QUESTION 18

Which of the following statements is CORRECT?

1.

An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

2.

Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.

3.

It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.

4.

An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks.

5.

The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.

10 points

QUESTION 19

Which of the following statements is CORRECT?

1.

The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return.

2.

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.

3.

Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio.

4.

A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

5.

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless.

10 points

QUESTION 20

Which of the following statements is CORRECT?

1.

An indenture is a bond that is less risky than a mortgage bond.

2.

The expected return on a corporate bond will generally exceed the bond's yield to maturity.

3.

Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

4.

All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

5.

If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors will also exceed its yield to maturity

10 points

QUESTION 21

Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, r RF, is 5.5% and the market risk premium, (r M r RF), equals 4%. Which of the following statements is CORRECT?

a.

Since Nile's beta is twice that of Elba's, its required rate of return will also be twice that of Elba's.

b.

If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.

c.

If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elba's required return will decline because it has a beta less than 1.0.

d.

If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.

e.

If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elba's will also decrease, but by more than Nile's because it has a beta less than 1.0.

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