The risk to which all investment securities are subject is known as
Answer (D) is correct. Systematic risk, also called market risk, is the risk faced by all firms. Changes in the economy as a whole, such as the business cycle, affect all players in the market. For this reason, systematic risk is sometimes referred to as undiversifiable risk. Since all investment securities are affected, this risk cannot be offset through portfolio diversification.
One type of risk to which investment securities are subject can be offset through portfolio diversification. This type of risk is referred to as
Answer (D) is correct. Unsystematic risk, also called company or diversifiable risk, is the risk inherent in a particular investment security. Since individual securities are affected by the particular strengths and weaknesses of the issuer, this risk can be offset through portfolio diversification.
A company holds industrial development bonds issued by a county in another state. The county commission has announced that its financial condition has changed drastically and that it is considering defaulting on the next interest and principal payment on these bonds. This situation exposes the company to all of the following types of risk except
Answer (B) is correct. Interest rate risk is the risk that an investment security will fluctuate in value due to changes in interest rates. The potential default is based on the issuer’s financial condition, not the movement of interest rates in the market.
Which one of the following lists properly ranks financial instruments in order from the highest risk/opportunity for return to the lowest risk/opportunity for return?
Answer (A) is correct. Common shareholders are the residual owners of a corporation; they stand last in order of priority during liquidation, but they have the right to receive distribution of excess profits. Preferred shareholders stand ahead of common shareholders in case
of liquidation, but their potential returns are capped by the board of directors. Income bonds, debentures, mortgage bonds, and U.S. Treasury bonds are all debt securities, meaning the issuer is legally obligated to redeem them. Because these returns are guaranteed, they are lower than those for equity investments. Income bonds pay a return only if the issuer is profitable, debentures are unsecured, mortgage bonds are secured by real property, and U.S. Treasury bonds are backed by the full faith and credit of the United States government.
In theory, which of the following coefficients of correlation would eliminate risk in an investment portfolio?
Answer (C) is correct. The correlation coefficient measures the degree to which any two variables, e.g., two stocks in a portfolio, are related. Perfect negative correlation (–1.0) means that the two variables always move in the opposite direction. Given perfect negative correlation, risk would in theory be eliminated. In practice, the existence of market risk makes perfect correlation all but impossible.
Listed below are four numbers. Which of these numbers represents the coefficient of correlation of a stock portfolio with the least risk?
Answer (D) is correct. The correlation coefficient measures the degree to which any two variables, e.g., two stocks in a portfolio, are related. Perfect negative correlation (–1.0) means that the two variables always move in the opposite direction. Given perfect negative correlation, risk would in theory be eliminated. In practice, the existence of market risk makes perfect correlation all but impossible.
The incremental benefits of portfolio diversification initially decrease as the number of
different securities held increases. The benefits become extremely small when more than about __________ different securities are held.
Answer (B) is correct. In principle, diversifiable risk should continue to decrease as the number of different securities held increases. In practice, however, the benefits of diversification become extremely small when more than about 20 to 30 different securities are held.
OldTime, Inc., is a mature firm operating in a very stable market. Earnings growth has averaged about 3.2% for the last dozen years, just staying in line with inflation. The firm’s weighted-average cost of capital is 8%, much lower than most firms. John Storms has just been hired as OldTime’s new CEO and wants to turn what he calls a “cash cow” into a “growth company.” Storms wants to reduce the dividend pay-out and use the resulting retained earnings to fund the firm’s expansion into new product lines. OldTime’s historical beta has been about . . With the CEO’s changes, what will most likely happen to OldTime’s beta and the required return on investment in its shares?
Answer (D) is correct. The required rate of return is equal to the risk-free return plus the beta times the market return less the risk-free return. If OldTime starts expanding into new product lines, the historical beta will increase, as the company will be taking on more risk with these new changes and investments. This will also increase the required rate of return, as per the formula.
If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a company’s required rate of return on its stock of an increase in the beta coefficient from 1.2 to 1.5?
Answer (B) is correct. The required rate of return on equity capital can be estimated with the capital asset pricing model (CAPM). CAPM consists of adding the risk-free rate (i.e., the return on government securities, denoted RF) to the product of the beta coefficient (a measure of the issuer’s risk and the difference between the market return and the risk-free rate (denoted RM – RF, referred to as the risk premium). Below is the basic equilibrium equation for the CAPM: Required rate of return = RF + ?(RM – RF) In this situation, the risk premium is 5% (10% – 5%). Thus, the required rate of return when the beta coefficient is 1.2 is 11% [5% + (1.2 × 5%)], and when the beta
coefficient is 1.5, the required rate is 12.5% [5% + (1.5 × 5%)]. This is an increase of 1.5% (12.5% – 11%).
The common stock of Wisconsin’s Finest Cheese has a beta coefficient of . . The following information about overall market conditions is available.
Expected return on U.S. Treasury bonds 6%
Expected return on the market portfolio 8.5%
Using the capital asset pricing model (CAPM), what is the risk premium on the market?
Answer (C) is correct. The risk premium on the market is the return on the market portfolio (8.5%) minus the risk-free return as measured by the return on U.S. Treasury securities (6%), or 2.5%.