Answer Choices:
a. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected.
b. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.
c. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0.
d. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8.
Answer: b. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.
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: Is it possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
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: Most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets. The relevant risk of each asset should be measured in terms of its effect on the risk of the firm’s stockholders.
Answer Choices:
a. True
b. False
Answer: a. True
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 Choices:
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%, with the return on Stock B would increase the most.
e. The required return for Stock A would fall, but the required return for Stock B would increase.
Answer: a. The required return on Portfolio P would increase by 1%.
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: An individual stock’s diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Assume that in recent years both expected inflation and the market risk premium (rM – rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes?
Answer Choices:
a. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.
b. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.
c. The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0.
d. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.
e. The required returns on all stocks have fallen by the same amount.
Answer: b. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.
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 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: True
Question: Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock’s returns is 20%. The stocks’ returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT?
Answer Choices:
a. Portfolio P has a standard deviation of 20%.
b. The required return on Portfolio P is equal to the market risk premium (rM – rRF).
c. Portfolio P has a beta of 0.7.
d. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
e. Portfolio P has the same required return as the market (rM).
Answer: e. Portfolio P has the same required return as the market (rM).
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: Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don’t want to relinquish voting control.
Answer Choices:
a. True
b. False
Answer: True
Question: Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
Answer Choices:
a. If a stock has a negative beta, its required return under the CAPM would be less than 5%.
b. If a stock’s beta doubled, its required return under the CAPM would also double.
c. If a stock’s beta doubled, its required return under the CAPM would more than double.
d. If a stock’s beta were 1.0, its required return under the CAPM would be 5%.
e. If a stock’s beta were less than 1.0, its required return under the CAPM would be less than 5%.
Answer: a. If a stock has a negative beta, its required return under the CAPM would be less than 5%.
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, rAB=0). Which of the following statements is CORRECT?
Answer Choices:
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 has a standard deviation that is equal to 25%.
e. Portfolio AB has a standard deviation that is less than 25%.
Answer: b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
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