Chapter (5): Risk and Return

Define the following.

Term Definition
Return is the total gain or loss experienced on an investment over a given period of time.
- is a measure of the uncertainty surrounding the return that an investment
will earn or, more formally, the
Risk
- The variability of returns associated with a given investment (asset).
- is the chance of suffering a financial loss.
is the attitude toward risk in which investors would ask or require for an increased
Risk Averse
return to compensate them for taking higher risk.
The attitude toward risk in which investors choose the investment with the higher
Risk In-different (Neutral)
return regardless of its risk.
The attitude toward risk in which investors prefer investments with greater risk
Risk Seeking (Lover)
even if they have lower expected returns.
Single Asset Investment Means that the investor his/her money in only one financial asset.
is an approach for assessing risk that uses several possible alternative outcomes
Scenario analysis (scenarios) to obtain a sense of the variability among returns (considering
pessimistic (worst), most likely (expected), and optimistic (best) outcomes)
- is a measure of an asset’s risk
Range - Range = Optimistic (Best) - Pessimistic (Worst)
- The higher the Range the higher the Risk and vice-versa
- Means using statistical measures (Standard deviation - coefficient of
Risk Assessment
variation).
- is the most common statistical indicator of an asset’s risk; it measures the
Standard Deviation dispersion around the expected value.
- The higher the SD the higher the Risk and vice-versa
- is a measure of relative dispersion that is useful in comparing the risks of
Coefficient of Variation assets with differing expected returns.
- The higher the CV the higher the Risk and vice-versa
Expected value of a return - The average return that an investment is expected to produce over time.
Portfolio Group of financial assets.
Efficient Portfolio - a portfolio that maximize return for a given level of risk.
Correlation - A statistical measure of the relationship between any two series of numbers.
Positively correlated Describes two series that move in the same direction
Negatively correlated Describes two series that move in opposite directions
Perfectly positively Describes two positively correlated series that have a correlation coefficient of +1.
correlated
Perfectly negatively Describes two negatively correlated series that have a correlation coefficient of -1
correlated
Describes two series that lack any interaction and therefore have a correlation
Uncorrelated
coefficient close to zero
The asset selection process allows the investor to reduce overall risk by combining
negatively correlated assets so that the risk of the portfolio is less than the risk of
Diversification
the individual assets in it. Even if assets are not negatively correlated, the lower the
positive correlation between them, the lower the resulting risks.

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 Term Definition
- The basic theory that links risk and return for all assets.
- It quantifies the relationship between risk and return.
Capital Asset
- Measures non-diversifiable risk using Beta.
Pricing Model
(CAPM) - The CAPM assumes that markets are efficient.
- The CAPM relies on historical data which means that the betas may or may not
actually reflect the future variability of returns.
Total Risk - = Non-diversifiable risk + Diversifiable risk
- The portion of an asset’s risk that is attributable to firm specific, random causes;
Diversifiable risk can be eliminated through diversification. Also called unsystematic risk.
- Such as lawsuits, regulatory actions
- The relevant portion of an asset’s risk attributable to market factors that affect all
Non-diversifiable
firms; cannot be eliminated through diversification. Also called systematic risk.
risk
- such as political events, inflation, economic situations
- A relative measure of non-diversifiable risk. An index of the degree of movement of
an asset’s return in response to a change in the market return.
- higher risk stocks will have higher beta values.

Beta coefficient

- is a graphical presentation of the relationship between the amount of systematic

risk associated with an asset and the required return.
- Systematic risk is measured by beta and is on the horizontal axis while the required
return is on the vertical axis.
- The risk-return tradeoff is clearly represented by the SML
- The Security Market Line (SML) is not stable over time.
▪ A - Changes in Inflationary expectations
- Changes in Inflationary expectations result in parallel shifts in the (SML)
▪ b. changes in Risk aversion
- Changes in Risk aversion and shifts in the (SML) result from changing preferences
of investors.
- Increasing risk aversion results in a steepening in the slop of (SML)
The Security
Market Line (SML) - Decreasing risk aversion results in reducing in the slop of (SML)
 Practical Part

1) Rate of Return

Example (1) At the beginning of the year, Apple stock traded for $90.75 per share, during the
year, Apple paid no dividends, at the end of the year, Apple stock was worth $210.73. Calculate
the annual rate of return.

2) Last year Mike bought 100 shares of Dallas Corporation common stock for $53 per share.
During the year he received dividends of $1.45 per share. The stock is currently selling for $60
per share. What rate of return did Mike earn over the year?
A) 11.7 percent
B) 13.2 percent
C) 14.1 percent
- Example (On PP and DPP) → Star food Company is a large industry company that is recently considering
D) 15.9 percent
two projects: Project (Y) requires an initial investment of EGP 350,000,000 project (Z) an initial investment
Answer: D
of EGP 320,000,000. The estimated cost of capital is 10%.
3) A company bought 100 shares of Cisco Systems stock for $24.00 per share on January 1, 2002.
He received a dividend of $2.00 per share at the end of 2002 and $3.00 per share at the end of
2003. At the end of 2004, Nico collected a dividend of $4.00 per share and sold his stock for
$18.00 per share. What was Nico's realized holding period return?
A) -12.5%
B) +12.5%
C) -16.7%
D) +16.7%
Answer: B
4) Nico bought 100 shares of Cisco Systems stock for $24.00 per share on January 1, 2002. He
received a dividend of $2.00 per share at the end of 2002 and $3.00 per share at the end of 2003.
At the end of 2004, Nico collected a dividend of $4.00 per share and sold his stock for $18.00 per
share. What was Nico's realized holding period return?
A) -12.5%
B) +12.5%
C) -16.7%
D) +16.7%
Answer: B

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 2) Range

Example → Solar Designs is considering an investment in an expanded product line. Two

possible types of expansion are being considered. After investigating the possible outcomes, the
company made the estimates shown in the following table.

a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?

3) Expected value of a return for single Asset (Using Probabilities)

5) Standard deviation for single Asset (Using Probabilities)

4) Coefficient of Variation

Example →

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6) Return on a portfolio

7) Expected value of a return and Standard deviation for portfolio (Without Probabilities)

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Example → Given the returns of two stocks J and K in the table below over the next 4 years. Find
the expected return and standard deviation of holding a portfolio of 40% of stock J and 60% in
stock K over the next 4 years:

8) Beta coefficient

1) An investment banker has recommended a $100,000 portfolio containing assets B, D, and F.

$20,000 will be invested in asset B, with a beta of 1.5; $50,000 will be invested in asset D, with a
beta of 2.0; and $30,000 will be invested in asset F, with a beta of 0.5. The beta of the portfolio is
A) 1.25.
B) 1.33.
C) 1.45.
D) unable to be determined from the information provided.
Answer: C
2) Nicole holds three stocks in her portfolio: A, B, and C. The portfolio beta is 1.40. Stock A
comprises 15 percent of the dollar value of her holdings and has a beta of 1.0. If Nicole sells all
of her investment in A and invests the proceeds in the risk-free asset, her new portfolio beta will
be
A) 0.60.
B) 0.88.
C) 1.00.
D) 1.25.
Answer: D
1 * 15% = 0.15
1.4 – 0.15 = 1.25

9) CAPM

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1) What is the expected market return if the expected return on asset X is 20 percent, its beta is
1.5, and the risk free rate is 5 percent?
A) 5.0%
B) 7.5%
C) 15.0%
D) 22.5%
Answer: C
20% = 5% + (1.5 * (x – 5%)
20% = 5% + 1.5x – 7.5%
20% = - 2.5% + 1.5x
22.5% = 1.5x
X = 15%
2) Asset P has a beta of 0.9. The risk-free rate of return is 8 percent, while the return on the
market portfolio of assets is 14 percent. The asset's required rate of return is
A) 13.4 percent.
B) 6.0 percent.
C) 5.4 percent.
D) 10 percent.
Answer: A
3) What is the expected risk-free rate of return if asset X, with a beta of 1.5, has an expected
return of 20 percent, and the expected market return is 15 percent?
A) 5.0%
B) 7.5%
C) 15.0%
D) 22.5%
Answer: A
4) What is the expected return for asset X if it has a beta of 1.5, the expected market return is 15
percent, and the expected risk-free rate is 5 percent?
A) 5.0%
B) 7.5%
C) 15.0%
D) 20.0%
Answer: D

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 Questions Part (Part 1)
artTrue
(2) or False
1) Portfolio objectives should be established before beginning to invest.
Answer: TRUE
2) A portfolio that offers the lowest risk for a given level of return is known as an efficient portfolio.
Answer: TRUE
3) By plotting the efficient frontier, investors can find the unique portfolio that is ideal for all investors.
Answer: FALSE
4) Portfolio objectives should be established independently of tax considerations.
Answer: FALSE
5) If the actual rate of return on an investment portfolio is constant from year to year, the standard deviation of that portfolio
is zero.
Answer: TRUE
6) An efficient portfolio maximizes the rate of return without consideration of risk.
Answer: FALSE
7) Negatively correlated assets reduce risk more than positively correlated assets.
Answer: TRUE
8) Correlation is a measure of the relationship between two series of numbers.
Answer: TRUE
9) Most assets show a slight degree of negative correlation.
Answer: FALSE
10) Investing globally offers better diversification than investing only domestically.
Answer: TRUE
11) Studies have shown that investing in different industries as well as different countries reduces portfolio risk.
Answer: TRUE
12) Coefficients of correlation range from a maximum of +10 to a minimum of -10.
Answer: FALSE
13) Diversifiable risk is also called systematic risk.
Answer: FALSE
14) Standard deviation is a measure that indicates how the price of an individual security responds to market forces.
Answer: FALSE
15) Betas for actively traded stocks. are readily available from online sources.
Answer: TRUE
16) A negative beta means that on average a stock moves in the opposite direction of the market.
Answer: TRUE
17) A beta of 0.5 means that a stock is half as risky the overall market.
Answer: TRUE
18) The index used to represent market returns is always assigned a beta of 1.0.
Answer: TRUE
19) The betas of most stocks are constant over time.
Answer: FALSE
20) A stock with a beta of 1.3 is less risky than a stock with a beta of 0.42.
Answer: FALSE
21) For stocks with positive betas, higher risk stocks will have higher beta values.
Answer: TRUE
22) Adding stocks with higher standard deviations to a portfolio will necessarily increase the portfolio's risk.
Answer: FALSE
23) Beta measures diversifiable risk while standard deviation measures systematic risk.
Answer: FALSE

24) By design, half of all stocks betas are positive betas and half are negative.
Answer: FALSE
25) The basic theory linking portfolio risk and return is the Capital Asset Pricing Model.
Answer: TRUE
26) The CAPM estimates the required rate of return on a stock held as part of a well diversified portfolio.
Answer: TRUE
27) In the Capital Asset Pricing Model, beta measures a stock's sensitivity to overall market returns.
Answer: TRUE
28) According to the CAPM, the required rate of a return on a stock can be estimated using only beta and the risk-free rate.
Answer: FALSE
29) The risk premium to be used in the Capital Asset Pricing Model is calculated as (rf-rm).
Answer: FALSE
30) Risk can be defined as uncertainty concerning the actual return that an investment will generate.
Answer: TRUE
31) Lower risk investments are associated with lower expected rates of return.
Answer: TRUE
32) Investing in short-term debt decreases exposure to interest rate risk.
Answer: TRUE
33) The standard deviation is computed by dividing the sum of the squared deviations by the number of observations.
Answer: FALSE
34) Historical returns are of no use in estimating the risk of an investment.
Answer: FALSE
35) The greater the dispersion around an asset's expected return, the greater the risk.
Answer: TRUE
36) Investments with lower standard deviations can be expected to produce higher rates of return.
Answer: FALSE
37) Historically speaking, the standard deviation of returns on U.S. Treasury Bills is zero.
Answer: FALSE
38) Most of investors are risk-seeking.
Answer: FALSE
39) Most of investors are risk-averse.
Answer: TRUE
40) Diversifiable risk is also called systematic risk
Answer: FALSE
41) A stock with a beta of 1.3 is less risky than a stock with a beta of 0.42.
Answer: FALSE
42) Risk can be totally eliminated by combining two assets that are perfectly positively correlated.
Answer: FALSE
43) The CAPM estimates the required rate of return on a stock held as part of a well diversified portfolio.
Answer: TRUE
44) In the Capital Asset Pricing Model, beta measures a stock's sensitivity to overall market returns
Answer: TRUE
45)Modern portfolio theory seeks to minimize risk and maximize return by combining highly
correlated assets.
Answer: FALSE
46) A portfolio with a beta of 1.5 will be 50% more volatile than the market portfolio.
Answer: TRUE
47) Both modern portfolio theory and traditional portfolio management result in diversified portfolios, but they
take different approaches to diversification.
Answer: TRUE
48) Portfolio betas will always be lower than the weighted average betas of the securities in the
portfolio.
Answer: FALSE
 MCQs
1) Melissa owns the following portfolio of stocks. What is the return on her portfolio?

A) 8.0%
B) 9.0%
C) 9.8%
D) 10.9%
Answer: C
2) Marco owns the following portfolio of stocks. What is the expected return on his portfolio?

A) 5.5%
B) 6.6%
C) 4.7%
D) 8.0%
Answer: A
3) A portfolio consisting of four stocks is expected to produce returns of -9%, 11%, 13% and 17%, respectively, over the
next four years. What is the standard deviation of these expected returns?
A) 10.05%
B) 11.60%
C) 8.00%
D) 33.42%
Answer: B
4) The stock of a technology company has an expected return of 15% and a standard deviation of 20% The stock of a
pharmaceutical company has an expected return of 13% and a standard deviation of 18%. A portfolio consisting of 50%
invested in each stock will have an expected return of 14 % and a standard deviation
A) less than the average of 20% and 18%.
B) the average of 20% and 18%.
C) greater than the average of 20% and 18%.
D) the answer cannot be determined with the information given.
Answer: A
5) The statement "A portfolio is less than the sum of its parts." means
A) it is less expensive to buy a group of assets than to buy those assets individually.
B) portfolio returns will always be lower than the returns on individual stocks.
C) a diversified group of assets will be less volatile than the individual assets within the group.
D) for reasons that are not well understood, the value of a portfolio is less than the sum of the values of its components.
Answer: C
6) Combining uncorrelated assets will
A) increase the overall risk level of a portfolio.
B) decrease the overall risk level of a portfolio.
C) not change the overall risk level of a portfolio.
D) cause the other assets in the portfolio to become positively related.
Answer: B
7) Two assets have a coefficient of correlation of -.4.
A) Combining these assets will increase risk.
B) Combining these assets will have no effect on risk.
C) Combining these assets may either raise or lower risk.
D) Combining these assets will reduce risk.
Answer: D
8) In the real world, most of the assets available to investors
A) tend to be somewhat positively correlated.
B) tend to be somewhat negatively correlated.
C) tend to be uncorrelated.
D) tend to be either perfectly positively or perfectly negatively correlated.
Answer: A
9) The risk of a portfolio consisting of two uncorrelated assets will be
A) equal to zero.
B) greater than the risk of the least risky asset but less than the risk level of the more risky asset.
C) greater than zero but less than the risk of the more risky asset.
D) equal to the average of the risk level of the two assets.
Answer: C
10) Which of the following represent unsystematic risks?
I. the president of a company suddenly resigns
II. the economy goes into a recessionary period
III. a company's product is recalled for defects
IV. the Federal Reserve unexpectedly changes interest rates
A) I, II and IV only
B) II and IV only
C) I and III only
D) I, II and III only
Answer: C
11) Which of the following represent systematic risks?
I. the president of a company suddenly resigns
II. the economy goes into a recessionary period
III. a company's product is recalled for defects
IV. the Federal Reserve unexpectedly changes interest rates
A) I, II and IV only
B) II and IV only
C) I and III only
D) I, II and III only
Answer: B
12) Estimates of a stock's beta may vary depending on
I. when the estimate was made.
II. the risk-free rate of interest used.
III. how many months of returns were used to estimate the beta.
IV. the index used to represent market returns.
A) I, II and IV only
B) II and IV only
C) I, III and IV only
D) I, II and III only
Answer: C
13) Which one of the following conditions can be effectively eliminated through portfolio diversification?
A) a general price increase nationwide
B) an interest rate reduction by the Federal Reserve
C) increased government regulation of auto emissions
D) change in the political party that controls Congress
Answer: C
14) Which one of the following types of risk cannot be effectively eliminated through portfolio
diversification?
A) inflation risk
B) labor problems
C) materials shortages
D) product recalls
Answer: A
15) Which one of the following conditions can be effectively eliminated through portfolio diversification?
A) a general price increase nationwide
B) an interest rate reduction by the Federal Reserve
C) increased government regulation of auto emissions
D) change in the political party that controls Congress
Answer: C
16) Systematic risks
A) can be eliminated by investing in a variety of economic sectors.
B) are forces that affect all investment categories.
C) result from random firm-specific events.
D) are unique to certain types of investment.
Answer: B
17) A measure of systematic risk is
A) standard deviation.
B) correlation coefficient.
C) beta.
D) variance.
Answer: C
18) Beta can be defined as the slope of the line that explains the relationship between
A) the return on a security and the return on the market.
B) the returns on a security and various points in time.
C) the return on stocks and the returns on bonds.
D) the risk free rate of return versus the market rate of return.
Answer: A
19) In designing a portfolio, relevant risk is
A) total risk.
B) unsystematic risk.
C) event risk.
D) non-diversifiable risk.
Answer: D
20) Which of the following best describes the relationship between a stock's beta and the standard deviation of the stock's
returns?
A) The higher the standard deviation, the higher the beta.
B) The higher the standard deviation, the lower the beta.
C) The relationship depends on the correlation between the stock's returns and the market's returns.
D) Standard deviation and beta are different ways of measuring the same thing.
Answer: C
21) A stock's beta value is a measure of
A) interest rate risk.
B) total risk.
C) systematic risk.
D) diversifiable risk.
Answer: C
22) The beta of the market is
A) -1.0.
B) 0.0.
C) 1.0.
D) undefined.
Answer: C
23) When the stock market has bottomed out and is beginning to recover, the best portfolio toown is the one with a beta of
A) 0.0.
B) +0.5.
C) +1.5.
D) +2.0.
Answer: D
24) The best stock to own when the stock market is at a peak and is expected to decline in value is one with a beta of
A) +1.5.
B) +1.0.
C) -1.0.
D) -0.5.
Answer: C
25) Stock of Gould and Silber Inc. has a beta of -1. If the market declines by 10%, Gould and Silber would be expected to
A) decline by 10%.
B) rise by 10%.
C) not respond to market fluctuations.
D) decline by 1%.
Answer: B
26) Beta is the slope of the best fit line for the points with coordinates representing the
________ and the ________ for each one of several years.
A) rate of return; level of risk for an individual security
B) rate of inflation; rate of return for an individual security
C) risk level of a stock; market rate of return
D) market rate of return; security's rate of return
Answer: D
27) The stock of ABC, Inc. has a beta of .80. The market rate of return is expected to increase by by 5%. Beta predicts
that ABC stock should
A) increase in value by 6.25%.
B) increase in value by 4.0%.
C) decrease in value by 1.0%.
D) increase in value by .8%.
Answer: B
28) The market rate of return increased by 8% while the rate of return on XYZ stock increased by 4%. The beta of XYZ
stock is
A) -2.0.
B) -0.40.
C) 0.50.
D) 2.0.
Answer: C
29) Which of the following statements concerning beta are correct?
I. Stock with high standard deviations of returns will always high betas.
II. The higher the beta, the higher the expected return.
III. A beta can be positive, negative, or equal to zero.
IV. A beta of .35 indicates a lower rate of risk than a beta of -0.50.
A) II and III only
B) I and IV only
C) II, III and IV only
D) I, II, III and IV
Answer: C
30) You have gathered the following information concerning a particular investment and conditions in the
market

According to the Capital Asset Pricing Model, the required return for this investment is
A) 8.85%.
B) 11.48%.
C) 13.98%.
D) 14.85%.
Answer: C
31) OKAY stock has a beta of 0.8. The market as a whole is expected to decline by 12% thereby causing OKAY stock to
A) decline by 9.6%.
B) decline by 12.5%.
C) increase by 9.6%.
D) increase by 12%.
Answer: A
32) The Capital Asset Pricing Model (CAPM) is a mathematical model that depicts the
A) positive relationship between risk and return.
B) standard deviation between a risk premium and an investment's expected return.
C) exact price that an investor should be willing to pay for any given investment.
D) difference between a risk-free return and the expected rate of inflation.
Answer: A
33) When the Capital Asset Pricing Model is depicted graphically, the result is the
A) standard deviation line.
B) coefficient of variation line.
C) security market line.
D) alpha-beta line.
Answer: C
34) Which of the following factors comprise the CAPM?
I. dividend yield
II. risk-free rate of return
III. the expected rate of return on the market
IV. risk premium for the firm
A) I and III only
B) II and IV only
C) III and IV only
D) II, III and IV only
Answer: D
35) The Franko Company has a beta of 1.90. By what percent will the required rate of return on the stock of Franko
Company increase if the expected market rate of return rises by 3%?
A) 1.91%
B) 2.75%
C) 3.27%
D) 5.70%
Answer: D
36) What is the expected return on a stock with a beta of 1.09, a market risk premium of 8%, and a risk-free rate of 4%?
A) 4.36%
B) 8.36%
C) 8.72%
D) 12.72%
Answer: D
37) According to MSN money, the stock of Orange Corporation has a beta of 1.5, but according to Yahoo Finance it is
1.75. The expected rate of return on the market is 12% and the risk free rate is 2%. What is the difference between the
required rates of return calculated using each of these betas?
A) 1.50%
B) 1.75%
C) 2.0%
D) 2.5%
Answer: D
38) The Capital Asset Pricing Model (CAPM) includes which of the following in its base
assumptions?
I. Investors should earn a minimum return equal to the risk-free rate.
II. Investors in the market should earn a return greater than the return on the overall market.
III. Investors should be rewarded for the amount of risk they assume.
IV. Investors should earn a return located above the Security Market Line.
A) I and III only
B) II and IV only
C) I, II and III only
D) I, III and IV only
Answer: A
39) Small company stocks are yielding 10.7% while the U.S. Treasury bill has a 1.3% yield and
a bank savings account is yielding 0.8%. What is the risk premium on small company stocks?
A) 10.7%
B) 9.4%
C) 12.0%
D) 9.9%
Answer: B
40) The risk-free rate of return is 2% while the market rate of return is 12%. Parson Company
has a historical beta of .85. Today, the beta for Delta Company was adjusted to reflect internal
changes in the structure of the company. The new beta is 1.38. What is the amount of the
change in the expected rate of return for Delta Company based on this revision to beta?
A) 8.5%
B) 5.3%
C) 12.2%
D) 14.0%
Answer: B
41) Which of the following statements about the Security Market Line are correct?
I. The intercept point is the risk-free rate of return.
II. The slope of the line is beta.
III. An investor should accept any return located above the SML line.
IV. A beta of 1.0 indicates the risk-free rate of return.
A) I and II only
B) III and IV only
C) II, III and IV only
D) I,II and III only
Answer: D
42) Investors are rewarded for assuming
A) total risk.
B) diversifiable risk.
C) nondiversifiable risk.
D) any type of risk.
Answer: C
43) Modern portfolio theory does not consider diversifiable risk relevant because
A) it is easy to eliminate.
B) it is impossible to eliminate.
C) its effects are unpredictable.
D) its effects are too small to make a difference in portfolio returns.
Answer: A
44) Amanda has the following portfolio of assets.