Chapter 13 - Return, Risk, and the Security Market Line

Chapter 13 5. A news flash just appeared that caused about a dozen stocks to suddenly
Return, Risk, and the Security Market Line drop in value by about 20 percent. What type of risk does this news flash
represent?
1. You own a stock that you think will produce a return of 11 percent in a A. portfolio
good economy and 3 percent in a poor economy. Given the probabilities of B. nondiversifiable
each state of the economy occurring, you anticipate that your stock will earn C. market
6.5 percent next year. Which one of the following terms applies to this 6.5 D. unsystematic
percent? E. total
A. arithmetic return
B. historical return 6. The principle of diversification tells us that:
C. expected return A. concentrating an investment in two or three large stocks will eliminate
D. geometric return all of the unsystematic risk.
E. required return B. concentrating an investment in three companies all within the same
industry will greatly reduce the systematic risk.
2. Suzie owns five different bonds valued at $36,000 and twelve different C. spreading an investment across five diverse companies will not lower the
stocks valued at $82,500 total. Which one of the following terms most total risk.
applies to Suzie's investments? D. spreading an investment across many diverse assets will eliminate all of
A. index the systematic risk.
B. portfolio E. spreading an investment across many diverse assets will eliminate some
C. collection of the total risk.
D. grouping
E. risk-free
7. The _____ tells us that the expected return on a risky asset depends only
3. Steve has invested in twelve different stocks that have a combined value on that asset's nondiversifiable risk.
today of $121,300. Fifteen percent of that total is invested in Wise Man A. efficient markets hypothesis
Foods. The 15 percent is a measure of which one of the following? B. systematic risk principle
A. portfolio return C. open markets theorem
B. portfolio weight D. law of one price
C. degree of risk E. principle of diversification
D. price-earnings ratio
E. index value 8. Which one of the following measures the amount of systematic risk
present in a particular risky asset relative to the systematic risk present in an
4. Which one of the following is a risk that applies to most securities? average risky asset?
A. unsystematic A. beta
B. diversifiable B. reward-to-risk ratio
C. systematic C. risk ratio
D. asset-specific D. standard deviation
E. total E. price-earnings ratio

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 Chapter 13 - Return, Risk, and the Security Market Line

9. Which one of the following is a positively sloped linear function that is created 14. The expected return on a stock computed using economic probabilities
when expected returns are graphed against security betas? is:
A. reward-to-risk matrix A. guaranteed to equal the actual average return on the stock for the next
B. portfolio weight graph five years.
C. normal distribution B. guaranteed to be the minimal rate of return on the stock over the next
D. security market line two years.
E. market real returns C. guaranteed to equal the actual return for the immediate twelve month
period.
10. Which one of the following is represented by the slope of the security market D. a mathematical expectation based on a weighted average and not an
line? actual anticipated outcome.
A. reward-to-risk ratio E. the actual return you should anticipate as long as the economic forecast
B. market standard deviation remains constant.
C. beta coefficient
D. risk-free interest rate 15. The expected risk premium on a stock is equal to the expected return on
E. market risk premium the stock minus the:
A. expected market rate of return.
B. risk-free rate.
11. Which one of the following is the formula that explains the relationship C. inflation rate.
between the expected return on a security and the level of that security's D. standard deviation.
systematic risk? E. variance.
A. capital asset pricing model
B. time value of money equation 16. Standard deviation measures which type of risk?
C. unsystematic risk equation A. total
D. market performance equation B. nondiversifiable
E. expected risk formula C. unsystematic
D. systematic
12. Treynor Industries is investing in a new project. The minimum rate of return E. economic
the firm requires on this project is referred to as the:
A. average arithmetic return. 17. The expected rate of return on a stock portfolio is a weighted average
B. expected return. where the weights are based on the:
C. market rate of return. A. number of shares owned of each stock.
D. internal rate of return. B. market price per share of each stock.
E. cost of capital C. market value of the investment in each stock.
D. original amount invested in each stock.
E. cost per share of each stock held.
13. The expected return on a stock given various states of the economy is equal
to the:
A. highest expected return given any economic state.
B. arithmetic average of the returns for each economic state.
C. summation of the individual expected rates of return.
D. weighted average of the returns for each economic state.
E. return for the economic state with the highest probability of occurrence.
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Chapter 13 - Return, Risk, and the Security Market Line

18. The expected return on a portfolio considers which of the following 21. The standard deviation of a portfolio:
factors? A. is a weighted average of the standard deviations of the individual
I. percentage of the portfolio invested in each individual security securities held in the portfolio.
II. projected states of the economy B. can never be less than the standard deviation of the most risky security in
III. the performance of each security given various economic states the portfolio.
IV. probability of occurrence for each state of the economy C. must be equal to or greater than the lowest standard deviation of any
A. I and III only single security held in the portfolio.
B. II and IV only D. is an arithmetic average of the standard deviations of the individual
C. I, III, and IV only securities which comprise the portfolio.
D. II, III, and IV only E. can be less than the standard deviation of the least risky security in the
E. I, II, III, and IV portfolio.

19. The expected return on a portfolio: 22. The standard deviation of a portfolio:
I. can never exceed the expected return of the best performing security in A. is a measure of that portfolio's systematic risk.
the portfolio. B. is a weighed average of the standard deviations of the individual
II. must be equal to or greater than the expected return of the worst securities held in that portfolio.
performing security in the portfolio. C. measures the amount of diversifiable risk inherent in the portfolio.
III. is independent of the unsystematic risks of the individual securities held D. serves as the basis for computing the appropriate risk premium for that
in the portfolio. portfolio.
IV. is independent of the allocation of the portfolio amongst individual E. can be less than the weighted average of the standard deviations of the
securities. individual securities held in that portfolio.
A. I and III only
B. II and IV only 23. Which one of the following statements is correct concerning a portfolio
C. I and II only of 20 securities with multiple states of the economy when both the
D. I, II, and III only securities and the economic states have unequal weights?
E. I, II, III, and IV A. Given the unequal weights of both the securities and the economic states,
the standard deviation of the portfolio must equal that of the overall market.
20. If a stock portfolio is well diversified, then the portfolio variance: B. The weights of the individual securities have no effect on the expected
A. will equal the variance of the most volatile stock in the portfolio. return of a portfolio when multiple states of the economy are involved.
B. may be less than the variance of the least risky stock in the portfolio. C. Changing the probabilities of occurrence for the various economic states
C. must be equal to or greater than the variance of the least risky stock in will not affect the expected standard deviation of the portfolio.
the portfolio. D. The standard deviation of the portfolio will be greater than the highest
D. will be a weighted average of the variances of the individual securities in standard deviation of any single security in the portfolio given that the
the portfolio. individual securities are well diversified.
E. will be an arithmetic average of the variances of the individual securities E. Given both the unequal weights of the securities and the economic states,
in the portfolio. an investor might be able to create a portfolio that has an expected standard
deviation of zero.

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Chapter 13 - Return, Risk, and the Security Market Line

24. Which one of the following events would be included in the expected 27. Which one of the following is an example of systematic risk?
return on Sussex stock? A. investors panic causing security prices around the globe to fall
A. The chief financial officer of Sussex unexpectedly resigned. precipitously
B. The labor union representing Sussex' employees unexpectedly called a B. a flood washes away a firm's warehouse
strike. C. a city imposes an additional one percent sales tax on all products
C. This morning, Sussex confirmed that its CEO is retiring at the end of the D. a toymaker has to recall its top-selling toy
year as was anticipated. E. corn prices increase due to increased demand for alternative fuels
D. The price of Sussex stock suddenly declined in value because
researchers accidentally discovered that one of the firm's products can be 28. Unsystematic risk:
toxic to household pets. A. can be effectively eliminated by portfolio diversification.
E. The board of directors made an unprecedented decision to give sizeable B. is compensated for by the risk premium.
bonuses to the firm's internal auditors for their efforts in uncovering C. is measured by beta.
wasteful spending. D. is measured by standard deviation.
E. is related to the overall economy.
25. Which one of the following statements is correct?
A. The unexpected return is always negative. 29. Which one of the following is an example of unsystematic risk?
B. The expected return minus the unexpected return is equal to the total A. income taxes are increased across the board
return. B. a national sales tax is adopted
C. Over time, the average return is equal to the unexpected return. C. inflation decreases at the national level
D. The expected return includes the surprise portion of news D. an increased feeling of prosperity is felt around the globe
announcements. E. consumer spending on entertainment decreased nationally
E. Over time, the average unexpected return will be zero.

30. Which one of the following is least apt to reduce the unsystematic risk
26. Which one of the following statements related to unexpected returns is of a portfolio?
correct? A. reducing the number of stocks held in the portfolio
A. All announcements by a firm affect that firm's unexpected returns. B. adding bonds to a stock portfolio
B. Unexpected returns over time have a negative effect on the total return of C. adding international securities into a portfolio of U.S. stocks
a firm. D. adding U.S. Treasury bills to a risky portfolio
C. Unexpected returns are relatively predictable in the short-term. E. adding technology stocks to a portfolio of industrial stocks
D. Unexpected returns generally cause the actual return to vary significantly
from the expected return over the long-term.
E. Unexpected returns can be either positive or negative in the short term
but tend to be zero over the long-term.

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Chapter 13 - Return, Risk, and the Security Market Line

31. Which one of the following statements is correct concerning 35. Which of the following statements are correct concerning diversifiable
unsystematic risk? risks?
A. An investor is rewarded for assuming unsystematic risk. I. Diversifiable risks can be essentially eliminated by investing in thirty
B. Eliminating unsystematic risk is the responsibility of the individual unrelated securities.
investor. II. There is no reward for accepting diversifiable risks.
C. Unsystematic risk is rewarded when it exceeds the market level of III. Diversifiable risks are generally associated with an individual firm or
unsystematic risk. industry.
D. Beta measures the level of unsystematic risk inherent in an individual IV. Beta measures diversifiable risk.
security. A. I and III only
E. Standard deviation is a measure of unsystematic risk. B. II and IV only
C. I and IV only
32. Which one of the following statements related to risk is correct? D. I, II and III only
A. The beta of a portfolio must increase when a stock with a high standard E. I, II, III, and IV
deviation is added to the portfolio.
B. Every portfolio that contains 25 or more securities is free of unsystematic 36. Which one of the following is the best example of a diversifiable risk?
risk. A. interest rates increase
C. The systematic risk of a portfolio can be effectively lowered by adding B. energy costs increase
T-bills to the portfolio. C. core inflation increases
D. Adding five additional stocks to a diversified portfolio will lower the D. a firm's sales decrease
portfolio's beta. E. taxes decrease
E. Stocks that move in tandem with the overall market have zero betas.
37. Which of the following statements concerning risk are correct?
I. Nondiversifiable risk is measured by beta.
33. Which one of the following risks is irrelevant to a well-diversified II. The risk premium increases as diversifiable risk increases.
investor? III. Systematic risk is another name for nondiversifiable risk.
A. systematic risk IV. Diversifiable risks are market risks you cannot avoid.
B. unsystematic risk A. I and III only
C. market risk B. II and IV only
D. nondiversifiable risk C. I and II only
E. systematic portion of a surprise D. III and IV only
E. I, II, and III only
34. Which of the following are examples of diversifiable risk?
I. earthquake damages an entire town 38. The primary purpose of portfolio diversification is to:
II. federal government imposes a $100 fee on all business entities A. increase returns and risks.
III. employment taxes increase nationally B. eliminate all risks.
IV. toymakers are required to improve their safety standards C. eliminate asset-specific risk.
A. I and III only D. eliminate systematic risk.
B. II and IV only E. lower both returns and risks.
C. II and III only
D. I and IV only
E. I, III, and IV only
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Chapter 13 - Return, Risk, and the Security Market Line

39. Which one of the following indicates a portfolio is being effectively 43. Which one of the following statements is correct concerning a
diversified? portfolio beta?
A. an increase in the portfolio beta A. Portfolio betas range between -1.0 and +1.0.
B. a decrease in the portfolio beta B. A portfolio beta is a weighted average of the betas of the individual
C. an increase in the portfolio rate of return securities contained in the portfolio.
D. an increase in the portfolio standard deviation C. A portfolio beta cannot be computed from the betas of the individual
E. a decrease in the portfolio standard deviation securities comprising the portfolio because some risk is eliminated via
diversification.
40. How many diverse securities are required to eliminate the majority of D. A portfolio of U.S. Treasury bills will have a beta of +1.0.
the diversifiable risk from a portfolio? E. The beta of a market portfolio is equal to zero.
A. 5
B. 10 44. The systematic risk of the market is measured by:
C. 25 A. a beta of 1.0.
D. 50 B. a beta of 0.0.
E. 75 C. a standard deviation of 1.0.
D. a standard deviation of 0.0.
41. Systematic risk is measured by: E. a variance of 1.0.
A. the mean.
B. beta. 45. At a minimum, which of the following would you need to know to
C. the geometric average. estimate the amount of additional reward you will receive for purchasing a
D. the standard deviation. risky asset instead of a risk-free asset?
E. the arithmetic average. I. asset's standard deviation
II. asset's beta
42. Which one of the following is most directly affected by the level of III. risk-free rate of return
systematic risk in a security? IV. market risk premium
A. variance of the returns A. I and III only
B. standard deviation of the returns B. II and IV only
C. expected rate of return C. III and IV only
D. risk-free rate D. I, III, and IV only
E. market risk premium E. I, II, III, and IV

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Chapter 13 - Return, Risk, and the Security Market Line

46. Total risk is measured by _____ and systematic risk is measured by

_____.
A. beta; alpha
B. beta; standard deviation
C. alpha; beta
D. standard deviation; beta
E. standard deviation; variance

47. The intercept point of the security market line is the rate of return which
corresponds to:
A. the risk-free rate.
B. the market rate.
C. a return of zero.
D. a return of 1.0 percent.
E. the market risk premium.

48. A stock with an actual return that lies above the security market line
has:
A. more systematic risk than the overall market.
B. more risk than that warranted by CAPM.
C. a higher return than expected for the level of risk assumed.
D. less systematic risk than the overall market.
E. a return equivalent to the level of risk assumed.

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Chapter 13 - Return, Risk, and the Security Market Line

49. The market rate of return is 11 percent and the risk-free rate of return is 52. The market risk premium is computed by:
3 percent. Lexant stock has 3 percent less systematic risk than the market A. adding the risk-free rate of return to the inflation rate.
and has an actual return of 12 percent. This stock: B. adding the risk-free rate of return to the market rate of return.
A. is underpriced. C. subtracting the risk-free rate of return from the inflation rate.
B. is correctly priced. D. subtracting the risk-free rate of return from the market rate of return.
C. will plot below the security market line. E. multiplying the risk-free rate of return by a beta of 1.0.
D. will plot on the security market line.
E. will plot to the right of the overall market on a security market line
graph.

50. Which one of the following will be constant for all securities if the
market is efficient and securities are priced fairly?
A. variance
B. standard deviation
C. reward-to-risk ratio
D. beta
E. risk premium

51. The reward-to-risk ratio for stock A is less than the reward-to-risk ratio
of stock B. Stock A has a beta of 0.82 and stock B has a beta of 1.29. This
information implies that:
A. stock A is riskier than stock B and both stocks are fairly priced.
B. stock A is less risky than stock B and both stocks are fairly priced.
C. either stock A is underpriced or stock B is overpriced or both.
D. either stock A is overpriced or stock B is underpriced or both.
E. both stock A and stock B are correctly priced since stock A is riskier than
stock B.

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Chapter 13 - Return, Risk, and the Security Market Line

53. The excess return earned by an asset that has a beta of 1.34 over that 56. According to CAPM, the amount of reward an investor receives for
earned by a risk-free asset is referred to as the: bearing the risk of an individual security depends upon the:
A. market risk premium. A. amount of total risk assumed and the market risk premium.
B. risk premium. B. market risk premium and the amount of systematic risk inherent in the
C. systematic return. security.
D. total return. C. risk free rate, the market rate of return, and the standard deviation of the
E. real rate of return. security.
D. beta of the security and the market rate of return.
E. standard deviation of the security and the risk-free rate of return.

54. The _____ of a security divided by the beta of that security is equal to
the slope of the security market line if the security is priced fairly.
A. real return
B. actual return
C. nominal return
D. risk premium
E. expected return

55. The capital asset pricing model (CAPM) assumes which of the
following?
I. a risk-free asset has no systematic risk.
II. beta is a reliable estimate of total risk.
III. the reward-to-risk ratio is constant.
IV. the market rate of return can be approximated.
A. I and III only
B. II and IV only
C. I, III, and IV only
D. II, III, and IV only
E. I, II, III, and IV

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Chapter 13 - Return, Risk, and the Security Market Line

57. Which one of the following should earn the most risk premium based on 60. You recently purchased a stock that is expected to earn 22 percent in a
CAPM? booming economy, 9 percent in a normal economy, and lose 33 percent in a
A. diversified portfolio with returns similar to the overall market recessionary economy. There is a 5 percent probability of a boom and a 75
B. stock with a beta of 1.38 percent chance of a normal economy. What is your expected rate of return
C. stock with a beta of 0.74 on this stock?
D. U.S. Treasury bill A. -3.40 percent
E. portfolio with a beta of 1.01 B. -2.25 percent
C. 1.25 percent
D. 2.60 percent
E. 3.50 percent

58. You want your portfolio beta to be 0.95. Currently, your portfolio
consists of $4,000 invested in stock A with a beta of 1.47 and $3,000 in
stock B with a beta of 0.54. You have another $9,000 to invest and want to
divide it between an asset with a beta of 1.74 and a risk-free asset. How
much should you invest in the risk-free asset?
A. $4,316.08
B. $4,425.29
C. $4,902.29
D. $4,574.71
E. $4,683.92

59. You have a $12,000 portfolio which is invested in stocks A and B, and a
risk-free asset. $5,000 is invested in stock A. Stock A has a beta of 1.76 and
stock B has a beta of 0.89. How much needs to be invested in stock B if you
want a portfolio beta of 1.10?
A. $3,750.00
B. $4,333.33
C. $4,706.20
D. $4,943.82
E. $5,419.27

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61. The common stock of Manchester & Moore is expected to earn 13 63. Jerilu Markets has a beta of 1.09. The risk-free rate of return is 2.75
percent in a recession, 6 percent in a normal economy, and lose 4 percent in percent and the market rate of return is 9.80 percent. What is the risk
a booming economy. The probability of a boom is 5 percent while the premium on this stock?
probability of a recession is 45 percent. What is the expected rate of return A. 6.47 percent
on this stock? B. 7.03 percent
A. 8.52 percent C. 7.68 percent
B. 8.74 percent D. 8.99 percent
C. 8.65 percent E. 9.80 percent
D. 9.05 percent
E. 9.28 percent

62. You are comparing stock A to stock B. Given the following

information, what is the difference in the expected returns of these two
securities?

A. -0.85 percent
B. 1.95 percent
C. 2.05 percent
D. 13.45 percent
E. 13.55 percent

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Chapter 13 - Return, Risk, and the Security Market Line

64. If the economy is normal, Charleston Freight stock is expected to return 66. The returns on the common stock of New Image Products are quite
15.7 percent. If the economy falls into a recession, the stock's return is cyclical. In a boom economy, the stock is expected to return 32 percent in
projected at a negative 11.6 percent. The probability of a normal economy comparison to 14 percent in a normal economy and a negative 28 percent in
is 80 percent while the probability of a recession is 20 percent. What is the a recessionary period. The probability of a recession is 25 percent while the
variance of the returns on this stock? probability of a boom is 10 percent. What is the standard deviation of the
A. 0.010346 returns on this stock?
B. 0.011925 A. 19.94 percent
C. 0.013420 B. 21.56 percent
D. 0.013927 C. 25.83 percent
E. 0.014315 D. 32.08 percent
E. 39.77 percent

65. The rate of return on the common stock of Lancaster Woolens is

expected to be 21 percent in a boom economy, 11 percent in a normal
economy, and only 3 percent in a recessionary economy. The probabilities
of these economic states are 10 percent for a boom, 70 percent for a normal
economy, and 20 percent for a recession. What is the variance of the returns
on this common stock?
A. 0.002150
B. 0.002606
C. 0.002244
D. 0.002359
E. 0.002421

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Chapter 13 - Return, Risk, and the Security Market Line

67. What is the standard deviation of the returns on a stock given the 69. You own the following portfolio of stocks. What is the portfolio weight
following information? of stock C?

A. 39.85 percent
A. 1.57 percent B. 42.86 percent
B. 2.03 percent C. 44.41 percent
C. 2.89 percent D. 48.09 percent
D. 3.42 percent E. 52.65 percent
E. 4.01 percent

68. You have a portfolio consisting solely of stock A and stock B. The
portfolio has an expected return of 8.7 percent. Stock A has an expected
return of 11.4 percent while stock B is expected to return 6.4 percent. What
is the portfolio weight of stock A?
A. 39 percent
B. 46 percent
C. 54 percent
D. 61 percent
E. 67 percent

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70. You own a portfolio with the following expected returns given the 71. What is the expected return on a portfolio which is invested 25 percent
various states of the economy. What is the overall portfolio expected in stock A, 55 percent in stock B, and the remainder in stock C?
return?

A. -1.06 percent
A. 6.49 percent B. 2.38 percent
B. 8.64 percent C. 2.99 percent
C. 8.87 percent D. 5.93 percent
D. 9.05 percent E. 6.10 percent
E. 9.23 percent

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Chapter 13 - Return, Risk, and the Security Market Line

72. What is the expected return on this portfolio?

A. 11.48 percent
B. 11.92 percent
C. 13.03 percent
D. 13.42 percent
E. 13.97 percent

73. What is the expected return on a portfolio that is equally weighted

between stocks K and L given the following information?

A. 11.13 percent
B. 11.86 percent
C. 12.25 percent
D. 13.32 percent
E. 14.40 percent

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Chapter 13 - Return, Risk, and the Security Market Line

74. What is the expected return on a portfolio comprised of $6,200 of stock 75. What is the variance of the returns on a portfolio that is invested 60
M and $4,500 of stock N if the economy enjoys a boom period? percent in stock S and 40 percent in stock T?

A. 10.93 percent A. .000017

B. 11.16 percent B. .000023
C. 12.55 percent C. .000118
D. 13.78 percent D. .000136
E. 15.43 percent E. .000161

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76. What is the variance of the returns on a portfolio comprised of $5,400 of 77. What is the standard deviation of the returns on a portfolio that is
stock G and $6,600 of stock H? invested 52 percent in stock Q and 48 percent in stock R?

A. .000709
B. .000848 A. 1.66 percent
C. .001097 B. 2.47 percent
D. .001254 C. 2.63 percent
E. .001468 D. 3.28 percent
E. 3.41 percent

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Chapter 13 - Return, Risk, and the Security Market Line

78. What is the standard deviation of the returns on a $30,000 portfolio 79. What is the standard deviation of the returns on a portfolio that is
which consists of stocks S and T? Stock S is valued at $12,000. invested in stocks A, B, and C? Twenty five percent of the portfolio is
invested in stock A and 40 percent is invested in stock C.

A. 1.07 percent
A. 6.31 percent
B. 1.22 percent
B. 6.49 percent
C. 1.36 percent
C. 7.40 percent
D. 1.49 percent
D. 7.83 percent
E. 1.63 percent
E. 8.72 percent

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Chapter 13 - Return, Risk, and the Security Market Line

80. What is the beta of the following portfolio? 82. Your portfolio has a beta of 1.12. The portfolio consists of 20 percent
U.S. Treasury bills, 50 percent stock A, and 30 percent stock B. Stock A has
a risk-level equivalent to that of the overall market. What is the beta of
stock B?
A. 1.47
B. 1.52
C. 1.69
D. 1.84
E. 2.07

A. 1.04
B. 1.07
C. 1.13
D. 1.16
E. 1.23

81. Your portfolio is comprised of 40 percent of stock X, 15 percent of

stock Y, and 45 percent of stock Z. Stock X has a beta of 1.16, stock Y has
a beta of 1.47, and stock Z has a beta of 0.42. What is the beta of your
portfolio?
A. 0.87
B. 1.09
C. 1.13
D. 1.18
E. 1.21

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Chapter 13 - Return, Risk, and the Security Market Line

83. You would like to combine a risky stock with a beta of 1.68 with U.S. 86. The common stock of Jensen Shipping has an expected return of 16.3
Treasury bills in such a way that the risk level of the portfolio is equivalent percent. The return on the market is 10.8 percent and the risk-free rate of
to the risk level of the overall market. What percentage of the portfolio return is 3.8 percent. What is the beta of this stock?
should be invested in the risky stock? A. .92
A. 32 percent B. 1.23
B. 40 percent C. 1.33
C. 54 percent D. 1.67
D. 60 percent E. 1.79
E. 68 percent

84. The market has an expected rate of return of 10.7 percent. The long-
term government bond is expected to yield 5.8 percent and the U.S.
Treasury bill is expected to yield 3.9 percent. The inflation rate is 3.6
percent. What is the market risk premium?
A. 6.0 percent
B. 6.8 percent
C. 7.5 percent
D. 8.5 percent
E. 9.3 percent

85. The risk-free rate of return is 3.9 percent and the market risk premium is
6.2 percent. What is the expected rate of return on a stock with a beta of
1.21?
A. 10.92 percent
B. 11.40 percent
C. 12.22 percent
D. 12.47 percent
E. 12.79 percent

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Chapter 13 - Return, Risk, and the Security Market Line

87. The common stock of United Industries has a beta of 1.34 and an 90. The common stock of Alpha Manufacturers has a beta of 1.47 and an
expected return of 14.29 percent. The risk-free rate of return is 3.7 percent. actual expected return of 15.26 percent. The risk-free rate of return is 4.3
What is the expected market risk premium? percent and the market rate of return is 12.01 percent. Which one of the
A. 7.02 percent following statements is true given this information?
B. 7.90 percent A. The actual expected stock return will graph above the Security Market
C. 10.63 percent Line.
D. 11.22 percent B. The stock is underpriced.
E. 11.60 percent C. To be correctly priced according to CAPM, the stock should have an
expected return of 21.95 percent.
D. The stock has less systematic risk than the overall market.
E. The actual expected stock return indicates the stock is currently
overpriced.
88. The expected return on JK stock is 15.78 percent while the expected
return on the market is 11.34 percent. The stock's beta is 1.62. What is the
risk-free rate of return?
A. 3.22 percent
B. 3.59 percent
C. 3.63 percent
D. 3.79 percent
E. 4.18 percent

89. Thayer Farms stock has a beta of 1.12. The risk-free rate of return is
4.34 percent and the market risk premium is 7.92 percent. What is the
expected rate of return on this stock?
A. 8.35 percent
B. 9.01 percent
C. 10.23 percent
D. 13.21 percent
E. 13.73 percent

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Chapter 13 - Return, Risk, and the Security Market Line

91. Which one of the following stocks is correctly priced if the risk-free rate 92. Which one of the following stocks is correctly priced if the risk-free rate
of return is 3.7 percent and the market risk premium is 8.8 percent? of return is 3.2 percent and the market rate of return is 11.76 percent?

A. A A. A
B. B B. B
C. C C. C
D. D D. D
E. E E. E

Essay Questions

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Chapter 13 - Return, Risk, and the Security Market Line

93. According to CAPM, the expected return on a risky asset depends on 96. Explain the difference between systematic and unsystematic risk. Also
three components. explain why one of these types of risks is rewarded with a risk premium
Describe each component and explain its role in determining expected while the other type is not.
return.

94. Explain how the slope of the security market line is determined and why
every stock that is correctly priced, according to CAPM, will lie on this
line.

95. Explain how the beta of a portfolio can equal the market beta if 50
percent of the portfolio is invested in a security that has twice the amount of
systematic risk as an average risky security.

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Chapter 13 - Return, Risk, and the Security Market Line

97. A portfolio beta is a weighted average of the betas of the individual 99. You have $10,000 to invest in a stock portfolio. Your choices are Stock
securities which comprise the portfolio. However, the standard deviation is X with an expected return of 13 percent and Stock Y with an expected
not a weighted average of the standard deviations of the individual return of 8 percent. Your goal is to create a portfolio with an expected
securities which comprise the portfolio. Explain why this difference exists. return of 12.4 percent. All money must be invested. How much will you
invest in stock X?
A. $800
B. $1,200
C. $4,600
D. $8,800
E. $9,200

Multiple Choice Questions

98. You own a portfolio that has $2,000 invested in Stock A and $1,400
invested in Stock B. The expected returns on these stocks are 14 percent
and 9 percent, respectively. What is the expected return on the portfolio?
A. 11.06 percent
B. 11.50 percent
C. 11.94 percent
D. 12.13 percent
E. 12.41 percent

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Chapter 13 - Return, Risk, and the Security Market Line

100. What is the expected return and standard deviation for the following 101. What is the expected return of an equally weighted portfolio comprised
stock? of the following three stocks?

A. 16.33 percent
B. 18.60 percent
A. 15.49 percent; 14.28 percent
C. 19.67 percent
B. 15.49 percent; 14.67 percent
D. 20.48 percent
C. 17.00 percent; 15.24 percent
E. 21.33 percent
D. 17.00 percent; 15.74 percent
E. 17.00 percent'; 16.01 percent

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Chapter 13 - Return, Risk, and the Security Market Line

102. Your portfolio is invested 26 percent each in Stocks A and C, and 48 104. A stock has an expected return of 11 percent, the risk-free rate is 6.1
percent in Stock B. What is the standard deviation of your portfolio given percent, and the market risk premium is 4 percent. What is the stock's beta?
the following information? A. 1.18
B. 1.23
C. 1.29
D. 1.32
E. 1.35

A. 12.38 percent
B. 12.64 percent
C. 12.72 percent
D. 12.89 percent
E. 13.73 percent

103. You own a portfolio equally invested in a risk-free asset and two
stocks. One of the stocks has a beta of 1.9 and the total portfolio is equally
as risky as the market. What is the beta of the second stock?
A. 0.75
B. 0.80
C. 0.94
D. 1.00
E. 1.10

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Chapter 13 - Return, Risk, and the Security Market Line

105. A stock has a beta of 1.2 and an expected return of 17 percent. A risk-
free asset currently earns 5.1 percent. The beta of a portfolio comprised of
these two assets is 0.85. What percentage of the portfolio is invested in the
stock?
A. 71 percent
B. 77 percent
C. 84 percent
D. 89 percent
E. 92 percent

106. Consider the following information on three stocks:

A portfolio is invested 35 percent each in Stock A and Stock B and 30

percent in Stock C. What is the expected risk premium on the portfolio if
the expected T-bill rate is 3.8 percent?
A. 11.47 percent
B. 12.38 percent
C. 16.67 percent
D. 24.29 percent
E. 29.99 percent

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Chapter 13 - Return, Risk, and the Security Market Line

107. Suppose you observe the following situation: 108. Consider the following information on Stocks I and II:

Assume these securities are correctly priced. Based on the CAPM, what is
the return on the market?
A. 13.99 percent
B. 14.42 percent
C. 14.67 percent
The market risk premium is 8 percent, and the risk-free rate is 3.6 percent.
D. 14.78 percent
The beta of stock I is _____ and the beta of stock II is _____.
E. 15.01 percent
A. 2.08; 2.47
B. 2.08; 2.76
C. 3.21; 3.84
D. 4.47; 3.89
E. 4.47; 4.26

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Chapter 13 - Return, Risk, and the Security Market Line

109. Suppose you observe the following situation:

Assume the capital asset pricing model holds and stock A's beta is greater
than stock B's beta by 0.21. What is the expected market risk premium?
A. 8.8 percent
B. 9.5 percent
C. 12.6 percent
D. 17.9 percent
E. 20.0 percent

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Chapter 13 - Return, Risk, and the Security Market Line

Chapter 13 Return, Risk, and the Security Market Line Answer Key 2. Suzie owns five different bonds valued at $36,000 and twelve different
stocks valued at $82,500 total. Which one of the following terms most
applies to Suzie's investments?
A. index
B. portfolio
C. collection
Multiple Choice Questions D. grouping
E. risk-free

1. You own a stock that you think will produce a return of 11 percent in a Refer to section 13.2
good economy and 3 percent in a poor economy. Given the probabilities of
each state of the economy occurring, you anticipate that your stock will earn
6.5 percent next year. Which one of the following terms applies to this 6.5
percent?
A. arithmetic return AACSB: N/A
B. historical return Bloom's: Knowledge
C. expected return Difficulty: Basic
D. geometric return Learning Objective: 13-2
E. required return Section: 13.2
Topic: Portfolio
Refer to section 13.1

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-1
Section: 13.1
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

3. Steve has invested in twelve different stocks that have a combined value 4. Which one of the following is a risk that applies to most securities?
today of $121,300. Fifteen percent of that total is invested in Wise Man A. unsystematic
Foods. The 15 percent is a measure of which one of the following? B. diversifiable
A. portfolio return C. systematic
B. portfolio weight D. asset-specific
C. degree of risk E. total
D. price-earnings ratio
E. index value Refer to section 13.4

Refer to section 13.2

AACSB: N/A
Bloom's: Knowledge
AACSB: N/A Difficulty: Basic
Bloom's: Knowledge Learning Objective: 13-3
Difficulty: Basic Section: 13.4
Learning Objective: 13-2 Topic: Systematic risk
Section: 13.2
Topic: Portfolio weight

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Chapter 13 - Return, Risk, and the Security Market Line

5. A news flash just appeared that caused about a dozen stocks to suddenly 6. The principle of diversification tells us that:
drop in value by about 20 percent. What type of risk does this news flash A. concentrating an investment in two or three large stocks will eliminate
represent? all of the unsystematic risk.
A. portfolio B. concentrating an investment in three companies all within the same
B. nondiversifiable industry will greatly reduce the systematic risk.
C. market C. spreading an investment across five diverse companies will not lower the
D. unsystematic total risk.
E. total D. spreading an investment across many diverse assets will eliminate all of
the systematic risk.
Refer to section 13.4 E. spreading an investment across many diverse assets will eliminate some
of the total risk.

Refer to section 13.5

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-3 AACSB: N/A
Section: 13.4 Bloom's: Knowledge
Topic: Unsystematic risk Difficulty: Basic
Learning Objective: 13-2
Section: 13.5
Topic: Diversification

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Chapter 13 - Return, Risk, and the Security Market Line

7. The _____ tells us that the expected return on a risky asset depends only 8. Which one of the following measures the amount of systematic risk
on that asset's nondiversifiable risk. present in a particular risky asset relative to the systematic risk present in an
A. efficient markets hypothesis average risky asset?
B. systematic risk principle A. beta
C. open markets theorem B. reward-to-risk ratio
D. law of one price C. risk ratio
E. principle of diversification D. standard deviation
E. price-earnings ratio
Refer to section 13.6
Refer to section 13.6

AACSB: N/A
Bloom's: Knowledge AACSB: N/A
Difficulty: Basic Bloom's: Knowledge
Learning Objective: 13-3 Difficulty: Basic
Section: 13.6 Learning Objective: 13-3
Topic: Systematic risk Section: 13.6
Topic: Beta

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Chapter 13 - Return, Risk, and the Security Market Line

9. Which one of the following is a positively sloped linear function that is 10. Which one of the following is represented by the slope of the security
created when expected returns are graphed against security betas? market line?
A. reward-to-risk matrix A. reward-to-risk ratio
B. portfolio weight graph B. market standard deviation
C. normal distribution C. beta coefficient
D. security market line D. risk-free interest rate
E. market real returns E. market risk premium

Refer to section 13.7 Refer to section 13.7

AACSB: N/A AACSB: N/A

Bloom's: Knowledge Bloom's: Comprehension
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-4 Learning Objective: 13-4
Section: 13.7 Section: 13.7
Topic: Security market line Topic: Security market line

13-34
Chapter 13 - Return, Risk, and the Security Market Line

11. Which one of the following is the formula that explains the relationship 12. Treynor Industries is investing in a new project. The minimum rate of
between the expected return on a security and the level of that security's return the firm requires on this project is referred to as the:
systematic risk? A. average arithmetic return.
A. capital asset pricing model B. expected return.
B. time value of money equation C. market rate of return.
C. unsystematic risk equation D. internal rate of return.
D. market performance equation E. cost of capital.
E. expected risk formula
Refer to section 13.8
Refer to section 13.7

AACSB: N/A
AACSB: N/A Bloom's: Knowledge
Bloom's: Knowledge Difficulty: Basic
Difficulty: Basic Learning Objective: 13-4
Learning Objective: 13-4 Section: 13.8
Section: 13.7 Topic: Cost of capital
Topic: Capital asset pricing model

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Chapter 13 - Return, Risk, and the Security Market Line

13. The expected return on a stock given various states of the economy is 14. The expected return on a stock computed using economic probabilities
equal to the: is:
A. highest expected return given any economic state. A. guaranteed to equal the actual average return on the stock for the next
B. arithmetic average of the returns for each economic state. five years.
C. summation of the individual expected rates of return. B. guaranteed to be the minimal rate of return on the stock over the next
D. weighted average of the returns for each economic state. two years.
E. return for the economic state with the highest probability of occurrence. C. guaranteed to equal the actual return for the immediate twelve month
period.
Refer to section 13.1 D. a mathematical expectation based on a weighted average and not an
actual anticipated outcome.
E. the actual return you should anticipate as long as the economic forecast
remains constant.

AACSB: N/A
Bloom's: Knowledge Refer to section 13.1
Difficulty: Basic
Learning Objective: 13-1
Section: 13.1
Topic: Expected return AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-1
Section: 13.1
Topic: Expected return

13-36
Chapter 13 - Return, Risk, and the Security Market Line

15. The expected risk premium on a stock is equal to the expected return on
the stock minus the:
A. expected market rate of return.
B. risk-free rate.
C. inflation rate.
D. standard deviation.
E. variance.

Refer to section 13.1

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-1
Section: 13.1
Topic: Risk premium

16. Standard deviation measures which type of risk?

A. total
B. nondiversifiable
C. unsystematic
D. systematic
E. economic

Refer to section 13.1

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-3
Section: 13.1
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

17. The expected rate of return on a stock portfolio is a weighted average 18. The expected return on a portfolio considers which of the following
where the weights are based on the: factors?
A. number of shares owned of each stock. I. percentage of the portfolio invested in each individual security
B. market price per share of each stock. II. projected states of the economy
C. market value of the investment in each stock. III. the performance of each security given various economic states
D. original amount invested in each stock. IV. probability of occurrence for each state of the economy
E. cost per share of each stock held. A. I and III only
B. II and IV only
Refer to section 13.2 C. I, III, and IV only
D. II, III, and IV only
E. I, II, III, and IV

AACSB: N/A Refer to section 13.2

Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2 AACSB: N/A
Topic: Expected return Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

19. The expected return on a portfolio: 20. If a stock portfolio is well diversified, then the portfolio variance:
I. can never exceed the expected return of the best performing security in A. will equal the variance of the most volatile stock in the portfolio.
the portfolio. B. may be less than the variance of the least risky stock in the portfolio.
II. must be equal to or greater than the expected return of the worst C. must be equal to or greater than the variance of the least risky stock in
performing security in the portfolio. the portfolio.
III. is independent of the unsystematic risks of the individual securities held D. will be a weighted average of the variances of the individual securities in
in the portfolio. the portfolio.
IV. is independent of the allocation of the portfolio amongst individual E. will be an arithmetic average of the variances of the individual securities
securities. in the portfolio.
A. I and III only
B. II and IV only Refer to section 13.5
C. I and II only
D. I, II, and III only
E. I, II, III, and IV

AACSB: N/A
Refer to sections 13.2 and 13.6 Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-2
Section: 13.5
AACSB: N/A Topic: Diversification
Bloom's: Comprehension
Difficulty: Intermediate
Learning Objective: 13-1
Section: 13.2 and 13.6
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

21. The standard deviation of a portfolio: 22. The standard deviation of a portfolio:
A. is a weighted average of the standard deviations of the individual A. is a measure of that portfolio's systematic risk.
securities held in the portfolio. B. is a weighed average of the standard deviations of the individual
B. can never be less than the standard deviation of the most risky security in securities held in that portfolio.
the portfolio. C. measures the amount of diversifiable risk inherent in the portfolio.
C. must be equal to or greater than the lowest standard deviation of any D. serves as the basis for computing the appropriate risk premium for that
single security held in the portfolio. portfolio.
D. is an arithmetic average of the standard deviations of the individual E. can be less than the weighted average of the standard deviations of the
securities which comprise the portfolio. individual securities held in that portfolio.
E. can be less than the standard deviation of the least risky security in the
portfolio. Refer to section 13.5

Refer to section 13.2

AACSB: N/A
Bloom's: Comprehension
AACSB: N/A Difficulty: Intermediate
Bloom's: Comprehension Learning Objective: 13-2
Difficulty: Basic Section: 13.5
Learning Objective: 13-1 Topic: Standard deviation
Section: 13.2
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

23. Which one of the following statements is correct concerning a portfolio 24. Which one of the following events would be included in the expected
of 20 securities with multiple states of the economy when both the return on Sussex stock?
securities and the economic states have unequal weights? A. The chief financial officer of Sussex unexpectedly resigned.
A. Given the unequal weights of both the securities and the economic states, B. The labor union representing Sussex' employees unexpectedly called a
the standard deviation of the portfolio must equal that of the overall market. strike.
B. The weights of the individual securities have no effect on the expected C. This morning, Sussex confirmed that its CEO is retiring at the end of the
return of a portfolio when multiple states of the economy are involved. year as was anticipated.
C. Changing the probabilities of occurrence for the various economic states D. The price of Sussex stock suddenly declined in value because
will not affect the expected standard deviation of the portfolio. researchers accidentally discovered that one of the firm's products can be
D. The standard deviation of the portfolio will be greater than the highest toxic to household pets.
standard deviation of any single security in the portfolio given that the E. The board of directors made an unprecedented decision to give sizeable
individual securities are well diversified. bonuses to the firm's internal auditors for their efforts in uncovering
E. Given both the unequal weights of the securities and the economic states, wasteful spending.
an investor might be able to create a portfolio that has an expected standard
deviation of zero. Refer to section 13.3

Refer to section 13.2

AACSB: N/A
Bloom's: Comprehension
AACSB: N/A Difficulty: Basic
Bloom's: Analysis Learning Objective: 13-1
Difficulty: Intermediate Section: 13.3
Learning Objective: 13-2 Topic: Expected return
Section: 13.2
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

25. Which one of the following statements is correct? 26. Which one of the following statements related to unexpected returns is
A. The unexpected return is always negative. correct?
B. The expected return minus the unexpected return is equal to the total A. All announcements by a firm affect that firm's unexpected returns.
return. B. Unexpected returns over time have a negative effect on the total return of
C. Over time, the average return is equal to the unexpected return. a firm.
D. The expected return includes the surprise portion of news C. Unexpected returns are relatively predictable in the short-term.
announcements. D. Unexpected returns generally cause the actual return to vary significantly
E. Over time, the average unexpected return will be zero. from the expected return over the long-term.
E. Unexpected returns can be either positive or negative in the short term
Refer to section 13.3 but tend to be zero over the long-term.

Refer to section 13.3

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic AACSB: N/A
Learning Objective: 13-1 Bloom's: Comprehension
Section: 13.3 Difficulty: Basic
Topic: Unexpected returns Learning Objective: 13-1
Section: 13.3
Topic: Unexpected returns

13-42
Chapter 13 - Return, Risk, and the Security Market Line

27. Which one of the following is an example of systematic risk?

A. investors panic causing security prices around the globe to fall
precipitously
B. a flood washes away a firm's warehouse
C. a city imposes an additional one percent sales tax on all products
D. a toymaker has to recall its top-selling toy
E. corn prices increase due to increased demand for alternative fuels

Refer to section 13.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-3
Section: 13.4
Topic: Systematic risk

28. Unsystematic risk:

A. can be effectively eliminated by portfolio diversification.
B. is compensated for by the risk premium.
C. is measured by beta.
D. is measured by standard deviation.
E. is related to the overall economy.

Refer to section 13.4

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-3
Section: 13.4
Topic: Unsystematic risk

13-43
Chapter 13 - Return, Risk, and the Security Market Line

29. Which one of the following is an example of unsystematic risk?

A. income taxes are increased across the board
B. a national sales tax is adopted
C. inflation decreases at the national level
D. an increased feeling of prosperity is felt around the globe
E. consumer spending on entertainment decreased nationally

Refer to section 13.4

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-3
Section: 13.4
Topic: Unsystematic risk

30. Which one of the following is least apt to reduce the unsystematic risk
of a portfolio?
A. reducing the number of stocks held in the portfolio
B. adding bonds to a stock portfolio
C. adding international securities into a portfolio of U.S. stocks
D. adding U.S. Treasury bills to a risky portfolio
E. adding technology stocks to a portfolio of industrial stocks

Refer to section 13.5

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-3
Section: 13.5
Topic: Unsystematic risk

13-44
Chapter 13 - Return, Risk, and the Security Market Line

31. Which one of the following statements is correct concerning 32. Which one of the following statements related to risk is correct?
unsystematic risk? A. The beta of a portfolio must increase when a stock with a high standard
A. An investor is rewarded for assuming unsystematic risk. deviation is added to the portfolio.
B. Eliminating unsystematic risk is the responsibility of the individual B. Every portfolio that contains 25 or more securities is free of unsystematic
investor. risk.
C. Unsystematic risk is rewarded when it exceeds the market level of C. The systematic risk of a portfolio can be effectively lowered by adding
unsystematic risk. T-bills to the portfolio.
D. Beta measures the level of unsystematic risk inherent in an individual D. Adding five additional stocks to a diversified portfolio will lower the
security. portfolio's beta.
E. Standard deviation is a measure of unsystematic risk. E. Stocks that move in tandem with the overall market have zero betas.

Refer to sections 13.5 and 13.6 Refer to section 13.5

AACSB: N/A AACSB: N/A

Bloom's: Comprehension Bloom's: Comprehension
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-3 Learning Objective: 13-3
Section: 13.5 and 13.6 Section: 13.5
Topic: Unsystematic risk Topic: Risk

13-45
Chapter 13 - Return, Risk, and the Security Market Line

33. Which one of the following risks is irrelevant to a well-diversified 34. Which of the following are examples of diversifiable risk?
investor? I. earthquake damages an entire town
A. systematic risk II. federal government imposes a $100 fee on all business entities
B. unsystematic risk III. employment taxes increase nationally
C. market risk IV. toymakers are required to improve their safety standards
D. nondiversifiable risk A. I and III only
E. systematic portion of a surprise B. II and IV only
C. II and III only
Refer to section 13.5 D. I and IV only
E. I, III, and IV only

Refer to section 13.5

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-3 AACSB: N/A
Section: 13.5 Bloom's: Comprehension
Topic: Unsystematic risk Difficulty: Basic
Learning Objective: 13-2 and 13-3
Section: 13.5
Topic: Unsystematic risk

13-46
Chapter 13 - Return, Risk, and the Security Market Line

35. Which of the following statements are correct concerning diversifiable 36. Which one of the following is the best example of a diversifiable risk?
risks? A. interest rates increase
I. Diversifiable risks can be essentially eliminated by investing in thirty B. energy costs increase
unrelated securities. C. core inflation increases
II. There is no reward for accepting diversifiable risks. D. a firm's sales decrease
III. Diversifiable risks are generally associated with an individual firm or E. taxes decrease
industry.
IV. Beta measures diversifiable risk. Refer to section 13.5
A. I and III only
B. II and IV only
C. I and IV only
D. I, II and III only
E. I, II, III, and IV AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Refer to sections 13.5 and 13.6 Learning Objective: 13-2 and 13-3
Section: 13.5
Topic: Unsystematic risk

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-3
Section: 13.5 and 13.6
Topic: Unsystematic risk

13-47
Chapter 13 - Return, Risk, and the Security Market Line

37. Which of the following statements concerning risk are correct? 38. The primary purpose of portfolio diversification is to:
I. Nondiversifiable risk is measured by beta. A. increase returns and risks.
II. The risk premium increases as diversifiable risk increases. B. eliminate all risks.
III. Systematic risk is another name for nondiversifiable risk. C. eliminate asset-specific risk.
IV. Diversifiable risks are market risks you cannot avoid. D. eliminate systematic risk.
A. I and III only E. lower both returns and risks.
B. II and IV only
C. I and II only Refer to section 13.5
D. III and IV only
E. I, II, and III only

Refer to section 13.5 AACSB: N/A

Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-2 and 13-3
AACSB: N/A Section: 13.5
Bloom's: Comprehension Topic: Diversification
Difficulty: Basic
Learning Objective: 13-3
Section: 13.5
Topic: Systematic and unsystematic risk

13-48
Chapter 13 - Return, Risk, and the Security Market Line

39. Which one of the following indicates a portfolio is being effectively 40. How many diverse securities are required to eliminate the majority of
diversified? the diversifiable risk from a portfolio?
A. an increase in the portfolio beta A. 5
B. a decrease in the portfolio beta B. 10
C. an increase in the portfolio rate of return C. 25
D. an increase in the portfolio standard deviation D. 50
E. a decrease in the portfolio standard deviation E. 75

Refer to section 13.5 Refer to section 13.5

AACSB: N/A AACSB: N/A

Bloom's: Comprehension Bloom's: Knowledge
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-3 Learning Objective: 13-2 and 13-3
Section: 13.5 Section: 13.5
Topic: Diversification Topic: Diversification

13-49
Chapter 13 - Return, Risk, and the Security Market Line

41. Systematic risk is measured by:

A. the mean.
B. beta.
C. the geometric average.
D. the standard deviation.
E. the arithmetic average.

Refer to section 13.6

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-3
Section: 13.6
Topic: Systematic risk

42. Which one of the following is most directly affected by the level of
systematic risk in a security?
A. variance of the returns
B. standard deviation of the returns
C. expected rate of return
D. risk-free rate
E. market risk premium

Refer to section 13.7

AACSB: N/A
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

13-50
Chapter 13 - Return, Risk, and the Security Market Line

43. Which one of the following statements is correct concerning a portfolio 44. The systematic risk of the market is measured by:
beta? A. a beta of 1.0.
A. Portfolio betas range between -1.0 and +1.0. B. a beta of 0.0.
B. A portfolio beta is a weighted average of the betas of the individual C. a standard deviation of 1.0.
securities contained in the portfolio. D. a standard deviation of 0.0.
C. A portfolio beta cannot be computed from the betas of the individual E. a variance of 1.0.
securities comprising the portfolio because some risk is eliminated via
diversification. Refer to section 13.6
D. A portfolio of U.S. Treasury bills will have a beta of +1.0.
E. The beta of a market portfolio is equal to zero.

Refer to section 13.6 AACSB: N/A

Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-4
AACSB: N/A Section: 13.6
Bloom's: Comprehension Topic: Beta
Difficulty: Basic
Learning Objective: 13-4
Section: 13.6
Topic: Beta

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Chapter 13 - Return, Risk, and the Security Market Line

45. At a minimum, which of the following would you need to know to 46. Total risk is measured by _____ and systematic risk is measured by
estimate the amount of additional reward you will receive for purchasing a _____.
risky asset instead of a risk-free asset? A. beta; alpha
I. asset's standard deviation B. beta; standard deviation
II. asset's beta C. alpha; beta
III. risk-free rate of return D. standard deviation; beta
IV. market risk premium E. standard deviation; variance
A. I and III only
B. II and IV only Refer to section 13.6
C. III and IV only
D. I, III, and IV only
E. I, II, III, and IV

AACSB: N/A
Refer to section 13.7 Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-4
Section: 13.6
AACSB: N/A Topic: Risk measures
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

47. The intercept point of the security market line is the rate of return which 48. A stock with an actual return that lies above the security market line
corresponds to: has:
A. the risk-free rate. A. more systematic risk than the overall market.
B. the market rate. B. more risk than that warranted by CAPM.
C. a return of zero. C. a higher return than expected for the level of risk assumed.
D. a return of 1.0 percent. D. less systematic risk than the overall market.
E. the market risk premium. E. a return equivalent to the level of risk assumed.

Refer to section 13.7 Refer to section 13.7

AACSB: N/A AACSB: N/A

Bloom's: Knowledge Bloom's: Comprehension
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-4 Learning Objective: 13-4
Section: 13.7 Section: 13.7
Topic: Security market line Topic: Security market line

13-53
Chapter 13 - Return, Risk, and the Security Market Line

49. The market rate of return is 11 percent and the risk-free rate of return is 50. Which one of the following will be constant for all securities if the
3 percent. Lexant stock has 3 percent less systematic risk than the market market is efficient and securities are priced fairly?
and has an actual return of 12 percent. This stock: A. variance
A. is underpriced. B. standard deviation
B. is correctly priced. C. reward-to-risk ratio
C. will plot below the security market line. D. beta
D. will plot on the security market line. E. risk premium
E. will plot to the right of the overall market on a security market line
graph. Refer to section 13.7

Refer to section 13.7

AACSB: N/A
Bloom's: Comprehension
AACSB: N/A Difficulty: Basic
Bloom's: Comprehension Learning Objective: 13-4
Difficulty: Basic Section: 13.7
Learning Objective: 13-4 Topic: Reward-to-risk ratio
Section: 13.7
Topic: Security market line

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Chapter 13 - Return, Risk, and the Security Market Line

51. The reward-to-risk ratio for stock A is less than the reward-to-risk ratio 52. The market risk premium is computed by:
of stock B. Stock A has a beta of 0.82 and stock B has a beta of 1.29. This A. adding the risk-free rate of return to the inflation rate.
information implies that: B. adding the risk-free rate of return to the market rate of return.
A. stock A is riskier than stock B and both stocks are fairly priced. C. subtracting the risk-free rate of return from the inflation rate.
B. stock A is less risky than stock B and both stocks are fairly priced. D. subtracting the risk-free rate of return from the market rate of return.
C. either stock A is underpriced or stock B is overpriced or both. E. multiplying the risk-free rate of return by a beta of 1.0.
D. either stock A is overpriced or stock B is underpriced or both.
E. both stock A and stock B are correctly priced since stock A is riskier than Refer to section 13.7
stock B.

Refer to section 13.7

AACSB: N/A
Bloom's: Knowledge
Difficulty: Basic
AACSB: N/A Learning Objective: 13-4
Bloom's: Analysis Section: 13.7
Difficulty: Intermediate Topic: Market risk premium
Learning Objective: 13-4
Section: 13.7
Topic: Reward-to-risk ratio

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Chapter 13 - Return, Risk, and the Security Market Line

53. The excess return earned by an asset that has a beta of 1.34 over that 54. The _____ of a security divided by the beta of that security is equal to
earned by a risk-free asset is referred to as the: the slope of the security market line if the security is priced fairly.
A. market risk premium. A. real return
B. risk premium. B. actual return
C. systematic return. C. nominal return
D. total return. D. risk premium
E. real rate of return. E. expected return

Refer to section 13.7 Refer to section 13.7

AACSB: N/A AACSB: N/A

Bloom's: Knowledge Bloom's: Knowledge
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-4 Learning Objective: 13-4
Section: 13.7 Section: 13.7
Topic: Risk premium Topic: Reward-to-risk ratio

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Chapter 13 - Return, Risk, and the Security Market Line

55. The capital asset pricing model (CAPM) assumes which of the 56. According to CAPM, the amount of reward an investor receives for
following? bearing the risk of an individual security depends upon the:
I. a risk-free asset has no systematic risk. A. amount of total risk assumed and the market risk premium.
II. beta is a reliable estimate of total risk. B. market risk premium and the amount of systematic risk inherent in the
III. the reward-to-risk ratio is constant. security.
IV. the market rate of return can be approximated. C. risk free rate, the market rate of return, and the standard deviation of the
A. I and III only security.
B. II and IV only D. beta of the security and the market rate of return.
C. I, III, and IV only E. standard deviation of the security and the risk-free rate of return.
D. II, III, and IV only
E. I, II, III, and IV Refer to section 13.7

Refer to section 13.7

AACSB: N/A
Bloom's: Comprehension
AACSB: N/A Difficulty: Basic
Bloom's: Comprehension Learning Objective: 13-4
Difficulty: Intermediate Section: 13.7
Learning Objective: 13-4 Topic: Risk premium
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

57. Which one of the following should earn the most risk premium based on 58. You want your portfolio beta to be 0.95. Currently, your portfolio
CAPM? consists of $4,000 invested in stock A with a beta of 1.47 and $3,000 in
A. diversified portfolio with returns similar to the overall market stock B with a beta of 0.54. You have another $9,000 to invest and want to
B. stock with a beta of 1.38 divide it between an asset with a beta of 1.74 and a risk-free asset. How
C. stock with a beta of 0.74 much should you invest in the risk-free asset?
D. U.S. Treasury bill A. $4,316.08
E. portfolio with a beta of 1.01 B. $4,425.29
C. $4,902.29
Refer to section 13.7 D. $4,574.71
E. $4,683.92

BetaPortfolio = 0.95 = ($4,000/$16,000)(1.47) + ($3,000/$16,000)(0.54) +

AACSB: N/A (x/$16,000)(1.74) + (($9,000 - x)/$16,000)(0); Investment in risk-free asset
Bloom's: Comprehension = $9,000 - $4,425.29 = $4,574.71
Difficulty: Basic
Learning Objective: 13-4
Section: 13.7
Topic: Risk premium AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-4
Section: 13.2 and 13.6
Topic: Portfolio beta

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Chapter 13 - Return, Risk, and the Security Market Line

59. You have a $12,000 portfolio which is invested in stocks A and B, and a 60. You recently purchased a stock that is expected to earn 22 percent in a
risk-free asset. $5,000 is invested in stock A. Stock A has a beta of 1.76 and booming economy, 9 percent in a normal economy, and lose 33 percent in a
stock B has a beta of 0.89. How much needs to be invested in stock B if you recessionary economy. There is a 5 percent probability of a boom and a 75
want a portfolio beta of 1.10? percent chance of a normal economy. What is your expected rate of return
A. $3,750.00 on this stock?
B. $4,333.33 A. -3.40 percent
C. $4,706.20 B. -2.25 percent
D. $4,943.82 C. 1.25 percent
E. $5,419.27 D. 2.60 percent
E. 3.50 percent
BetaPortfolio = 1.10 = ($5,000/$12,000)(1.76) + (x/$12,000)(0.89) + (($12,000
- $5,000 - x)/$12,000)(0); x = $4,943.82 E(r) = (0.05  0.22) + (0.75  0.09) + (0.20  -0.33) = 1.25 percent

AACSB: Analytic AACSB: Analytic

Bloom's: Application Bloom's: Application
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-4 Learning Objective: 13-1
Section: 13.2 and 13.6 Section: 13.1
Topic: Portfolio beta Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

61. The common stock of Manchester & Moore is expected to earn 13

percent in a recession, 6 percent in a normal economy, and lose 4 percent in
a booming economy. The probability of a boom is 5 percent while the
probability of a recession is 45 percent. What is the expected rate of return
on this stock?
A. 8.52 percent
B. 8.74 percent
C. 8.65 percent
D. 9.05 percent
E. 9.28 percent

E(r) = (0.45 0.13) + (0.50  0.06) + (0.05  -0.04) = 8.65 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.1
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

62. You are comparing stock A to stock B. Given the following 63. Jerilu Markets has a beta of 1.09. The risk-free rate of return is 2.75
information, what is the difference in the expected returns of these two percent and the market rate of return is 9.80 percent. What is the risk
securities? premium on this stock?
A. 6.47 percent
B. 7.03 percent
C. 7.68 percent
D. 8.99 percent
E. 9.80 percent

Risk premium = 1.09 (0.098 - 0.0275) = 7.68 percent

A. -0.85 percent AACSB: Analytic

B. 1.95 percent Bloom's: Application
C. 2.05 percent Difficulty: Basic
D. 13.45 percent Learning Objective: 13-4
E. 13.55 percent Section: 13.1
Topic: Risk premium

E(r)A = (0.45 0.14) + (0.55  -0.22) = -5.80 percent

E(r)B = (0.45  0.17) + (0.55  -0.28) = -7.75 percent
Difference = -5.80 percent - (-7.75 percent) = 1.95 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.1
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

64. If the economy is normal, Charleston Freight stock is expected to return 65. The rate of return on the common stock of Lancaster Woolens is
15.7 percent. If the economy falls into a recession, the stock's return is expected to be 21 percent in a boom economy, 11 percent in a normal
projected at a negative 11.6 percent. The probability of a normal economy economy, and only 3 percent in a recessionary economy. The probabilities
is 80 percent while the probability of a recession is 20 percent. What is the of these economic states are 10 percent for a boom, 70 percent for a normal
variance of the returns on this stock? economy, and 20 percent for a recession. What is the variance of the returns
A. 0.010346 on this common stock?
B. 0.011925 A. 0.002150
C. 0.013420 B. 0.002606
D. 0.013927 C. 0.002244
E. 0.014315 D. 0.002359
E. 0.002421
E(r) = (0.80  0.157) + (0.20  -0.116) = 0.1024
Var = 0.80 (0.157 - 0.1024)2 + 0.20 (-0.116 - 0.1024)2 = 0.011925 E(r) = (0.10  0.21) + (0.70  0.11) + (0.20  0.03) = 0.104
Var = 0.10 (0.21 - 0.104)2 + 0.70 (0.11 - 0.104)2 + 0.20 (0.03 - 0.104)2 =
0.002244

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate AACSB: Analytic
Learning Objective: 13-1 Bloom's: Application
Section: 13.1 Difficulty: Intermediate
Topic: Variance Learning Objective: 13-1
Section: 13.1
Topic: Variance

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Chapter 13 - Return, Risk, and the Security Market Line

66. The returns on the common stock of New Image Products are quite
cyclical. In a boom economy, the stock is expected to return 32 percent in
comparison to 14 percent in a normal economy and a negative 28 percent in
a recessionary period. The probability of a recession is 25 percent while the
probability of a boom is 10 percent. What is the standard deviation of the
returns on this stock?
A. 19.94 percent
B. 21.56 percent
C. 25.83 percent
D. 32.08 percent
E. 39.77 percent

E(r) = (0.10  0.32) + (0.65  0.14) + (0.25  -0.28) = 0.053

Var = 0.10 (0.32 - 0.053)2 + 0.65 (0.14 - 0.053)2 + 0.25 (-0.28 - 0.053)2 =
0.039771
Std dev = 0.039771 = 19.94 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 13-1
Section: 13.1
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

67. What is the standard deviation of the returns on a stock given the 68. You have a portfolio consisting solely of stock A and stock B. The
following information? portfolio has an expected return of 8.7 percent. Stock A has an expected
return of 11.4 percent while stock B is expected to return 6.4 percent. What
is the portfolio weight of stock A?
A. 39 percent
B. 46 percent
C. 54 percent
D. 61 percent
E. 67 percent

0.087 = [0.114 x] + [0.064 (1 - x)]; x = 46 percent

A. 1.57 percent
B. 2.03 percent AACSB: Analytic
C. 2.89 percent Bloom's: Application
D. 3.42 percent Difficulty: Basic
E. 4.01 percent Learning Objective: 13-1
Section: 13.2
Topic: Portfolio weight
E(r) = (0.30  0.15) + (0.65  0.12) + (0.05  0.06) = 0.126
Var = 0.30 (0.15 - 0.126)2 + 0.65 (0.12 - 0.126)2 + 0.05 (0.06 - 0.126)2 =
0.000414
Std dev = 0.000414 = 2.03 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 13-1
Section: 13.1
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

69. You own the following portfolio of stocks. What is the portfolio weight
of stock C?

A. 39.85 percent
B. 42.86 percent
C. 44.41 percent
D. 48.09 percent
E. 52.65 percent

Portfolio weightC = (600  $18)/[(500  $14) + (200  $23) + (600  $18) +

(100  $47)] = $10,800/$27,100 = 39.85 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2
Topic: Portfolio weight

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Chapter 13 - Return, Risk, and the Security Market Line

70. You own a portfolio with the following expected returns given the
various states of the economy. What is the overall portfolio expected
return?

A. 6.49 percent
B. 8.64 percent
C. 8.87 percent
D. 9.05 percent
E. 9.23 percent

E(r) = (0.27  0.14) + (0.70  0.08) + (0.03  -0.11) = 9.05 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

71. What is the expected return on a portfolio which is invested 25 percent

in stock A, 55 percent in stock B, and the remainder in stock C?

A. -1.06 percent
B. 2.38 percent
C. 2.99 percent
D. 5.93 percent
E. 6.10 percent

E(r)Boom = (0.25  0.19) + (0.55  0.09) + (0.20  0.06) = 0.109

E(r)Normal = (0.25  0.11) + (0.55  0.08) + (0.20  0.13) = .0975
E(r)Bust = (0.25  - 0.23) + (0.55  0.05) + (0.20  0.25) = 0.02
E(r)Portfolio = (0.05  0.109) + (0.45  0.0975) + (0.50  0.02) = 5.93 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

72. What is the expected return on this portfolio?

A. 11.48 percent
B. 11.92 percent
C. 13.03 percent
D. 13.42 percent
E. 13.97 percent

Portfolio value = (300  $28) + (500  $10) + (600  $13) = $8,400 +

$5,000 + $7,800 = $21,200; E(r) = ($8,400/$21,200) (0.12) +
($5,000/$21,200) (0.07) + ($7,800/$21,200) (0.15) = 11.92 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

73. What is the expected return on a portfolio that is equally weighted

between stocks K and L given the following information?

A. 11.13 percent
B. 11.86 percent
C. 12.25 percent
D. 13.32 percent
E. 14.40 percent

E(r) = 0.25[(0.16 + 0.13)/2] + 0.75[(0.12 + 0.08)/2] = 11.13 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

13-69
Chapter 13 - Return, Risk, and the Security Market Line

74. What is the expected return on a portfolio comprised of $6,200 of stock

M and $4,500 of stock N if the economy enjoys a boom period?

A. 10.93 percent
B. 11.16 percent
C. 12.55 percent
D. 13.78 percent
E. 15.43 percent

E(r)Boom = [$6,200/($6,200 + $4,500)][0.23] + [$4,500/($6,200 + $4,500)]

[0.05] = 15.43 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

75. What is the variance of the returns on a portfolio that is invested 60

percent in stock S and 40 percent in stock T?

A. .000017
B. .000023
C. .000118
D. .000136
E. .000161

E(r)Boom = (0.60  0.17) + (0.40  0.07) = 0.13

E(r)Normal = (0.60  0.13) + (0.40  0.10) = 0.118
E(r)Portfolio = (0.20  0.13) + (0.80  0.118) = 0.1204
VarPortfolio = 0.20 (0.13 - 0.1204)2] + 0.80 (0.118 - 0.1204)2 = .000023

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 13-2
Section: 13.2
Topic: Variance

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Chapter 13 - Return, Risk, and the Security Market Line

76. What is the variance of the returns on a portfolio comprised of $5,400 of

stock G and $6,600 of stock H?

A. .000709
B. .000848
C. .001097
D. .001254
E. .001468

E(r)Boom = [$5,400/($5,400 + $6,600)][0.21] + [($6,600/($5,400 + $6,600)][0

.13] = 0.166
E(r)Normal = [$5,400/($5,400 + $6,600)][0.13] + [$6,600/($5,400 + $6,600)]
[0.07] = 0.097
E(r)Portfolio = (0.36  0.166) + (0.64  0.097) = 0.12184
VarPortfolio = [0.36  (0.166 - 0.12184)2] + [0.64  (0.097 - 0.12184)2] =
0.001097

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 13-1
Section: 13.2
Topic: Variance

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Chapter 13 - Return, Risk, and the Security Market Line

77. What is the standard deviation of the returns on a portfolio that is

invested 52 percent in stock Q and 48 percent in stock R?

A. 1.66 percent
B. 2.47 percent
C. 2.63 percent
D. 3.28 percent
E. 3.41 percent

E(r)Boom = (0.52  0.14) + (.0.48  0.16) = 0.1496

E(r)Normal = (0.52  0.08) + (0.48  0.11) = 0.0944
E(r)Portfolio = (0.10  .0.1496) + (0.90  0.0944) = 0.09992
VarPortfolio = [0.10  (0.1496 - 0.09992)2] + [0.90  (0.0944 - 0.09992)2] =
0.000274
Std dev = 0.000274 = 1.66 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 13-1
Section: 13.2
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

78. What is the standard deviation of the returns on a $30,000 portfolio

which consists of stocks S and T? Stock S is valued at $12,000. AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 13-1
Section: 13.2
Topic: Standard deviation

A. 1.07 percent
B. 1.22 percent
C. 1.36 percent
D. 1.49 percent
E. 1.63 percent

E(r)Boom = [$12,000/$30,000] [0.11] + [($30,000 - $12,000)/$30,000] [0.05]

= 0.074
E(r)Normal = [$12,000/$30,000] [0.08] + [($30,000 - $12,000)/$30,000] [0.06]
= 0.068
E(r)Bust = [$12,000/$30,000] [-0.05] + [($30,000 - $12,000)/$30,000] [0.08]
= 0.028
E(r)Portfolio = (0.05  0.074) + (0.85  0.068) + (0.10  0.028) = 0.0643
VarPortfolio = [0.05  (0.074 - 0.0643)2] + [0.85  (0.068 - 0.0643)2] + [0.10 
(0.028 - 0.0643)2] = .000148111
Std dev = 0.000148111 = 1.22 percent

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Chapter 13 - Return, Risk, and the Security Market Line

79. What is the standard deviation of the returns on a portfolio that is

invested in stocks A, B, and C? Twenty five percent of the portfolio is
invested in stock A and 40 percent is invested in stock C.

A. 6.31 percent
B. 6.49 percent
C. 7.40 percent
D. 7.83 percent
E. 8.72 percent

E(r)Boom = (0.25  0.17) + (0.35  0.06) + (0.40  0.22) = 0.1515

E(r)Normal = (0.25  0.08) + (0.35  0.10) + (0.40  0.15) = 0.115
E(r)Bust = (0.25  -0.03) + (0.35  0.19) + (0.40  -0.25) = -0.041
E(r)Portfolio = (0.05  0.1515) + (0.55  0.115) + (0.40  -0.041) = 0.054425
VarPortfolio = [0.05  (0.1515 - 0.054425)2] + [0.55  (0.115 - 0.054425)2] +
[0.40  (-0.041 - 0.054425)2] = 0.006132
Std dev = .006132 = 7.83 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
Learning Objective: 13-1
Section: 13.2
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

80. What is the beta of the following portfolio? 81. Your portfolio is comprised of 40 percent of stock X, 15 percent of
stock Y, and 45 percent of stock Z. Stock X has a beta of 1.16, stock Y has
a beta of 1.47, and stock Z has a beta of 0.42. What is the beta of your
portfolio?
A. 0.87
B. 1.09
C. 1.13
D. 1.18
E. 1.21

BetaPortfolio = (0.40  1.16) + (0.15  1.47) + (0.45  0.42) = 0.87

A. 1.04
B. 1.07
C. 1.13
D. 1.16
E. 1.23 AACSB: Analytic
Bloom's: Application
Difficulty: Basic
ValuePortfolio = $6,700 + $4,900 + $8,500 = $20,100 Learning Objective: 13-4
BetaPortfolio = ($6,700/$20,100  1.58) + ($4,900/$20,100  1.23) + Section: 13.6
($8,500/$20,100  0.79) = 1.16 Topic: Beta

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-4
Section: 13.6
Topic: Beta

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82. Your portfolio has a beta of 1.12. The portfolio consists of 20 percent 83. You would like to combine a risky stock with a beta of 1.68 with U.S.
U.S. Treasury bills, 50 percent stock A, and 30 percent stock B. Stock A has Treasury bills in such a way that the risk level of the portfolio is equivalent
a risk-level equivalent to that of the overall market. What is the beta of to the risk level of the overall market. What percentage of the portfolio
stock B? should be invested in the risky stock?
A. 1.47 A. 32 percent
B. 1.52 B. 40 percent
C. 1.69 C. 54 percent
D. 1.84 D. 60 percent
E. 2.07 E. 68 percent

BetaPortfolio = 1.12 = (0.2  0) + (0.5  1) + (0.3  B); B = 2.07 BetaPortfolio = 1.0 = [(x)  1.68] + [(1 - x)  0]; x = 60 percent
The beta of a risk-free asset is zero. The beta of the market is 1.0.

AACSB: Analytic
AACSB: Analytic Bloom's: Application
Bloom's: Application Difficulty: Basic
Difficulty: Basic Learning Objective: 13-4
Learning Objective: 13-4 Section: 13.6
Section: 13.6 Topic: Beta
Topic: Beta

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Chapter 13 - Return, Risk, and the Security Market Line

84. The market has an expected rate of return of 10.7 percent. The long- 85. The risk-free rate of return is 3.9 percent and the market risk premium is
term government bond is expected to yield 5.8 percent and the U.S. 6.2 percent. What is the expected rate of return on a stock with a beta of
Treasury bill is expected to yield 3.9 percent. The inflation rate is 3.6 1.21?
percent. What is the market risk premium? A. 10.92 percent
A. 6.0 percent B. 11.40 percent
B. 6.8 percent C. 12.22 percent
C. 7.5 percent D. 12.47 percent
D. 8.5 percent E. 12.79 percent
E. 9.3 percent
E(r) = 0.039 + (1.21  0.062) = 11.40 percent
Market risk premium = 10.7 percent - 3.9 percent = 6.8 percent

AACSB: Analytic
AACSB: Analytic Bloom's: Application
Bloom's: Application Difficulty: Basic
Difficulty: Basic Learning Objective: 13-4
Learning Objective: 13-4 Section: 13.7
Section: 13.7 Topic: CAPM
Topic: Risk premium

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Chapter 13 - Return, Risk, and the Security Market Line

86. The common stock of Jensen Shipping has an expected return of 16.3 87. The common stock of United Industries has a beta of 1.34 and an
percent. The return on the market is 10.8 percent and the risk-free rate of expected return of 14.29 percent. The risk-free rate of return is 3.7 percent.
return is 3.8 percent. What is the beta of this stock? What is the expected market risk premium?
A. .92 A. 7.02 percent
B. 1.23 B. 7.90 percent
C. 1.33 C. 10.63 percent
D. 1.67 D. 11.22 percent
E. 1.79 E. 11.60 percent

E(r) = 0.163 = 0.038 +  (0.108 - 0.038);  = 1.79 E(r) = 0.1429 = 0.037 + 1.34 Mrp; Mrp = 7.90 percent

AACSB: Analytic AACSB: Analytic

Bloom's: Application Bloom's: Application
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-4 Learning Objective: 13-4
Section: 13.7 Section: 13.7
Topic: CAPM Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

88. The expected return on JK stock is 15.78 percent while the expected 89. Thayer Farms stock has a beta of 1.12. The risk-free rate of return is
return on the market is 11.34 percent. The stock's beta is 1.62. What is the 4.34 percent and the market risk premium is 7.92 percent. What is the
risk-free rate of return? expected rate of return on this stock?
A. 3.22 percent A. 8.35 percent
B. 3.59 percent B. 9.01 percent
C. 3.63 percent C. 10.23 percent
D. 3.79 percent D. 13.21 percent
E. 4.18 percent E. 13.73 percent

E(r) = 0.1578 = rf + 1.62 (0.1134 - rf); rf = 4.18 percent E(r) = 0.0434 + (1.12  0.0792) = 13.21 percent

AACSB: Analytic AACSB: Analytic

Bloom's: Application Bloom's: Application
Difficulty: Basic Difficulty: Basic
Learning Objective: 13-4 Learning Objective: 13-4
Section: 13.7 Section: 13.7
Topic: CAPM Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

90. The common stock of Alpha Manufacturers has a beta of 1.47 and an
actual expected return of 15.26 percent. The risk-free rate of return is 4.3
percent and the market rate of return is 12.01 percent. Which one of the
following statements is true given this information?
A. The actual expected stock return will graph above the Security Market
Line.
B. The stock is underpriced.
C. To be correctly priced according to CAPM, the stock should have an
expected return of 21.95 percent.
D. The stock has less systematic risk than the overall market.
E. The actual expected stock return indicates the stock is currently
overpriced.

E(r) = 0.043 + 1.47 (0.1201 - 0.043) = 15.63 percent

The stock is overpriced because its actual expected return is less than the
CAPM return.

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

91. Which one of the following stocks is correctly priced if the risk-free rate
of return is 3.7 percent and the market risk premium is 8.8 percent?

A. A
B. B
C. C
D. D
E. E

E(r)A = 0.037 + (0.64  0.088) = 0.0933

E(r)B = 0.037 + (0.97  0.088) = 0.1224
E(r)C = 0.037 + (1.22  0.088) = 0.1444 Stock C is correctly priced.
E(r)D = 0.037 + (1.37  0.088) = 0.1576
E(r)E = 0.037 + (1.68  0.088) = 0.1848

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

92. Which one of the following stocks is correctly priced if the risk-free rate
of return is 3.2 percent and the market rate of return is 11.76 percent?

A. A
B. B
C. C
D. D
E. E

E(r)A = 0.032 + [0.87  (0.1176 - 0.032)] = 0.1065

E(r)B = 0.032 + [1.09  (0.1176 - 0.032)] = 0.1253
E(r)C = 0.032 + [1.18  (0.1176 - 0.032)] = 0.1330
E(r)D = 0.032 + [1.34  (0.1176 - 0.032)] = 0.1467
E(r)E = 0.032 + [1.62  (0.1176 - 0.032)] = 0.1707 Stock E is correctly
priced.

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

Essay Questions

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Chapter 13 - Return, Risk, and the Security Market Line

93. According to CAPM, the expected return on a risky asset depends on 94. Explain how the slope of the security market line is determined and why
three components. every stock that is correctly priced, according to CAPM, will lie on this
Describe each component and explain its role in determining expected line.
return.
The market risk premium is the slope of the security market line. Slope is
CAPM suggests the expected return is a function of (1) the risk-free rate of the rise over the run, which in this case is the difference between the market
return, which is the pure time value of money, (2) the market risk premium, return and the risk-free rate divided by a beta of 1.0 minus a beta of zero. If
which is the reward for bearing systematic risk, and (3) beta, which is the a stock is correctly priced the reward-to-risk ratio will be constant and equal
amount of systematic risk present in a particular asset. Better answers will to the slope of the security market line. Thus, every stock that is correctly
point out that both the pure time value of money and the reward for bearing priced will lie on the security market line.
systematic risk are exogenously determined and can change on a daily
basis, while the amount of systematic risk for a particular asset is Feedback: Refer to section 13.7
determined by the firm's decision-makers.

Feedback: Refer to section 13.7

AACSB: Reflective thinking
Bloom's: Analysis
Difficulty: Intermediate
AACSB: Reflective thinking Learning Objective: 13-4
Bloom's: Analysis Section: 13.7
Difficulty: Intermediate Topic: Security market line
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

95. Explain how the beta of a portfolio can equal the market beta if 50 96. Explain the difference between systematic and unsystematic risk. Also
percent of the portfolio is invested in a security that has twice the amount of explain why one of these types of risks is rewarded with a risk premium
systematic risk as an average risky security. while the other type is not.

An average risky security has a beta of 1.0, which is the market beta. Risk- Unsystematic, or diversifiable, risk affects a limited number of securities
free securities, i.e., U.S. Treasury bills, have a beta of zero. A portfolio that and can be eliminated by investing in securities from various industries and
is invested 50 percent in a security that has a beta of 2.0 (twice the geographic regions. Unsystematic risk is not rewarded since it can be
systematic risk as an average risky security) and 50 percent in risk-free eliminated by investors. Systematic risk is risk which affects most, or all,
securities (U.S. Treasury bills) will have a beta of 1.0 (which is the market securities and cannot be diversified away. Since systematic risk must be
beta). accepted by investors it is rewarded with a risk premium and is measured by
beta.
Feedback: Refer to section 13.7
Feedback: Refer to section 13.5

AACSB: Reflective thinking

Bloom's: Analysis AACSB: Reflective thinking
Difficulty: Intermediate Bloom's: Analysis
Learning Objective: 13-4 Difficulty: Intermediate
Section: 13.7 Learning Objective: 13-3
Topic: Beta Section: 13.5
Topic: Systematic and unsystematic risk

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Chapter 13 - Return, Risk, and the Security Market Line

97. A portfolio beta is a weighted average of the betas of the individual 98. You own a portfolio that has $2,000 invested in Stock A and $1,400
securities which comprise the portfolio. However, the standard deviation is invested in Stock B. The expected returns on these stocks are 14 percent
not a weighted average of the standard deviations of the individual and 9 percent, respectively. What is the expected return on the portfolio?
securities which comprise the portfolio. Explain why this difference exists. A. 11.06 percent
B. 11.50 percent
Standard deviation measures total risk. The unsystematic portion of the total C. 11.94 percent
risk can be eliminated by diversification. Therefore, the total risk of a D. 12.13 percent
diversified portfolio is less than the total risk of the component parts. Beta, E. 12.41 percent
on the other hand, measures systematic risk, which cannot be eliminated by
diversification. Thus, the systematic risk of a portfolio is the summation of E(Rp) = [$2,000/($2,000 + $1,400)] [0.14] + [$1,400/($2,000 + $1,400)]
the systematic risk of the component parts. [0.09] = 11.94 percent

Feedback: Refer to section 13.5

AACSB: Analytic
Bloom's: Application
AACSB: Reflective thinking Difficulty: Basic
Bloom's: Analysis EOC #: 13-2
Difficulty: Intermediate Learning Objective: 13-1
Learning Objective: 13-3 Section: 13.1
Section: 13.5 Topic: Expected return
Topic: Systematic and unsystematic risk

Multiple Choice Questions

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Chapter 13 - Return, Risk, and the Security Market Line

99. You have $10,000 to invest in a stock portfolio. Your choices are Stock
X with an expected return of 13 percent and Stock Y with an expected
return of 8 percent. Your goal is to create a portfolio with an expected
return of 12.4 percent. All money must be invested. How much will you
invest in stock X?
A. $800
B. $1,200
C. $4,600
D. $8,800
E. $9,200

E(Rp) = 0.124 = .13x + .08(1 - x); x = 88 percent

Investment in Stock X = 0.88($10,000) = $8,800

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #:13-4
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

100. What is the expected return and standard deviation for the following
stock?

A. 15.49 percent; 14.28 percent

B. 15.49 percent; 14.67 percent
C. 17.00 percent; 15.24 percent
D. 17.00 percent; 15.74 percent
E. 17.00 percent'; 16.01 percent

E(R) = 0.10(-0.19) + 0.60(0.14) + 0.30(0.35) = 17.00 percent

2 = 0.10(-0.19 - 0.17)2 + 0.60(0.14 - 0.17)2 + 0.30(0.35 - 0.17)2 = 0.02322
 = 0.02322 = 15.24 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 13-7
Learning Objective: 13-1
Section: 13.2
Topic: Standard deviation

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Chapter 13 - Return, Risk, and the Security Market Line

101. What is the expected return of an equally weighted portfolio comprised

of the following three stocks?

A. 16.33 percent
B. 18.60 percent
C. 19.67 percent
D. 20.48 percent
E. 21.33 percent

E(Rp)Boom = (0.19 + 0.13 + 0.31)/3 = 0.21

E(Rp)Bust = (0.15 + 0.11 + 0.17)/3 = 0.1433
E(Rp) = 0.64(0.21) + 0.36(0.1433) = 18.60 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 13-9
Learning Objective: 13-1
Section: 13.2
Topic: Expected return

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Chapter 13 - Return, Risk, and the Security Market Line

102. Your portfolio is invested 26 percent each in Stocks A and C, and 48

percent in Stock B. What is the standard deviation of your portfolio given AACSB: Analytic
the following information? Bloom's: Application
Difficulty: Basic
EOC #: 13-10
Learning Objective: 13-1
Section: 13.2
Topic: Standard deviation

A. 12.38 percent
B. 12.64 percent
C. 12.72 percent
D. 12.89 percent
E. 13.73 percent

E(Rp)Boom = 0.26(0.25) + 0.48(0.25) + 0.26(0.45) = 0.302

E(Rp)Good = 0.26(0.10) + 0.48(0.13) + 0.26(0.11) = 0.117
E(Rp)Poor = 0.26(0.03) + 0.48(0.05) + 0.26(0.05) = 0.0448
E(Rp)Bust = 0.26(-0.04) + 0.48(-0.09) + 0.26(-0.09) = -0.077
E(Rp) = 0.25(0.302) + 0.25(0.117) + 0.25(0.0448) + 0.25(-0.077) = 0.0967
p2 = 0.25(0.302 - 0.0967)2 + 0.25(0.117 - 0.0967)2 + 0.25(0.0448 - 0.0967)2
+ 0.25(-0.077 - 0.0967)2 = 0.018856
p = 0.018856 = 13.73 percent

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Chapter 13 - Return, Risk, and the Security Market Line

103. You own a portfolio equally invested in a risk-free asset and two 104. A stock has an expected return of 11 percent, the risk-free rate is 6.1
stocks. One of the stocks has a beta of 1.9 and the total portfolio is equally percent, and the market risk premium is 4 percent. What is the stock's beta?
as risky as the market. What is the beta of the second stock? A. 1.18
A. 0.75 B. 1.23
B. 0.80 C. 1.29
C. 0.94 D. 1.32
D. 1.00 E. 1.35
E. 1.10
E(Ri) = 0.11 = 0.61 + i(0.04); i = 1.23
p = 1.0 = (1/3)(0) + (1/3)(x) + (1/3)(1.9); x = 1.1

AACSB: Analytic
AACSB: Analytic Bloom's: Analysis
Bloom's: Application Difficulty: Basic
Difficulty: Basic EOC #: 13-14
EOC #: 13-12 Learning Objective: 13-4
Learning Objective: 13-4 Section: 13.7
Section: 13.6 Topic: CAPM
Topic: Beta

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Chapter 13 - Return, Risk, and the Security Market Line

105. A stock has a beta of 1.2 and an expected return of 17 percent. A risk-
free asset currently earns 5.1 percent. The beta of a portfolio comprised of
these two assets is 0.85. What percentage of the portfolio is invested in the
stock?
A. 71 percent
B. 77 percent
C. 84 percent
D. 89 percent
E. 92 percent

p = 0.85 = 1.2x + (1 -x)(0); Bp = 71 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Basic
EOC #: 13-17
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

106. Consider the following information on three stocks:

A portfolio is invested 35 percent each in Stock A and Stock B and 30

percent in Stock C. What is the expected risk premium on the portfolio if
the expected T-bill rate is 3.8 percent?
A. 11.47 percent
B. 12.38 percent
C. 16.67 percent
D. 24.29 percent
E. 29.99 percent

E(Rp)Boom = 0.35(0.55) + 0.35(0.35) + 0.30(0.65) = 0.51

E(Rp)Normal = 0.35(0.44) + 0.35(0.18) + 0.30(0.04) = 0.229
E(Rp)Bust = 0.35(0.37) + 0.35(-0.17) + 0.30(-0.64) = -0.122
E(Rp) = 0.45(0.51) + 0.50(0.229) + 0.05(-0.122) = 0.3379
RPi = 0.3379 - 0.038 = 29.99 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
EOC #: 13-23
Learning Objective: 13-2
Section: 13.1
Topic: Portfolio risk premium

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Chapter 13 - Return, Risk, and the Security Market Line

107. Suppose you observe the following situation:

Assume these securities are correctly priced. Based on the CAPM, what is
the return on the market?
A. 13.99 percent
B. 14.42 percent
C. 14.67 percent
D. 14.78 percent
E. 15.01 percent

Rf : (0.12 - Rf)/0.8 = (0.16 - Rf)/1.1; Rf = 1.33 percent

RM: 0.12 = 0.0133 + 0.8(RM - 0.0133); RM = 14.67 percent

AACSB: Analytic
Bloom's: Application
Difficulty: Intermediate
EOC #: 13-27
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

108. Consider the following information on Stocks I and II:

The market risk premium is 8 percent, and the risk-free rate is 3.6 percent.
The beta of stock I is _____ and the beta of stock II is _____.
A. 2.08; 2.47
B. 2.08; 2.76
C. 3.21; 3.84
D. 4.47; 3.89
E. 4.47; 4.26

E(RI) = 0.06(0.15) + 0.25(0.35) + 0.69(0.43) = 0.3932

BI: 0.3932 = 0.036 + BI (0.08); BI = 4.47
E(RII) = 0.06(-0.35) + 0.25(0.35) + 0.69(0.45) = 0.0377
BII: 0.0377 = 0.036 + BII (0.08); BII = 4.26

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
EOC #: 13-26
Learning Objective: 13-4
Section: 13.7
Topic: CAPM

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Chapter 13 - Return, Risk, and the Security Market Line

109. Suppose you observe the following situation:

Assume the capital asset pricing model holds and stock A's beta is greater
than stock B's beta by 0.21. What is the expected market risk premium?
A. 8.8 percent
B. 9.5 percent
C. 12.6 percent
D. 17.9 percent
E. 20.0 percent

E(RA) = 0.22(-0.12) + 0.48(0.10) + 0.30(0.23) = .0906

E(RB) = 0.22(-0.27) + 0.48(0.05) + 0.30(0.28) = .0486
SlopeSML = (.0906 - 0.486)/0.21 = 20 percent

AACSB: Analytic
Bloom's: Analysis
Difficulty: Intermediate
EOC #: 13-28
Learning Objective: 13-3
Section: 13.7
Topic: Security market line

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