EXAMINATION 7

Risk analysis and portfolio diversification Answer: d Diff: E

i. 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.

ii. Consider the following information for three stocks, Stock A, Stock B, and Stock C. The returns on

each of the three stocks are positively correlated, but they are not perfectly correlated. (That is, all of

the correlation coefficients are between 0 and 1.)

Expected Standard

Stock Return Deviation Beta

Stock A 10% 20% 1.0

Stock B 10 20 1.0

Stock C 12 20 1.4

Portfolio P has half of its funds invested in Stock A and half invested in Stock B. Portfolio Q has one

third of its funds invested in each of the three stocks. The risk-free rate is 5 percent, and the market

is in equilibrium. (That is, required returns equal expected returns.) Which of the following

statements is most correct?

a. Portfolio P has a standard deviation of 20 percent.

b. Portfolio P’s coefficient of variation is greater than 2.0.

c. Portfolio Q’s expected return is 10.67 percent.

d. Portfolio Q has a standard deviation of 20 percent.

e. Portfolio P’s required return is greater than the required return on Stock A.
Medium:

Risk aversion Answer: b Diff: M

iii. You have developed the following data on three stocks:

Stock Standard Deviation Beta

A 0.15 0.79

B 0.25 0.61

C 0.20 1.29

If you are a risk minimizer, you should choose Stock if it is to be held in isolation and

Stock if it is to be held as part of a well-diversified portfolio.

a. A; A

b. A; B

c. B; A

d. C; A

e. C; B
SML and risk aversion Answer: e Diff: M

iv. Assume that investors become increasingly risk averse, so that the market risk premium

increases. Also, assume that the risk-free rate and expected inflation remain the same.

Which of the following is most likely to occur?

a. The required rate of return will decline for stocks that have betas less than 1.0.

b. The required rate of return on the market, kM, will remain the same.

c. The required rate of return for each stock in the market will increase by an amount

equal to the increase in the market risk premium.

d. Statements a and b are correct.

e. None of the statements above is correct.

Portfolio risk and return Answer: c Diff: M

v. In a portfolio of three different stocks, which of the following could not be true?

a. The riskiness of the portfolio is less than the riskiness of each of the stocks if each were

held in isolation.

b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.

c. The beta of the portfolio is less than the beta of each of the individual stocks.

d. The beta of the portfolio is greater than the beta of one or two of the individual stocks’ betas.

e. None of the above (that is, they all could be true, but not necessarily at the same time).
i. Risk analysis and portfolio diversification Answer: d Diff: E
A security’s beta does indeed measure market risk relative to that of an average stock. Diversification
reduces the variability of the port-folio’s return. An investor, through diversification, can eliminate
company-specific risk; however, a portfolio containing all publicly-traded stocks would still be exposed to
market risk. The CAPM specifies a stock’s required return as: k s = kRF + (kM - kRF)b. Thus, the risk-free
rate and the market risk premium are needed along with a stock’s beta to determine its required return. A
stock’s beta is more relevant as a measure of risk to an investor with a well-diversified portfolio than to an
investor who holds only that one stock.

X̄

ii. Miscellaneous risk concepts Answer: c Diff: E N

P’s standard deviation is less than 20%, its CV (/ X̄ ) is less than 2.0. So, statement b is incorrect. And,
statement e is incorrect since Portfolio P’s required return equals that of Stock A. Portfolio Q’s required
return = (10% + 10% + 12%)/3 = 10.67%. So, statement c is the correct choice.

iii X̄ . Risk aversion

v X̄ . Portfolio risk and return Answer: c Diff: M