Answer Choices:
a. True
b. False
Answer: b. False
Question: Under the CAPM, the required rate of return on a firm’s common stock is determined only by the firm’s market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm’s required rate of return.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The corporate valuation model cannot be used unless a company pays dividends.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
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 capital structure or the type of assets it employs.
e. A stock with a beta of –1.0 has zero market risk if held in a 1-stock portfolio.
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 capital structure or the type of assets it employs.
Question: Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky.
Answer Choices:
a. True
b. False
Answer: b. False
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 Choices:
a. True
b. False
Answer: b. False
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 Choices:
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. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
Question: In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement is false?
Answer Choices:
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 betas of the individual stocks’ betas.
Answer: d. The beta of the portfolio is higher than the highest of the three betas.
Question: Which of the following statements is CORRECT?
Answer Choices:
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. 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.
Question: Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?
Answer Choices:
a. The required return on a stock with beta = 1.0 will not change.
b. The required return on a stock with beta > 1.0 will increase.
c. The return on “the market” will remain constant.
d. The return on “the market” will increase.
e. The required return on a stock with a positive beta < 1.0 will decline.
Answer: e. The required return on a stock with a positive beta < 1.0 will decline.
Question: The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate.
Answer Choices:
a. True
b. False
Answer: a. True
Question: We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.
Answer Choices:
a. True
b. False
Answer: b. False
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 Choices:
a. If expected inflation remains constant but the market risk premium (r_M – r_F) 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_F) 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_F) 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_F) declines, the required return of Stock HB will decline by more than that on Stock LB.
Answer: b. If both expected inflation and the market risk premium (r_M – r_F) increase, the required return on Stock HB will increase by more than that on Stock LB.
Question: Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?
Answer Choices:
a. A portfolio consisting of $50,000 invested in Stock X and $50,000 invested in Stock Y will have a required return that exceeds that of the overall market.
b. Stock Y must have a higher expected return and a higher standard deviation than Stock X.
c. If expected inflation increases but the market risk premium is unchanged, the required return on both stocks will fall by the same amount.
d. If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y.
e. If expected inflation decreases but the market risk premium is unchanged, then the required return on both stocks will decrease but the decrease will be greater for Stock Y.
Answer: d. If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y.