The standard deviation of returns on Wildcat Oil Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not. The equation for beta in Chapter 8 shows that the nondiversifiable risk of an asset is the product of its standard deviation of returns and the correlation of those returns with those on a well-diversified portfolio. Wildcat Oil Drilling may have a high standard deviation of returns, but if those returns are poorly correlated with those on a well-diversified portfolio, as is likely the case, nondiversifiable risk may be low. In other words, if investors can diversify away most of Wildcat’s risk, then it is not truly a high-risk investment.

The standard deviation of returns on Wildcat Oil Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not. The equation for beta in Chapter 8 shows that the nondiversifiable risk of an asset is the product of its standard deviation of returns and the correlation of those returns with those on a well-diversified portfolio. Wildcat Oil Drilling may have a high standard deviation of returns, but if those returns are poorly correlated with those on a well-diversified portfolio, as is likely the case, nondiversifiable risk may be low. In other words, if investors can diversify away most of Wildcat’s risk, then it is not truly a high-risk investment.

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter25: Portfolio Theory And Asset Pricing Models

Section: Chapter Questions

Problem 9MC

See similar textbooks

Similar questions

You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Suppose a risk-free asset has an expected return of 5%. By definition, its standard deviation is zero, and its correlation with any other asset is also zero. Using only Asset A and the risk-free asset, plot the attainable portfolios.
You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: What is the Capital Asset Pricing Model (CAPM)? What are the assumptions that underlie the model? What is the Security Market Line (SML)?
You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Write out the equation for the Capital Market Line (CML), and draw it on the graph. Interpret the plotted CML. Now add a set of indifference curves and illustrate how an investor’s optimal portfolio is some combination of the risky portfolio and the risk-free asset. What is the composition of the risky portfolio?
You have been hired at the investment firm of Bowers Noon. One of its clients doesnt understand the value of diversification or why stocks with the biggest standard deviations dont always have the highest expected returns. Your assignment is to address the clients concerns by showing the client how to answer the following questions: Add a set of indifference curves to the graph created for part b. What do these curves represent? What is the optimal portfolio for this investor? Add a second set of indifference curves that leads to the selection of a different optimal portfolio. Why do the two investors choose different portfolios?
Determine whether each of the statements (a)–(c) is True or False. A) Underestimation of the market risk premium results in the underestimation of the cost of capital for a project and in turn increases the likelihood that a negative NPV project is falsely accepted. B) The CAPM beta of a security measures the variability of the return of the security in isolation. C) If an investor holds a well-diversified portfolio, the type of risk left in such a portfolio is primarily the idiosyncratic risk. Answer: a) b) c)
Which of the following statements is MOST correct concerning diversification and risk? Select one:Proper diversification generally results in the elimination of riskOnly wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks to gain the benefits of diversification.Risk-averse investors often choose companies from different industries for their portfolios because the correlation of returns is less than if all the companies came from the same industry.Risk-averse investors often select portfolios that include only companies from the same industry group because the familiarity reduces the risk.
What should be the risk premium and return on a stock with a Beta of zero under the Capital Asset Pricing Model (CAPM)? What about the risk premium and return on a stock with a Beta of 1? In a world of certainty, investors will always invest in the asset with the highest return. In the real world, investors hold a diversified portfolio of securities. Why is this the case? Theoretically, returns on stocks or assets can be negatively correlated. In the real world, however, we usually encounter only positive correlations. Whymay this be the case?
Which of the following statements is CORRECT? a. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. b. An investor can eliminate almost all risk if he or she holds a very large and well diversified portfolio of stocks. c. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. d. An investor can eliminate almost all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks. e. An investor can eliminate almost all market risk if he or she holds a very large and well diversified portfolio of stocks.
Which of the following statements is most correct? A. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all the market risk from the portfolio. B. If you form a large portfolio of stocks each with a beta greater than 1.0, this portfolio will have more market risk exposure than a single stock with a beta of 0.8. C. Company-specific (or unsystematic) risk can be reduced by forming a large portfolio, but normally even highly diversified portfolios are subject to market (or systematic) risk. D. Statements B and C are correct. E. All of the above statements are correct.
Consider the stocks in the table with their respective beta coefficients to answer the following questions:a. Which of the assets represents the most sensitive to fluctuations or changes in market returns and why? What impact in terms of risk and return would this asset have if you add it to an investment portfolio in a higher proportion than all other assets? b. Which of the assets represents the least sensitive to fluctuations or changes in market returns and why? What impact in terms of risk and return would this asset have, if you add it to an investment portfolio in a greater proportion than all other assets? Stock Beta SKT 0.65 COST 0.90 SU 1.42 AMZN 1.57 V 0.94
Which of the following statements is CORRECT? a. Portfolio diversification reduces the variability of returns on an individual stock. b. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events. c. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs. d. A stock with a beta of −1.0 has zero market risk if held in a 1-stock portfolio. e. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.
Given the information in the table below, which of the following statements is correct, assuming that either security will be held in a portfolio with other investments? Stock Expected Return Required Return Beta Standard Deviation A 10% 12% 0.9 25% B 8% 5% 0.3 35% Question 26 options: The investor should purchase both stocks because their beta is less than that of the market. The investor should purchase A since its risk, as measured by standard deviation, is the lowest. The investor should purchase A because it requires the highest rate of return. The investor should purchase B since its expected return exceeds its required return.