Risk and Return

Need to know — The main focus is on defining and measuring types of risk and return. You need to be able to calculate returns, standard deviations, of individual securities and returns and betas of portfolios. Be able to understand the impact of diversification. You should be able to understand the Capital Asset Pricing Model (CAPM) as it is the predominant theory of the relationship between risk and return. You need to understand CAPM’s uses and the inputs used in CAPM’s calculations.

Do not need to know — How to use or calculate the coefficient of variation or regressions using the security market line.

Questions:

1. Which of the following statements is most correct?

a. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio.

b. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the nonmarket (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless.

c. The required return on a firm’s common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm’s required return.

d. A security’s beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock.

e. A stock’s beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.

2. The Security Market Line (SML) relates risk to return, for a given set of financial market conditions. If the general level of risk aversion among investors suddenly increases, which of the following changes would be most likely to occur?

a. The market risk premium would decrease.

b. Beta would decrease.

c. The SML would shift upward, but the slope of the SML would remain unchanged.

d. The required return on the market portfolio (kM) would increase.

e. None of the indicated changes would be likely to occur.

3. The Security Market Line (SML) relates risk to return, for a given set of financial market conditions. If the general level of risk aversion among investors suddenly decreases (all else constant), which of the following changes would be most likely to occur?

a. The market risk premium would decrease.

b. The beta of the market portfolio would decrease.

c. The SML would shift upward, but the slope of the SML would remain unchanged.

d. The required return on the market portfolio (kM) would increase.

e. None of the indicated changes would be likely to occur.