Chapter 7 Practice Question Answers
1. Answer: B. Systematic risk is the risk that the whole system (e.g., market) will drop, causing a drop in the performance of individual stocks or the entire portfolio. If a portfolio is sufficiently diversified, it is possible to reduce nonsystematic risk to almost zero. Diversification does not reduce the systematic risk of a portfolio. Credit risk and liquidity risk are considered nonsystematic risk will be lessened by diversification.
2. Answer: D. Debt securities are associated with purchasing power risk, credit risk, call risk interest rate risk, and often liquidity risk. Legislative risk is the risk that a piece of legislation will be introduced that will have an adverse effect on the company. For example, the health care industry is sensitive to changes in legislation relating to insurance coverage. This may affect debt securities, but it is as likely to affect equity securities.
3. Answer: B. The alpha of the portfolio is equal to the actual return minus the expected return. Using CAPM, the expected return of the portfolio is (2% + 1.0 × (8% – 2%)) = 8%. Note that because the beta is equal to 1.0, the risk-free rate is irrelevant here and the expected return is simply equal to the performance of the market. Alpha = 6% – 8% = -2%.
4. Answer: A. Beta is a measure of how the systematic (undiversifiable) risk of the market affects an individual security. A security with a beta of 1.5 will be subject to more systematic risk than a security with a beta of 1.0. Beta is not a measure of nonsystematic risk. If a security has a market price of $10, a beta of 1.5, and the market returned 10%, we can expect that the security will have a 15% return of $1.50, and therefore, be priced around $11.50. A security with a beta of 1.5 can only be expected to outperform a security with a beta of 1.0 when the market shows a positive return. The opposite can be expected when