Reading 63: portfolio risk and return- part II Flashcards
An investor put 60% of his portfolio into a risky asset offering a 10% return with a standard deviation of returns of 8% and put the balance of his portfolio in a risk-free asset offering 5%. What is the expected return and standard deviation of his portfolio?
Expected return: (0.60 × 0.10) + (0.40 × 0.05) = 0.08, or 8.0%
Standard deviation: 0.60 × 0.08 = 0.048, or 4.8%
(LOS 63.a)
What is the risk measure associated with the capital market line (CML)?
Beta risk.
Unsystematic risk.
Total risk.
The capital market line (CML) plots return against total risk, which is measured by standard deviation of returns. (LOS 63.b)
A portfolio to the right of the market portfolio on the CML is:
a lending portfolio.
a borrowing portfolio.
an inefficient portfolio.
A portfolio to the right of a portfolio on the CML has more risk than the market portfolio. Investors seeking to take on more risk will borrow at the risk-free rate to purchase more of the market portfolio. (LOS 63.b)
As the number of stocks in a portfolio increases, the portfolio’s systematic risk:
can increase or decrease.
decreases at a decreasing rate.
decreases at an increasing rate.
When you increase the number of stocks in a portfolio, unsystematic risk will decrease at a decreasing rate. However, the portfolio’s systematic risk can be increased by adding higher-beta stocks or decreased by adding lower-beta stocks. (LOS 63.c)
Total risk equals:
unique plus diversifiable risk.
market plus nondiversifiable risk.
systematic plus unsystematic risk.
Total risk equals systematic plus unsystematic risk. Unique risk is diversifiable and is unsystematic. Market (systematic) risk is nondiversifiable risk. (LOS 63.c)
A return generating model is least likely to be based on a security’s exposure to:
statistical factors.
macroeconomic factors.
fundamental factors.
Macroeconomic, fundamental, and statistical factor exposures can be included in a return generating model to estimate the expected return of an investment. However, statistical factors may not have any theoretical basis, so analysts prefer macroeconomic and fundamental factor models. (LOS 63.d)
The covariance of the market’s returns with a stock’s returns is 0.005 and the standard deviation of the market’s returns is 0.05. What is the stock’s beta?
1.0.
1.5.
2.0.
beta = covariance / market variance
market variance = 0.052 = 0.0025
beta = 0.005 / 0.0025 = 2.0
(LOS 63.e)
Which of the following statements about the SML and the CML is least accurate?
Securities that plot above the SML are undervalued.
Investors expect to be compensated for systematic risk.
Securities that plot on the SML have no value to investors.
Securities that plot on the SML are expected to earn their equilibrium rate of return and, therefore, do have value to an investor and may have diversification benefits as well. The other statements are true. (LOS 63.f)
According to the CAPM, what is the expected rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the market rate of return is 12%?
7.2%.
12.0%.
13.2%.
6 + 1.2(12 − 6) = 13.2% (LOS 63.g)
According to the CAPM, what is the required rate of return for a stock with a beta of 0.7, when the risk-free rate is 7% and the expected market rate of return is 14%?
11.9%.
14.0%.
16.8%.
7 + 0.7(14 − 7) = 11.9% (LOS 63.g)
The risk-free rate is 6%, and the expected market return is 15%. A stock with a beta of 1.2 is selling for $25 and will pay a $1 dividend at the end of the year. If the stock is priced at $30 at year-end, it is:
overpriced, so short it.
underpriced, so buy it.
underpriced, so short it.
required rate = 6 + 1.2(15 − 6) = 16.8%
return on stock = (30 − 25 + 1) / 25 = 24%
Based on risk, the stock plots above the SML and is underpriced, so buy it. (LOS 63.h)
A stock with a beta of 0.7 currently priced at $50 is expected to increase in price to $55 by year-end and pay a $1 dividend. The expected market return is 15%, and the risk-free rate is 8%. The stock is:
overpriced, so do not buy it.
underpriced, so buy it.
properly priced, so buy it.
required rate = 8 + 0.7(15 − 8) = 12.9%
return on stock = (55 − 50 + 1) / 50 = 12%
The stock falls below the SML, so it is overpriced. (LOS 63.h)
Which of these return metrics is defined as excess return per unit of systematic risk?
Sharpe ratio.
Jensen’s alpha.
Treynor measure.
The Treynor measure is excess return (return in excess of the risk-free rate) per unit of systematic risk (beta). The Sharpe ratio is excess return per unit of total risk (portfolio standard deviation). Jensen’s alpha is the difference between a portfolio’s actual rate of return and the equilibrium rate of return for a portfolio with the same level of beta (systematic) risk. (LOS 63.i)
