Answer Choices:
a. True
b. False
Answer: b. False
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, (rM – rRF). Under these conditions, with other things held constant, which of the following statements is most correct?
Answer Choices:
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. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
Question: The slope of the SML is determined by the value of beta.
Answer Choices:
a. True
b. False
Answer: False
Question: A portfolio’s risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.
Answer Choices:
a. True
b. False
Answer: b. False
Question: A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.
Answer Choices:
a. True
b. False
Answer: b. False
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, rRF, is 5.5% and the market risk premium, (rM – rRF), equals 4%. Which of the following statements is CORRECT?
Answer Choices:
a. If the risk-free rate increases but the market risk premium remains unchanged, the 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.
c. Since Nile’s beta is twice that of Elba’s, its required rate of return will also be twice that of Elba’s.
d. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.
e. If the market risk premium decreases but the risk-free rate remains unchanged, Nile’s required return will decrease because it has a beta greater than 1.0 and Elba’s will also decrease, but by more than Nile’s because it has a beta less than 1.0.
Answer: a. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections’ revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.’s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.
b. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
c. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
d. You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should rebalance your portfolio to include more high-beta stocks.
e. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline.
Answer: b. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
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 Choices:
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
Answer Choices:
a. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.
b. The effect of a change in the market risk premium depends on the slope of the yield curve.
c. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
e. The effect of a change in the market risk premium depends on the level of the risk-free rate.
Answer: d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
Question: For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?
Answer Choices:
a. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.
b. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
c. The beta of the portfolio is less than the weighted average of the betas of the individual stocks.
d. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.
e. The beta of the portfolio is larger than the weighted average of the betas of the individual stocks.
Answer: d. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.
Question: If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13% and a standard deviation of 30%. The risk-free rate is 5% and the market risk premium, rM – rRF, is 6%. Assume that the market is in equilibrium. Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the following statements is CORRECT?
Answer Choices:
a. Stock A’s beta is 0.8333.
b. Since the two stocks have zero correlation, Portfolio AB is riskless.
c. Stock B’s beta is 1.0000.
d. Portfolio AB’s required return is 11%.
e. Portfolio AB’s standard deviation is 25%.
Answer: a. Stock A’s beta is 0.8333.
Question: Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.)
Answer Choices:
a. Stock A’s returns are less highly correlated with the returns on most other stocks than are B’s returns.
b. Stock B has a higher required rate of return than Stock A.
c. Portfolio P has a standard deviation of 22.5%.
d. More information is needed to determine the portfolio’s beta.
e. Portfolio P has a beta of 1.0.
Answer: e. Portfolio P has a beta of 1.0.
Question: If you plotted the returns on a given stock against those of the market, and you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.
Answer Choices:
a. True
b. False
Answer: False
Question: The slope of the SML is determined by investors’ aversion to risk. The greater the average investor’s risk aversion, the steeper the SML.
Answer Choices:
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT?
Answer Choices:
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.
c. A standard deviation is a measure of total risk.
d. If a stock has a positive beta, its required rate of return is above the return on a riskless stock.
e. The slope of the SML is unrelated to the volatility of the stock market as a whole.
Answer: d. If a stock has a positive beta, its required rate of return is above the return on a riskless stock.
Question: The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
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: Managers should under no conditions take actions that increase their firm’s risk relative to the market, regardless of how much those actions would increase the firm’s expected rate of return.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Over the past 88 years, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last?
Answer Choices:
a. Small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
b. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds.
c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
d. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks.
e. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
Answer: c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.