Inflation, recession, and high interest rates are economic events that are best
ID: 2664011 • Letter: I
Question
Inflation, recession, and high interest rates are economic events that are best characterized as being...A) systematic risk factors that can be diversified away.
B) company-specific risk factors that can be diversified away.
C) among the factors that are responsible for market risk.
D) risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.
E) irrelevant except to governmental authorities like the Federal Reserve.
Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio?
A) Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.
B) Adding more such stocks will increase the portfolio's expected rate of return.
C) Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk.
D) Adding more such stocks will have no effect on the portfolio's risk.
E) Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.
Explanation / Answer
Question 1: The correct answer is C market risk. There are two types of risk that make up the required return for equities (stocks). The first is market risk the second is firm specific risk. Market risk is built into every security and can't be avoided like... interest rates, economic events, natural disasters, war, etc. Firm specific risk can be diversified away and includes... CEO getting fired, accounting fraud, poor management.
Question 2: This is actually poorly worded question because the right answer still has some holes in it. The correct answer is A. Adding more stocks will reduce the portfolio's unsystematic or diversifiable risk but only if the stock's are unrelated and only to a certain extent. It is theoretically possible to add a stock to a portfolio that is so similar to all of the other stocks that it hasn't really reduced the unsystematic or diversifiable risk. Answer B is wrong because simply adding stocks won't increase your rate of return. You could have a portfolio with an expected return of 25% and add a stock with an expected return of 5% which would do the opposite of answer B. C is wrong because adding stocks won't necessarily reduce the portfolio Beta. For example we could have a portfolio with a Beta of 2 and add a stock with a Beta of 5 thereby increasing the portfolio Beta. D is wrong because adding stocks generally has an effect on the portfolio's risk but it's definitely the second best choice here. Academics show that as you add stocks to your portfolio you get closer and closer holding just pure market risk. Even if we have a portfolio of every stock in the world we might not have every security so there must be some risk adjustment by adding a random security. Answer E is wrong because while it's possible to be true it's not necessarily true. We could be adding stock's with High Beta (increasing the portfolio's market risk) but low relation to other stocks (decreasing unsystematic risk).
Hope this helps!