Answer Options:
a. Your portfolio has a standard deviation of 30%, and its expected return is 15%.
b. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.
c. Your portfolio has a beta equal to 1.6, and its expected return is 15%.
d. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.
e. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.
Answer: A. Your portfolio has a standard deviation of 30%, and its expected return is 15%.
Question: The CAPM is a multi-period model that takes account of differences in securities’ maturities, and it can be used to determine the required rate of return for any given level of systematic risk.
Answer Options:
a. True
b. False
Answer: b. False
Question: Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?
Answer Options:
a. The required return on Portfolio P would increase by 1%.
b. The required return on both stocks would increase by 1%.
c. The required return on Portfolio P would remain unchanged.
d. The required returns on all three stocks will increase by more than 1%, but the return on Stock B would increase more than the return on Stock A.
e. The required return for Stock A would fall, but the required return for Stock B would increase.
Answer: B. The required return on both stocks would increase by 1%.
Question: Assume that the risk-free rate, r_RF, increases but the market risk premium, (r_M − r_RF), declines with the net effect being that the overall required return on the market, r_M, remains constant. Which of the following statements is CORRECT?
Answer Options:
a. The required return of all stocks will increase by the amount of the increase in the risk-free rate.
b. The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0.
c. Since the overall return on the market stays constant, the required return on each individual stock will also remain constant.
d. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
e. The required return of all stocks will fall by the amount of the decline in the market risk premium.
Answer: E. The required return of all stocks will fall by the amount of the decline in the market risk premium.
Question: The risk-free rate is 6% and the market risk premium is 5%. Your $1 million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. Which of the following statements is CORRECT?
Answer Options:
a. If the stock market is efficient, your portfolio’s expected return should equal the expected return on the market, which is 11%.
b. The required return on the market is 10%.
c. The portfolio’s required return is less than 11%.
d. If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio’s required return will increase by more than 2%.
e. If the market risk premium remains unchanged but expected inflation increases by 2%, your portfolio’s required return will increase by more than 2%.
Answer: D. If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio’s required return will increase by more than 2%.
Question: Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate that is required to compensate stock investors for assuming an average amount of risk.
Answer Options:
a. True
b. False
Answer: a. True
Question: Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A’s portfolio has a beta of minus 2.0, while Investor B’s portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some “normal” stocks with beta = 1.0.
Answer Options:
a. True
b. False
Answer: b. False
Question: Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?
Answer Options:
a. Portfolio P’s expected return is greater than the expected return on Stock B.
b. Portfolio P’s expected return is equal to the expected return on Stock A.
Answer: B. Portfolio P’s expected return is equal to the expected return on Stock A.
Question: Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would be affected as follows:
Answer Options:
a. The y-axis intercept would decline, and the slope would increase.
b. The x-axis intercept would decline, and the slope would increase.
c. The y-axis intercept would increase, and the slope would decline.
d. The SML would be affected only if betas changed.
e. Both the y-axis intercept and the slope would increase, leading to higher required returns.
Answer: A. The y-axis intercept would decline, and the slope would increase.
Question: Which of the following statements is CORRECT?
Answer Options:
a. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.
b. Portfolio diversification reduces the variability of returns on an individual stock.
c. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events.
d. The SML relates a stock’s required return to its market risk. The slope and intercept of this line cannot be controlled by the firm’s managers, but managers can influence their firms’ positions on the line by such actions as changing the firm’s riskiness or its capital structure.
Answer: D. The SML relates a stock’s required return to its market risk. The slope and intercept of this line cannot be controlled by the firm’s managers, but managers can influence their firms’ positions on the line by such actions as changing the firm’s riskiness or its capital structure.
Question: Which of the following statements is CORRECT?
Answer Options:
a. Jane’s portfolio will have less diversifiable risk and also less market risk than Dick’s portfolio.
b. The required return on Jane’s portfolio will be lower than that on Dick’s portfolio because Jane’s portfolio will have less total risk.
c. Dick’s portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane’s portfolio, but the required (and expected) returns will be the same on both portfolios.
d. If the two portfolios have the same beta, their required returns will be the same, but Jane’s portfolio will have less market risk than Dick’s.
e. The expected return on Jane’s portfolio must be lower than the expected return on Dick’s portfolio because Jane is more diversified.
Answer: C. Dick’s portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane’s portfolio, but the required (and expected) returns will be the same on both portfolios.
Question: Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?
Answer Options:
a. If expected inflation remains constant but the market risk premium (r_M − r_RF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase.
b. If both expected inflation and the market risk premium (r_M − r_RF) increase, the required return on Stock HB will increase by more than that on Stock LB.
c. If both expected inflation and the market risk premium (r_M − r_RF) increase, the required returns of both stocks will increase by the same amount.
d. Since the market is in equilibrium, the required returns of the two stocks should be the same.
e. If expected inflation remains constant but the market risk premium (r_M − r_RF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase.
Answer: B. If both expected inflation and the market risk premium (r_M − r_RF) increase, the required return on Stock HB will increase by more than that on Stock LB.
Question: Which of the following statements is CORRECT?
Answer Options:
a. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.
b. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio.
c. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.
d. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
e. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.
Answer: C. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.
Question: Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?
Answer Options:
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: C. The beta of an “average stock,” or “the market,” can change over time, sometimes drastically.
Question: Which of the following statements is CORRECT?
Answer Options:
a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.
b. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.
c. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
d. Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless.
e. A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.
Answer: C. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
Question: Which of the following statements is CORRECT?
Answer Options:
a. The slope of the security market line is equal to the market risk premium.
b. Lower beta stocks have higher required returns.
c. A stock’s beta indicates its diversifiable risk.
d. Diversifiable risk cannot be completely diversified away.
e. Two securities with the same stand-alone risk must have the same betas.
Answer: A. The slope of the security market line is equal to the market risk premium.
Question: Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (r_M − r_RF) were to increase but the risk-free rate (r_RF) remained constant, which of the following would occur?
Answer Options:
a. The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.
b. The required return would decrease by the same amount for both Stock A and Stock B.
c. The required return would increase for Stock A but decrease for Stock B.
d. The required return on Portfolio P would remain unchanged.
e. The required return would increase for Stock B but decrease for Stock A.
Answer: A. The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.
Question: Nile Food’s stock has a beta of 1.4, while Elba Eateries’ stock has a beta of 0.7. Assume that the risk-free rate, r_RF, is 5.5% and the market risk premium, (r_M − r_RF), equals 4%. Which of the following statements is CORRECT?
Answer Options:
a. If the risk-free rate increases but the market risk premium remains unchanged, Nile’s required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.
b. If the market risk premium increases but the risk-free rate remains unchanged, Nile’s required return will increase because it has a beta greater than 1.0 but Elba’s required return will decline because it has a beta less than 1.0.
Answer: A. If the risk-free rate increases but the market risk premium remains unchanged, Nile’s required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.