# FIN4504 Chapter 6

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### Risk that can be eliminated through diversification is called ______ risk.

A. unique
B. firm-specific
C. diversifiable
D. all of the above

### The _______ decision should take precedence over the _____ decision.

asset allocation, stock selection

### Many current and retired Enron Corp. employees had their 401k retirement accounts wiped out when Enron collapsed because ___.

their 401k accounts were not well diversified

I and II only

asset A

up, left

### An investor's degree of risk aversion will determine his or her ______.

optimal mix of the risk-free asset and risky asset

### The ________ is equal to the square root of the systematic variance divided by the total variance.

correlation coefficient

Variance

### Asset A has an expected return of 20% and a standard deviation of 25%. The risk free rate is 10%. What is the reward-to-variability ratio?

20-10 / 25 = .40 = 40%

### The correlation coefficient between two assets equals to _________.

their covariance divided by the product of their standard deviations

### Diversification is most effective when security returns are _________.

negatively correlated

### The expected rate of return of a portfolio of risky securities is _________.

the weighted sum of the securities' expected returns

market risk

### The risk that can be diversified away is __________.

firm specific risk

n/(n - 1)

equal to 0

### Market risk is also called __________ and _________.

systematic risk, nondiversifiable risk

### Firm specific risk is also called __________ and __________.

unique risk, diversifiable risk

Average return

### Harry Markowitz is best known for his Nobel prize winning work on _____________.

techniques used to identify efficient portfolios of risky assets

### Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means that ______.

the returns on the stock and bond portfolio tend to vary independently of each other

### You put half of your money in a stock portfolio that has an expected return of 14% and a standard deviation of 24%. You put the rest of you money in a risky bond portfolio that has an expected return of 6% and a standard deviation of 12%. The stock and bond portfolio have a correlation 0.55. The standard deviation of the resulting portfolio will be ________________.

more than 12% but less than 18%

left and above

### The term "complete portfolio" refers to a portfolio consisting of _________________.

the risk-free asset combined with at least one risky asset

### Rational risk-averse investors will always prefer portfolios _____________.

located on the capital market line to those located on the efficient frontier

III and IV only

lower; steeper

### A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 24% while stock B has a standard deviation of return of 18%. Stock A comprises 60% of the portfolio while stock B comprises 40% of the portfolio. If the variance of return on the portfolio is .0380, the correlation coefficient between the returns on A and B is _________.

A. 0.583

0.0380 = (.62)(.242) + (.42)(.182) + 2(.6)(.4)(.24)(.18) ;  = 0.583

### The standard deviation of return on investment A is .10 while the standard deviation of return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation coefficient between the returns on A and B is _________.

correlation = .0030 / .10(.05) = .60

### A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of 35% while stock B has a standard deviation of return of 15%. The correlation coefficient between the returns on A and B is 0.45. Stock A comprises 40% of the portfolio while stock B comprises 60% of the portfolio. The standard deviation of the return on this portfolio is _________.

19.76%

2p = (.402)(.352) + (.602)(.15)2 + (2)(.4)(.6)(.35)(.15)(.45)
2p = .039046
p = 19.76%

### The standard deviation of return on investment A is .10 while the standard deviation of return on investment B is .04. If the correlation coefficient between the returns on A and B is -.50, the covariance of returns on A and B is _________.

Covariance = -.50(.10)(.04)= -.0020

40%

0%

### The expected return on the optimal risky portfolio is _________.

14.0%

E(rp) = 1.00(.14)=.14

5%

71%

16%

### The standard deviation of the returns on the optimal risky portfolio is _________.

21.4%

2rp = (.292)(.392) + (.712)(.202) + 2(.29)(.71)(.39)(.20).4
2rp = .045804
rp = 21.4%

85%

13.60%

12%

### A measure of the riskiness of an asset held in isolation is ____________.

standard deviation

### Semitool Corp has an expected excess return of 6% for next year. However for every unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it turns out the economy and the stock market do better than expected by 1.5% and Semitool's products experience more rapid growth than anticipated, pushing up the stock price by another 1%. Based on this information what was Semitool's actual excess return?

8.80%

6% + (1.5%)(1.2) + 1% = 8.8%

I and II only

20% more

I and III

### According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of __________ and __________.

identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion

### You are constructing a scatter plot of excess returns for Stock A versus the market index. If the correlation coefficient between Stock A and the index is -1 you will find that the points of the scatter diagram ______________________ and the line of best fit has a ______________.

all fall on the line of best fit; negative slope

### The term excess-return refers to ______________.

the difference between the rate of return earned and the risk-free rate

### You are recalculating the risk of ACE stock in relation to the market index and you find the ratio of the systematic variance to the total variance has risen. You must also find that the ____________.

correlation coefficient between ACE and the market has risen

0.75

### The values of beta coefficients of securities are __________.

usually positive, but are not restricted in any particular way

### A security's beta coefficient will be negative if ____________.

its returns are negatively correlated with market index returns

1

non-systematic

-1.0

less than 1

### If an investor does not diversify their portfolio and instead puts all of their money in one stock, the appropriate measure of security risk for that investor is the ________.

stock's standard deviation

### Which of the following provides the best example of a systematic risk event?

The Federal Reserve increases interest rates 50 basis points.

I, II and III

43%

### The beta of this stock is ____.

1.32
Beta equals slope coefficient = 1.32

0.50

0.50 < 1.32

### The characteristic line for this stock is Rstock = ___ + ___ Rmarket.

4.05, 1.32
Intercept equals 4.05 and slope equals 1.32.

### ____ percent of the variance is explained by this regression.

12
R2 = 12 means 12% of the variance is explained by the regression.

### The stock is ______ riskier than the typical stock.

32%
Beta of 1.32 means that this stock is 32% riskier than the market.

### Decreasing the number of stocks in a portfolio from 50 to 10 would likely _________________________.

increase the unsystematic risk of the portfolio

### If you want to know the portfolio standard deviation for a three stock portfolio you will have to

calculate three covariances

0.8

-0.9

1.0

Unique risk

### Investing in two assets with a correlation coefficient of 1.0 will reduce which kind of risk?

With a correlation of 1.0, no risk will be reduced

systematic risk

I and II only

I, II and III

### Which of the following is a correct expression concerning the formula for the standard deviation of returns of a two asset portfolio where the correlation coefficient is positive?

2rp < (W1212 + W2222)

9.7%

10.8%

### The expected return of portfolio is 8.9% and the risk free rate is 3.5%. If the portfolio standard deviation is 12.0%, what is the reward to variability ratio of the portfolio?

0.45
Reward to variability ratio = (.089 - .035)/.12 = 0.45

73%

### A project has a 50% chance of doubling your investment in one year and a 50% chance of losing half your money. What is the expected return on this investment project?

25%
E[rp] = (.5)(100) + (.5)(-50) = 25%

Stock B

### Which stock is riskier to a non-diversified investor who puts all his money in only one of these stocks?

Stock A is riskier

Example: