Answer Choices:
a. True
b. False
Answer: a. True
Question: Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of +0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?
Answer Choices:
a. Portfolio P has a beta that is greater than 1.2.
b. Portfolio P has a standard deviation that is greater than 25%.
c. Portfolio P has an expected return that is less than 12%.
d. Portfolio P has a standard deviation that is less than 25%.
e. Portfolio P has a beta that is less than 1.2.
Answer: d. Portfolio P has a standard deviation that is less than 25%.
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 Choices:
a. True
b. False
Answer: b. False
Question: Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio?
Answer Choices:
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: If a stock’s expected return as seen by the marginal investor exceeds this investor’s required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to the required return.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Beta is measured by the slope of the security market line.
b. If the risk-free rate rises, then the market risk premium must also rise.
c. If a company’s beta is halved, then its required return will also be halved.
d. If a company’s beta doubles, then its required return will also double.
e. The slope of the security market line is equal to the market risk premium, (rM – rF).
Answer: e. The slope of the security market line is equal to the market risk premium, (rM – rF).
Question: For a stock to be in equilibrium, two conditions are necessary: (1) The stock’s market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor’s required return.
Answer Choices:
a. True
b. False
Answer: a. True
Question: During the coming year, the market risk premium (r_M – r_F) is expected to fall, while the risk-free rate, r_F, is expected to remain the same. Given this forecast, which of the following statements is CORRECT?
Answer Choices:
a. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.
b. The required return on all stocks will remain unchanged.
c. The required return will fall for all stocks, but it will fall more for stocks with higher betas.
d. The required return for all stocks will fall by the same amount.
e. The required return will fall for all stocks, but it will fall less for stocks with higher betas.
Answer: c. The required return will fall for all stocks, but it will fall more for stocks with higher betas.
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 Choices:
a. True
b. False
Answer: b. False
Question: We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.
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.
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. 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: 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.
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.
Answer Choices:
a. True
b. False
Answer: a. True
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: a. True
Question: From an investor’s perspective, a firm’s preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer’s standpoint, these risk relationships are reversed: bonds are the most risky for the firm, preferred is next, and common is least risky.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will by definition be riskless.
Answer Choices:
a. True
b. False
Answer: b. False
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 Choices:
a. True
b. False
Answer: a. True
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.
Answer Choices:
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 Stock 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: Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?
Answer Choices:
a. Stock B’s required return is double that of Stock A’s.
b. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.
c. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2.
d. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B.
e. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B.
Answer: b. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.