Chapter 7.
Risk and return
I. Multiple choice question
1. What is the principle of diversification?
A. Spreading an investment across a number of assets will eliminate systematic
risk
B. Spreading an investment across a number of assets will eliminate
unsystematic risk
C. Investing more money to a asset to eliminate systematic risk
D. Investing more money to a asset to eliminate unsystematic risk
2. What is the other name of systematic risk?
A. Diversifiable risk
B. Unique risk
C. Asset-specific risk
D. Market risk
3. The greater the beta, the .......... of the security involved.
A. greater the avoidable risk
B. less the unavoidable risk
C. less the avoidable risk
D. greater the unavoidable risk
4. Suppose all the following companies' stocks are trade in the same stock market.
Which one has the highes expected return?
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A. The Gap
B. ExxonMobill
C. Google
D. They are equal
5. ABC Company is investing in a new project. The minimum rate of return the firm
requires on this project is referred to as the ……….
A. average arithmetic return.
B. internal rate of return.
C. market rate of return.
D. cost of capital.
6. There is an inverse relationship between bonds’ quality ratings and their
required return. Thus, the required return is .......... for AAA-rated bonds, and
required returns .......... as the ratings get lower.
A. highest; decrease
B. lowest; increase
C. highest; increase
D. none of the above
7. A stock has a beta of 1.05, the expected return on the market is 11 percent, and
the risk-free rate is 5.2 percent. What must the expected return on this stock be?
A. -0.89%
B. 11.29%
C. 12.20%
D. 22.21%
8. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the
following statements is correct?
A. If expected inflation increases, the required return on both stocks will
increase by the same amount.
B. If expected inflation increases, the required return on both stocks will
decrease by the same amount.
C. If the market risk premium decreases, the required return on both stocks will
decrease but the decrease will be less for Stock Y.
D. If the market risk premium decreases, the required return on both stocks will
decrease but the decrease will be greater for Stock Y.
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9. Assume that the risk-free rate is 5%. Which of the following statements is
correct?
A. If a stock’s beta were less than 1.0, its required return would be less than 5%
B. If a stock’s beta doubled, its required return would more than double.
C. If a stock’s beta were 1.0, its required return would be 5%.
D. If a stock’s beta were negative, its required return would be less than 5%.
10. Jerilu Markets has a beta of 1.09. The risk-free rate of return is 2.75 percent
and the market rate of return is 9.80 percent. What is the risk premium on this
stock?
A. 6.47 percent
B. 7.03 percent
C. 7.68 percent
D. 8.99 percent
Risk premium = 1.09 (0.098 - 0.0275) = 7.68 percent
II. Exercise
1. The rate of return on the common stock of Lancaster Woolens is expected to be
21 percent in a boom economy, 11 percent in a normal economy, and only 3
percent in a recessionary economy. The probabilities of these economic states are
10 percent for a boom, 70 percent for a normal economy, and 20 percent for a
recession. What is the variance of the returns on this common stock?
2. The returns on the common stock of New Image Products are quite cyclical. In a
boom economy, the stock is expected to return 32 percent in comparison to 14
percent in a normal economy and a negative 28 percent in a recessionary period.
The probability of a recession is 25 percent while the probability of a boom is 20
percent. What is the standard deviation of the returns on this stock?
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3. What is the standard deviation of the returns on a stock given the following
information?
4. What is the expected return on a portfolio which is invested 25 percent in stock
A, 55 percent in stock B, and the remainder in stock C? What is the expected risk
premium on the portfolio if the expected T-bill rate (rf) is 3%
5. An investor has a two-stock portfolio with 25 million VND invested in stock X
and 50 million VND invested in stock Y. X's beta is 1.50, and Y's beta is 0.60. What
is the beta of the investor's portfolio?
=25/(25+50)*1.5 + 50/(25+50)*0.6 = 0.9
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6. You want to create a portfolio equally as risky as the market, and you have
$1,000,000 to invest. Given this information, fill in the rest of the following table: