a. True
b. False
Answer: True
Question: Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock’s returns is 20%. The stocks’ returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT?
Answer Options:
a. Portfolio P has a standard deviation of 20%.
b. The required return on Portfolio P is equal to the market risk premium (M – rRF).
c. Portfolio P has a beta of 0.7.
d. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
e. Portfolio P has the same required return as the market (M).
Answer: a
Question: Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Becky also has a $50,000 portfolio, but it has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Bob’s and Becky’s portfolios is zero. If Bob and Becky marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio?
a. The combined portfolio’s expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.
b. The combined portfolio’s beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios’ standard deviations, 25%.
c. The combined portfolio’s expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.
d. The combined portfolio’s standard deviation will be greater than the simple average of the two portfolios’ standard deviations, 25%.
e. The combined portfolio’s standard deviation will be equal to a simple average of the two portfolios’ standard deviations, 25%.
Answer: b. The combined portfolio’s beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios’ standard deviations, 25%.
Question: Which of the following statements is CORRECT?
Answer Options:
a. If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.
b. The slope of the Security Market Line is beta.
c. Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive.
d. If a stock’s beta doubles, its required rate of return must also double.
e. If a stock’s returns are negatively correlated with returns on most other stocks, the stock’s beta will be negative.
Answer: e
Question: Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, the standard deviation.
a. True
b. False
Answer: True
Question: Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments’ stand-alone risk.
a. True
b. False
Answer: True
Question: Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed’s actions would lead to a recession, and that led to an increase in the market risk premium, (M – rRF). Under these conditions, with other things held constant, which of the following statements is most correct?
Answer Options:
a. The required return on all stocks would increase by the same amount.
b. The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0.
c. Stocks’ required returns would change, but so would expected returns, and the result would be no change in stocks’ prices.
d. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
e. The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.
Answer: d
Question: Bad managerial judgments or unforeseen negative events that happen to a firm are defined as “company-specific,” or “unsystematic,” events, and their effects on investment risk can in theory be diversified away.
Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Options:
a. A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.
b. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
Answer: a
Question: When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio’s risk.
a. True
b. False
Answer: True
Question: Is it possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.
a. True
b. False
Answer: True
Question: 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.
Answer: a. Adding more such stocks will reduce the portfolio’s unsystematic, or diversifiable, risk.
Question: Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.
Answer Options:
a. True
b. False
Answer: b. False
Question: Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?
a. The fact that a security or project may not have a past history that can be used as the basis for calculating beta.
b. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the “true” or “expected future” beta.
c. The beta of an “average stock,” or “the market,” can change over time, sometimes drastically.
d. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
e. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. This calculated historical beta may differ from the beta that exists in the future.
Answer: a. The fact that a security or project may not have a past history that can be used as the basis for calculating beta.
Question: Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.
a. True
b. False
Answer: True