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PART FIVE Risk and Return

Concepts Review and Critical Thinking Questions

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

Information and Market Returns Suppose the government announces that, based on a just-completed survey, the growth rate in the economy is likely to be 2 percent in the coming year, as compared to 5 percent for the year just completed. Will security prices increase, decrease, or stay the same following this announcement? Does it make any difference whether or not the 2 percent figure was anticipated by the market? Explain.

Systematic versus Unsystematic Risk Classify the following events as mostly systematic or mostly unsystematic. Is the distinction clear in every case?

a. Short-term interest rates increase unexpectedly.

b. The interest rate a company pays on its short-term debt borrowing is increased by its bank. Oil prices unexpectedly decline. An oil tanker ruptures, creating a large oil spill. A manufacturer loses a multimillion-dollar product liability suit. A Supreme Court decision substantially broadens producer liability for injuries suffered by product users.

Systematic versus Unsystematic Risk Indicate whether the following events might cause stocks in general to change price, and whether they might cause Big Widget Corp.'s stock to change price.

a. The government announces that inflation unexpectedly jumped by 2 percent last month.

b. Big Widget's quarterly earnings report, just issued, generally fell in line with analysts' expectations.

c. The government reports that economic growth last year was at 3 percent, which generally agreed with most economists' forecasts.

d. The directors of Big Widget die in a plane crash.

e. Congress approves changes to the tax code that will increase the top marginal corporate tax rate. The legislation had been debated for the previous six months.

Expected Portfolio Returns If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to one or both of these questions, give an example to support your answer.

Diversification True or false: The most important characteristic in determining the expected return of a well-diversified portfolio is the variances of the individual assets in the portfolio. Explain.

Portfolio Risk If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?

Beta and CAPM Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM pre-

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

13. Return, Risk, and the Security Market Line

© The McGraw-Hill Companies, 2002

CHAPTER 13 Return, Risk, and the Security Market Line diet about the expected return on such an asset? Can you give an explanation for your answer?

9. Corporate Downsizing In recent years, it has been common for companies to experience significant stock price changes in reaction to announcements of massive layoffs. Critics charge that such events encourage companies to fire longtime employees and that Wall Street is cheering them on. Do you agree or disagree?

10. Earnings and Stock Returns As indicated by a number of examples in this chapter, earnings announcements by companies are closely followed by, and frequently result in, share price revisions. Two issues should come to mind. First, earnings announcements concern past periods. If the market values stocks based on expectations of the future, why are numbers summarizing past performance relevant? Second, these announcements concern accounting earnings. Going back to Chapter 2, such earnings may have little to do with cash flow, so, again, why are they relevant?

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