (.30
.20) = .0135 + .0845 .06 = .038
Var = .05 (.27 .038)2 + .65 (.13 .038)2 + .30 ( .20 .038)2 = .0026912 +
.0055016 + .0169932 = .025186
Std dev = .025186 = .1587 = 15.87 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: STANDARD DEVIATION
TYPE: PROBLEMS
13-25
Chapter 013 Return Risk and the Security Market Line
67. What is the standard deviation of the returns on a stock given the following information?
A. 7.24 percent
b. 7.64 percent
c. 9.26 percent
d. 9.75 percent
e. 27.64 percent
E(r) = (.18 .19) + (.76 .12) + (.06
.15) = .0342 + .0912 .009 = .1164
Var = .18 (.19 .1164)2 + .76 (.12 .1164)2 + .06 ( .15 .1164)2 = .000975053 +
.00000985 + .004258138 = .00524304
Std dev = .00524304 = .07241 = 7.24 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.1
TOPIC: STANDARD DEVIATION
TYPE: PROBLEMS
68. You have a portfolio consisting solely of stock A and stock B. The portfolio has an
expected return of 10.8 percent. Stock A has an expected return of 13 percent while stock B is
expected to return 8 percent. What is the portfolio weight of stock A?
a. 38 percent
b. 44 percent
C. 56 percent
d. 64 percent
e. 78 percent
.108 = [.13
x] + [.08
(1
x)] = .13x + .08
.08x; .028 =.05x; x = 56 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO WEIGHT
TYPE: PROBLEMS
13-26
Chapter 013 Return Risk and the Security Market Line
69. You own the following portfolio of stocks. What is the portfolio weight of stock C?
a. 2.6 percent
b. 3.2 percent
C. 5.6 percent
d. 6.0 percent
e. 7.8 percent
Portfolio weightC = (100 $31) / [(200
= $3,100 / $55,000 = 5.6 percent
$27) + (900
$48) + (100
$31) + (300
$11)]
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO WEIGHT
TYPE: PROBLEMS
70. You own a portfolio with the following expected returns given the various states of the
economy. What is the overall portfolio expected return?
a. 7.71 percent
b. 9.60 percent
c. 12.76 percent
D. 13.25 percent
e. 14.88 percent
E(r) = (.35
.22) + (.60
.13) + (.05
.45) = .077 + .078
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO EXPECTED RETURN
TYPE: PROBLEMS
13-27
.0225 = .1325 = 13.25 percent
Chapter 013 Return Risk and the Security Market Line
71. What is the expected return on a portfolio which is invested 30 percent in stock A, 40
percent in stock B, and 30 percent in stock C?
A. 8.56 percent
b. 8.62 percent
c. 8.76 percent
d. 8.79 percent
e. 8.82 percent
E(r)Boom = (.30 .17) + (.40 .10) + (.30 .04) = .051 + .04 + .012 = .103
E(r)Normal = (.30 .12) + (.40 .08) + (.30 .09) = .036 + .032 + .027 = .095
E(r)Bust = (.30
.10) + (.40 .03) + (.30 . 15) = -.03 + .012 + .045 = .027
E(r)Portfolio = (.10 .103) + (.75 .095) + (.15 .027) = .0103 + .07125 + .00405 = .0856 =
8.56 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO EXPECTED RETURN
TYPE: PROBLEMS
13-28
Chapter 013 Return Risk and the Security Market Line
72. What is the expected return on this portfolio?
A. 10.84 percent
b. 11.67 percent
c. 12.39 percent
d. 12.91 percent
e. 13.16 percent
Portfolio value = (750 $33) + (220 $51) + (460 $19) = $24,750 + $11,220 + $8,740 =
$44,710; E(r) = ($24,750 / $44,710 .09) + ($11,220 / $44,710 .14) + ($8,740 / $44,710
.12) = .04982 + .03513 + .02346 = .10841 = 10.84 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO EXPECTED RETURN
TYPE: PROBLEMS
73. What is the expected return on a portfolio comprised of $4,000 in stock K and $6,000 in
stock L if the economy is normal?
a. 4.65 percent
B. 6.20 percent
c. 8.95 percent
d. 13.35 percent
e. 17.80 percent
E(r)Normal = [$4,000 / ($4,000 + $6,000)
.03 = .062 = 6.20 percent
.08] + [$6,000 / ($4,000 + $6,000)
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO EXPECTED RETURN
TYPE: PROBLEMS
13-29
.05) = .032 +
Chapter 013 Return Risk and the Security Market Line
74. What is the expected return on a portfolio comprised of $7,500 in stock M and $2,500 in
stock N if the economy enjoys a boom period?
a. 6.93 percent
b. 8.16 percent
c. 8.25 percent
d. 12.25 percent
E. 15.75 percent
E(r)Boom = [($7,500 / ($7,500 + $2,500)
.03 = .1575 = 15.75 percent
.17] + [$2,500 / ($7,500 + $2,500)
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO EXPECTED RETURN
TYPE: PROBLEMS
13-30
.12] = .1275 +
Chapter 013 Return Risk and the Security Market Line
75. What is the portfolio variance if 55 percent is invested in stock S and 45 percent is
invested in stock T?
A. .001314
b. .003148
c. .009128
d. .036250
e. .056106
E(r)Boom = (.55 .16) + (.45 .18) = .088 + .081 = .169
E(r)Normal = (.55 .12) + (.45 .06) = .066 + .027 = .093
E(r)Portfolio = (.35 .169) + (.65 .093) = .05915 + .06045 = .1196
VarPortfolio = [.35 (.169 .1196)2] + [.65 (.093 .1196)2] = .000854126 + .000459914 =
.001314
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO VARIANCE
TYPE: PROBLEMS
13-31
Chapter 013 Return Risk and the Security Market Line
76. What is the variance of a portfolio consisting of $5,500 in stock G and $4,500 in stock H?
A. .000387
b. .000778
c. .001482
d. .019677
e. .038496
E(r)Boom = [$5,500 / ($5,500 + $4,500) .14)] + [$4,500 / ($5,500 + $4,500) .11) = .077 +
.0495 = .1265
E(r)Normal = [$5,500 / ($5,500 + $4,500) .07)] + [$4,500 / ($5,500 + $4,500) .09) = .0385
+ .0405 = .079
E(r)Portfolio = (.22 .1265) + (.78 .079) = .02783 + .06162 = .08945
VarPortfolio = [.22 (.1265 .08945)2] + [.78 (.079 .08945)2] = .000301995 +
.000085178 = .000387173 = .000387
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO VARIANCE
TYPE: PROBLEMS
13-32
Chapter 013 Return Risk and the Security Market Line
77. What is the standard deviation of a portfolio that is invested 68 percent in stock Q and 32
percent in stock R?
a. 2.7 percent
B. 3.0 percent
c. 3.2 percent
d. 4.1 percent
e. 4.3 percent
E(r)Boom = (.68 .17) + (.32 .10) = .1156 + .032 = .1476
E(r)Normal = (.68 .07) + (.32 .08) = .0476 + .0256 = .0732
E(r)Portfolio = (.20 .1476) + (.80 .0732) = .02952 + .05856 = .08808
VarPortfolio = [.20 (.1476 .08808)2] + [.80 (.0732 .08808)2] = .000708526 +
.000177132 = .000885658
Std dev = .000885658 = .02976 = 3.0 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO STANDARD DEVIATION
TYPE: PROBLEMS
13-33
Chapter 013 Return Risk and the Security Market Line
78. What is the standard deviation of a portfolio which is comprised of $9,000 invested in
stock S and $6,000 in stock T?
A. 2.1 percent
b. 3.6 percent
c. 4.0 percent
d. 4.4 percent
e. 6.3 percent
E(r)Boom = [$9,000 / ($9,000 + $6,000) .11)] + [$6,000 / ($9,000 + $6,000) .05) = .066 +
.02 = .086
E(r)Normal = [$9,000 / ($9,000 + $6,000) .08)] + [$6,000 / ($9,000 + $6,000) .06) = .048 +
.024 = .072
E(r)Bust =[$9,000 / ($9,000 + $6,000)
.05)] + [$6,000 / ($9,000 + $6,000) .08) = .03 +
.032 = .002
E(r)Portfolio = (.05 .086) + (.85 .072) + (.10 .002) = .0043 + .0612 + .0002 = .0657
VarPortfolio = [.05 (.086 .06572)] + [.85 (.072 .0657)2] + [.10 (.002 .0657)2] =
.000020605 + .000033737 + .000405769 = .00046011
Std dev = .00046011 = .02145 = 2.1 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO STANDARD DEVIATION
TYPE: PROBLEMS
13-34
Chapter 013 Return Risk and the Security Market Line
79. What is the standard deviation of a portfolio which is invested 15 percent in stock A, 45
percent in stock B and 40 percent in stock C?
a. 1.0 percent
b. 2.5 percent
C. 5.0 percent
d. 7.6 percent
e. 9.5 percent
E(r)Boom = (.15 .21) + (.45 .12) + (.40 .16) = .0315 + .054 + .064 = .1495
E(r)Normal = (.15 .11) + (.45 .09) + (.40 .12) = .0165 + .0405 + .048 = .105
E(r)Bust = (.15
.18) + (.45 .02) + (.40
.22) = .027 + .009 .088 = .106
E(r)Portfolio = (.15 .1495) + (.80 .105) + (.05
.106) = .022425 + .084 .0053 =
.101125
VarPortfolio = [.15 (.1495 .101125)2] + [.80 (.105 .101125)2] + [.05 ( .106
.101125)2] = .000351021 + .000012013 + .002145038 = .002508072
Std dev = .002508072 = .05008 = 5.0 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.2
TOPIC: PORTFOLIO STANDARD DEVIATION
TYPE: PROBLEMS
13-35
Chapter 013 Return Risk and the Security Market Line
80. What is the beta of a portfolio comprised of the following securities?
A. .98
b. 1.04
c. 1.09
d. 1.15
e. 1.32
ValuePortfolio = $3,500 + $1,000 + $9,500 = $14,000
BetaPortfolio = ($3,500 / $14,000 1.12) + ($1,000 / $14,000
.84) = .28 + .1293 + .57 = .9793 = .98
1.81) + ($9,500 / $14,000
AACSB TOPIC: ANALYTIC
SECTION: 13.2 AND 13.6
TOPIC: BETA
TYPE: PROBLEMS
81. Your portfolio is comprised of 35 percent of stock X, 25 percent of stock Y, and 40
percent of stock Z. Stock X has a beta of 0.82, stock Y has a beta of 1.09, and stock Z has a
beta of 1.63. What is the beta of your portfolio?
a. .76
b. 1.18
C. 1.21
d. 3.50
e. 3.54
BetaPortfolio = (.35
.82) + (.25
1.09) + (.40
1.63) = .287 + .2725 + .652 = 1.21
AACSB TOPIC: ANALYTIC
SECTION: 13.2 AND 13.6
TOPIC: PORTFOLIO BETA
TYPE: PROBLEMS
13-36
Chapter 013 Return Risk and the Security Market Line
82. Your portfolio has a beta of 1.24. The portfolio consists of 10 percent U.S. Treasury bills,
55 percent in stock A, and 35 percent in stock B. Stock A has a risk-level equivalent to that of
the overall market. What is the beta of stock B?
a. 0
b. .69
c. 1.00
d. 1.24
E. 1.97
The beta of a risk-free asset is zero. The beta of the market is 1.0.
AACSB TOPIC: ANALYTIC
SECTION: 13.2 AND 13.6
TOPIC: PORTFOLIO BETA
TYPE: PROBLEMS
83. You would like to combine a risky stock with a beta of 1.68 with U.S. Treasury bills in
such a way that the risk level of the portfolio is equivalent to the risk level of the overall
market. What percentage of the portfolio should be invested in Treasury bills?
a. .32
B. .40
c. .50
d. .60
e. .68
BetaPortfolio = 1.0 = [(1-w)
1.68] + [w
0] = 1.68
AACSB TOPIC: ANALYTIC
SECTION: 13.2 AND 13.6
TOPIC: PORTFOLIO BETA
TYPE: PROBLEMS
13-37
1.68w; 1.68w = .68; w = .40
Chapter 013 Return Risk and the Security Market Line
84. The market has an expected rate of return of 11.4 percent. The long-term government
bond is expected to yield 5.4 percent and the U.S. Treasury bill is expected to yield 4.6
percent. The inflation rate is 3.9 percent. What is the market risk premium?
a. 6.0 percent
B. 6.8 percent
c. 7.5 percent
d. 8.5 percent
e. 9.3 percent
Risk premium = 11.4 percent
4.6 percent = 6.8 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: MARKET RISK PREMIUM
TYPE: PROBLEMS
85. The risk-free rate of return is 5.2 percent and the market risk premium is 8.4 percent.
What is the expected rate of return on a stock with a beta of 1.34?
a. 8.29 percent
b. 9.49 percent
c. 13.60 percent
D. 16.46 percent
e. 18.22 percent
E(r) = .052 + (1.34
.084) = .16456 = 16.46 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: PROBLEMS
13-38
Chapter 013 Return Risk and the Security Market Line
86. The common stock of Abbott International has an expected return of 15.6 percent. The
return on the market is 12.7 percent and the risk-free rate of return is 3.9 percent. What is the
beta of this stock?
a. .92
b. 1.23
C. 1.33
d. 1.67
e. 1.77
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: PROBLEMS
87. The common stock of GO Limited has a beta of 1.23 and an expected return of 12.84
percent. The risk-free rate of return is 4.2 percent. What is the expected return on the market?
a. 7.02 percent
b. 8.64 percent
c. 10.63 percent
D. 11.22 percent
e. 17.04 percent
E(r) = .1284 = .042 + 1.23 (rm
.042); .13806 = 1.23rm; rm = .1122 = 11.22 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: PROBLEMS
13-39
Chapter 013 Return Risk and the Security Market Line
88. The expected return on Joseph's Restaurant's stock is 14.25 percent while the expected
return on the market is 12.38 percent. The stock's beta is 1.18. What is the risk-free rate of
return?
A. 1.99 percent
b. 2.04 percent
c. 2.48 percent
d. 3.23 percent
e. 3.68 percent
E(r) = .1425 = rf + 1.18
(.1238
rf); .18rf = .003584; rf = .0199 = 1.99 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: PROBLEMS
89. The stock of Markley Toys has a beta of 1.37. The risk-free rate of return is 3.90 percent
and the market risk premium is 8.75 percent. What is the expected rate of return on Markley
Toys stock?
a. 10.59 percent
b. 12.72 percent
c. 14.60 percent
D. 15.89 percent
e. 17.33 percent
E(r) = .039 + (1.37
.0875) = .1589 = 15.89 percent
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: PROBLEMS
13-40
Chapter 013 Return Risk and the Security Market Line
90. The common stock of PDS has a beta of .98 and an expected return of 12.34 percent. The
risk-free rate of return is 4.1 percent and the market rate of return is 11.65 percent. Which one
of the following statements is true given this information?
a. The return on PDS stock will graph below the Security Market Line.
B. PDS stock is underpriced.
c. The expected return on PDS stock based on the Capital Asset Pricing Model is 15.52
percent.
d. PDS stock has more systematic risk than the overall market.
e. PDS stock is correctly priced.
E(r) = .041 + [.98 (.1165 .041) = .11499 = 11.50 percent; PDS stock is underpriced as its
actual expected return exceeds the expected return based on CAPM.
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: PROBLEMS
91. Which one of the following stocks is correctly priced if the risk-free rate of return is 3.2
percent and the market risk premium is 8.4 percent?
a. A
b. B
C. C
d. D
e. E
E(r)A = .032 + (.72 .084) = .0925
E(r)B = .032 + (1.46 .084) = .1546
E(r)C = .032 + (1.38 .084) = .1479 Stock C is correctly priced.
E(r)D = .032 + (1.01 .084) = .1168
E(r)E = .032 + (.95 .084) = .1118
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: REWARD-TO-RISK RATIO
TYPE: PROBLEMS
13-41
Chapter 013 Return Risk and the Security Market Line
92. Which one of the following stocks is correctly priced if the risk-free rate of return is 3.5
percent and the market rate of return is 12.56 percent?
a. A
B. B
c. C
d. D
e. E
E(r)A = .035 + [.84 (.1256 .035)] = .1111
E(r)B = .035 + [1.13 (.1256 .035)] = .1374 Stock B is correctly priced.
E(r)C = .035 + [1.47 (.1256 .035)] = .1682
E(r)D = .035 + [.76 (.1256 .035)] = .1039
E(r)E = .035 + [1.87 (.1256 .035)] = .2044
AACSB TOPIC: ANALYTIC
SECTION: 13.7
TOPIC: CAPITAL ASSET PRICING MODEL (CAPM)
TYPE: PROBLEMS
Essay Questions
93. According to CAPM, the expected return on a risky asset depends on three components.
Describe each component, and explain its role in determining expected return.
CAPM suggests the expected return is a function of (1) the risk-free rate of return, which is
the pure time value of money, (2) the market risk premium, which is the reward for bearing
systematic risk, and (3) beta, which is the amount of systematic risk present in a particular
asset. Better answers will point out that both the pure time value of money and the reward for
bearing systematic risk are exogenously determined and can change on a daily basis, while the
amount of systematic risk for a particular asset is determined by the firm's decision-makers.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 13.7
TOPIC: CAPM
13-42
Chapter 013 Return Risk and the Security Market Line
94. Explain how the slope of the security market line is determined and why every stock that
is correctly priced will lie on this line.
The market risk premium is the slope of the security market line. Slope is the rise over the
run, which in this case is the difference between the market return and the risk-free rate
divided by a beta of 1.0 minus a beta of zero. If a stock is correctly priced the reward-to-risk
ratio will be constant and equal to the slope of the security market line. Thus, every stock that
is correctly priced will lie on the security market line.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 13.7
TOPIC: SECURITY MARKET LINE
95. Explain how the beta of a portfolio can equal the market beta if 50 percent of the portfolio
is invested in a risky security that has twice the amount of systematic risk as an average risky
security.
An average risky security has a beta of 1.0, which is the market beta. Risk-free securities, i.e.,
U.S. Treasury bills, have a beta of zero. A portfolio that is invested 50 percent in a security
that has a beta of 2.0 (twice the systematic risk as an average risky security) and 50 percent in
risk-free securities (U.S. Treasury bills) will have a beta of 1.0 (which is the market beta).
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 13.7
TOPIC: PORTFOLIO BETA
96. Discuss the various types of risk and explain which types are rewarded with a risk
premium.
Unsystematic, or diversifiable, risk affects a limited number of securities and can be
diversified away by investing in 25 diverse securities. Unsystematic risk is not rewarded.
Systematic risk is risk which affects most, or all, securities and cannot be diversified away.
Systematic risk is rewarded with a risk premium and is measured by beta. Total risk is the
summation of unsystematic and systematic risk.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 13.5
TOPIC: RISK
13-43
Chapter 013 Return Risk and the Security Market Line
97. A portfolio beta is a weighted average of the betas of the individual securities which
comprise the portfolio. However, the standard deviation is not a weighted average of the
standard deviations of the individual securities which comprise the portfolio. Explain why.
Standard deviation measures total risk. The unsystematic portion of the total risk can be
eliminated by diversification. Therefore, the total risk of a portfolio is less than the total risk
of the component parts. Beta, on the other hand, measures systematic risk which cannot be
eliminated by diversification. Thus, the systematic risk of a portfolio is the summation of the
systematic risk of the component parts.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 13.5
TOPIC: BETA AND STANDARD DEVIATION
13-44