a. A stock’s beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.
b. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless.
c. The required return on a firm’s common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm’s required return.
d. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio.
e. A security’s beta measures its non-diversifiable, or market, risk relative to that of an average stock.
Answer: e. A security’s beta measures its non-diversifiable, or market, risk relative to that of an average stock.
Question: Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.
a. Stock A would be a more desirable addition to a portfolio than Stock B.
b. In equilibrium, the expected return on Stock B will be greater than that on A.
c. When held in isolation, Stock A has more risk than Stock B.
d. Stock B would be a more desirable addition to a portfolio than A.
e. In equilibrium, the expected return on Stock A will be greater than that on B.
Answer: e. In equilibrium, the expected return on Stock A will be greater than that on B.
Question: If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.
Answer Options:
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.
a. True
b. False
Answer: True
Question: In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement is false?
Answer Options:
a. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.
b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
c. The beta of the portfolio is lower than the lowest of the three betas.
d. The beta of the portfolio is higher than the highest of the three betas.
e. The beta of the portfolio is equal to the weighted average of the individual stocks’ betas.
Answer: d. The beta of the portfolio is higher than the highest of the three betas.
Question: Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% of Stock A and 50% of Stock B. Which of the following statements is CORRECT?
Answer Options:
a. The portfolio’s beta is less than 1.2.
b. The portfolio’s expected return is 15%.
c. The portfolio’s standard deviation is greater than 20%.
d. The portfolio’s beta is greater than 1.2.
e. The portfolio’s standard deviation is 20%.
Answer: b. The portfolio’s expected return is 15%.
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 Options:
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
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 return on all three stocks will remain unchanged, but the returns on Stock B would increase.
e. The required return for Stock A would fall, but the required return for Stock B would increase.
Answer: a
Question: Which of the following statements is CORRECT?
a. If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
b. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock’s beta was correctly calculated and is stable.
c. If a stock has a negative beta, its expected return must be negative.
d. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
e. According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.
Answer: d. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
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 equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT?
Answer Options:
a. The required return on all three stocks will remain unchanged since there was no change in their betas.
b. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium.
c. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease.
d. The required returns on all three stocks will increase by the amount of the increase in the market risk premium.
e. The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.
Answer: b
Question: Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?
Answer Options:
a. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
b. The required rate of return will decline for stocks whose betas are less than 1.0.
c. The required rate of return on the market, rM, will not change as a result of these changes.
d. The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium.
e. The required rate of return on a riskless bond will decline.
Answer: 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
Question: Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT?
Answer Options:
a. An index fund with beta = 1.0 should have a required return of 11%.
b. If a stock has a negative beta, its required return must also be negative.
c. An index fund with beta = 1.0 should have a required return less than 11%.
d. If a stock’s beta doubles, its required return must also double.
e. An index fund with beta = 1.0 should have a required return greater than 11%.
Answer: a
Question: The SML relates required returns to firms’ systematic (or market) risk. The slope and intercept of this line can be influenced by a manager’s actions.
Answer Options:
a. True
b. False
Answer: b. False
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 (M – rRF) were to increase but the risk-free rate (rRF) 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.
Answer: a
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: 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.
c. Portfolio P’s expected return is less than the expected return on Stock B.
d. Portfolio P’s expected return is equal to the expected return on Stock B.
e. Portfolio P’s expected return is greater than the expected return on Stock C.
Answer: d. Portfolio P’s expected return is equal to the expected return on Stock B.
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: Which of the following statements is CORRECT?
Answer Options:
a. If a company’s beta doubles, then its required rate of return will also double.
b. Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase.
c. If a company’s beta were cut in half, then its required rate of return would also be halved.
d. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will increase.
e. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise.
Answer: b
Question: Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B. The correlation between the two stocks’ returns is zero (that is, r_AB=0). Which of the following statements is CORRECT?
Answer Options:
a. Portfolio AB’s standard deviation is 17.5%.
b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
c. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued.
d. Portfolio AB’s expected return is 11.0%.
e. Portfolio AB’s beta is less than 1.2.
Answer: b
Question: If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.
a. True
b. False
Answer: False
Question: In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data.
a. True
b. False
Answer: True
Question: The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.
Answer Options:
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, (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