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Q2: You own a portfolio that has $700 invested in Stock A and $2,400 invested in Stock B. If the expected returns on these stocks are 11 percent and 18 percent, respectively. 
 
Required:  
 
a) What is the expected return on the portfolio?
b) Why is some risk diversifiable? Why are some risks non-diversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk? 
c) Can the risk of a portfolio be reduced to zero by increasing the number of stocks in the portfolio? Explain.
d) If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock? Explain.

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Related questions

Can we have high-beta stocks that might be attractive from a risk perspective and low-beta stocks that are unattractive? Explain.

In broad terms, why is some risk diversifiable? Why are some risks non diversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

RISK AND RATES OF RETURN

(I need help explaining the following and/or demonstrating it for my upcoming exam if anyone could help me comprehend the concepts I would greatly appreciate it!!)

Explain the positive relationship between risk and return..

Interpret standard deviation and probability distributions as a measure of risk..

Explain diversifiable (business-specific or unsystematic) risk versus non-diversifiable (systematic) risk..

Interpret correlations between investments and explain how basic diversification works..

Explain and interpret beta (β) for an individual security and for a portfolio..

Calculate portfolio beta (β) given the betas and weightings of individual securities..

Calculate expected return, E(r), for a stock using the CAPM formula..

Calculate portfolio expected return given the returns and weightings of individual securities..

Relate the CAPM formula to the Security Market Line (SML) and explain what the SML shows..

Explain how inflation affects the SML..


Explain how changes in investor risk aversion (MRP) affects the SML..

1. If we are able to eliminate all of the unsystematic or diversifiable risk in a portfolio then, what is the result?

a.

a risk-free portfolio
b.
a portfolio that has an expected return of zero
c.

a portfolio that contains only systematic risk

2. A portfolio consists 20% of a risk-free asset and 80% of a stock. The risk-free return is 4%. The stock has an expected return of 15% and a standard deviation of 30%. What’s the expected return of the portfolio?

a.
9.5%
b.
15.0%
c.
12.8%

d.
2%


3. The risk-free rate is 5% and the expected return on the market portfolio is 13%. A stock has a beta of 1.5, what is its expected return?


a.
12%
b.
19.5%
c.

17%

4. For what value of the correlation coefficient for the returns of a pair of stocks will the benefits of diversification the largest?


a.

1.0
b.

-1.0
c.

0.0
d.

0.5


5. Which of the following is an example of systematic risk?
a.
IBM posts lower than expected earnings.
b.
The overall stock market becomes more risky due to super fasting trading algorithms.
c.

Intel announces record earnings.

6. According to the CAPM (capital asset pricing model), the security market line is a straight line. The intercept of this line should be equal to

a.
zero
b.
the expected risk premium on the market portfolio
c.
the expected return on the market portfolio
d.
the risk-free rate


7. A portfolio has 40% invested in Asset 1, 50% invested in Asset 2 and 10% invested in Asset 3. Asset 1 has a beta of 1.2, Asset 2 has a beta of 0.8 and Asset 3 has a beta of 1.8, what’s the beta of the portfolio?

a.
0.80
b.
1.06
c.
1.27


8. Suppose you can borrow and lend at the risk free-rate of 3%. Which of the following four risky portfolios has the best return relative to risk. (Hint: Calculate Sharpe Ratios the ratio of risk premium to standard deviation for each portfolio)

a.
portfolio with a standard deviation of 15% and an expected return of 12%
b.
portfolio with a standard deviation of 12% and an expected return of 9%
c.
portfolio with a standard deviation of 25% and an expected return of 18%
d.
portfolio with a standard deviation of 19% and an expected return of 15%


9. Which statements are TRUE regarding risk and return?

Statement I:
Diversification is the process of removing systematic risk from a portfolio.
Statement II:
In general, the greater the risk, the greater the return required by an investor.
Statement III:
Investors should focus on real returns if they are concerned about the purchasing power of their wealth.


a.
Statements II and III only
b.
Statement I only
c.
Statements I and III only
d.
Statements I and II only

10. The beta of the risk-free asset is:
a.

1.0
b.

0.5
c.

0.0
d.

-1.0

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