Chapt 6 Risk Return Principles

Question 1

Which of the following types of risk can be reduced by diversification?

Answer 1

The basic types of investment risk are systematic risk and unsystematic risk. Systematic risk, or market risk, is faced by all firms and cannot be diversified. Unsystematic risk, or unique risk, is the risk inherent in a particular security. A labor strike primarily affects the company experiencing the strike, not the market as a whole. Thus, the risk of a labor strike can be diversified.

Question 2

The type of risk that is undiversifiable and affects the value of a portfolio is

Answer 2

Answer (D) is correct.
Prices of all stocks, even the value of portfolios, are correlated to some degree with broad swings in the stock market. Market risk is the risk that changes in a stock’s price will result from changes in the stock market as a whole. Market risk is commonly referred to as undiversifiable risk.

Question 3

A company has an online order processing system. The company is in the process of determining the dollar amount of loss from user error. The company estimates the probability of occurrence of user error to be 90%, with evenly distributed losses ranging from $1,000 to $30,000. What is the expected annual loss from user error?

Answer 3

Answer (A) is correct.
The first step in calculating the expected annual loss from user error is determining the midpoint of the range of possible losses ($1,000 to $30,000). The midpoint of the range is $15,500 [($1,000 + $30,000) ÷ 2]. The expected annual loss from user error is thus $13,950 ($15,500 × 90%)

Question 4

Management’s financial estimates are based on all of the following except:

Answer 4

Known outcomes.

Question 5

In theory, which of the following coefficients of correlation would eliminate unsystematic risk in an investment portfolio?

Answer 5

–1.0
Answer (C) is correct.
The correlation coefficient measures the degree to which any two variables, e.g., two stocks in a portfolio, are related. Perfect negative correlation (–1.0) means that the two variables always move in the opposite direction. Given perfect negative correlation, unsystematic risk is, in theory, eliminated.