FIN534 Quiz 4 Solution

1) Which of the following statements is CORRECT? Answer a)A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. b)A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. c)A two-stock portfolio will always have a lower beta than a one-stock portfolio. d)If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. e)A stock with an above-average standard deviation must also have an aboveaverage beta. 2 points Question 2 Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio? Answer a)Your portfolio has a standard deviation of 30%, and its expected return is 15%. b)Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. c)Your portfolio has a beta equal to 1.6, and its expected return is 15%. d)Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. e)Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6. Question 3 Assume that in recent years both expected inflation and the market risk premium (rM− rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes? Answer The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. The required returns on all stocks have fallen by the same amount Question 4 1. Which of the following statements is CORRECT? Answer The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF. 2 points Question 5 1. Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio? Answer Variance; correlation coefficient. Standard deviation; correlation coefficient. Beta; variance. Coefficient of variation; beta. Beta; beta.