Module 4 Conceputals

Which of the following statements is not (or least) correct?

• The coefficient of variation is a measure of a distribution’s degree of dispersion per unit of expected value.

• Although the beta of a diversified portfolio represents that risk which cannot be diversified away, the beta of a single security, since it is not diversified, is a measure of its total or stand-alone risk.

• Beta can be defined either as [(COVJM) / ( 2 M)] or as [(CORJM)(J) / (M)]. This indicates that when comparing securities, a security that has a higher correlation with the market may not necessarily also have the higher beta

• The beta of a portfolio comprised of 100 stocks will not necessarily be less than the beta of a portfolio comprised of only 50 stocks.

• The standard deviation (or stand-alone risk) of a portfolio comprised of 100 stocks will not necessarily be less than the standard deviation of a portfolio comprised of only 50 stocks.

Select the statement that is most correct.

• Assuming that everyone can lend and borrow at the same risk-free rate, rational investors will hold a portfolio on the capital market line (i.e., a ray from the risk-free rate that is tangent to the efficient frontier of risky securities).

• The Capital Asset Pricing Model is based on the proposition that any stock’s required rate of return is equal to the risk-free rate plus a risk premium that compensates investors for diversifiable risk.

• An investor can eliminate company specific risk simply by increasing a security’s correlation with the market.

• The slope of the security market line measures a security’s beta (nondiversifiable risk) and beta can change whenever there is a change in investors’ expectations of inflation and/or their degree of risk aversion.

• A portfolio consisting of two stocks that are perfectly positively correlated will be exactly as risky (using either standard deviation or beta) as either of the stocks comprising the portfolio.

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements is most correct?

• Stock Y's actual return this year will be higher than Stock X's return.

• Stock Y's actual return has a higher standard deviation than Stock X

• If expected inflation increases (but the market risk premium is unchanged), the required returns on the two stocks will increase by the same amount.

• If the market risk premium declines (leaving the risk-free rate unchanged), Stock X will have a larger decline in its required return than will Stock Y.

• If you invest $50,000 in Stock X and $50,000 in Stock Y, your portfolio will have a beta less than 1.0, provided the stock returns on the two stocks are not perfectly correlated.

Which of the following statements is most correct?

• Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio.

• If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the non-market (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be risk less.

• The required return on a firm’s common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information, including market information, is required to specify the firm’s required return.

• A security’s beta measures its non-diversifiable (systematic, or market) risk relative to that of the market or an “average stock” within the market.

• A stock’s beta is less relevant as a measure of risk to an investor with a well diversified portfolio than to an investor who holds only that one stock.

Which of the following statements is most correct?

• Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not accurately measure stand-alone risk.

• If the calculated beta underestimates the firm's true investment risk, then the CAPM method will overestimate ks.

• The discounted cash flow method of estimating the cost of equity can't be used unless the growth component, g, is constant during the analysis period.

• An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that they yield precise estimates and require little or no judgment.

• All of the statements above are false.