Finance practice questions

Question: Assume that the risk-free rate, rRF, increases but the market risk premium, (rM – rRF), declines with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT? a. The required return of all stocks will increase by the amount of the increase in the risk-free rate. b. The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. c. Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. d. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. e. The required return of all stocks will fall by the amount of the decline in the market risk premium.

Correct Answer: d. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.

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? 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.

Correct Answer: d. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.

Question: Which of the following statements is CORRECT? a. If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium. b. The slope of the Security Market Line is beta. c. Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive. d. If a stock’s beta doubles, its required rate of return must also double. e. If a stock’s returns are negatively correlated with returns on most other stocks, the stock’s beta will be negative.

Correct Answer: e. If a stock’s returns are negatively correlated with returns on most other stocks, the stock’s beta will be negative.

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? 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.

Correct 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: Which of the following statements is CORRECT? 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.

Correct Answer: d. If a stock has a positive beta, its required rate of return is above the return on a riskless stock.

Question: Which of the following statements is CORRECT? 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.

Correct 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: You observe the following information regarding Companies X and Y: Company X has a higher expected return than Company Y. Company X has a higher standard deviation of returns than Company Y. Comparing X’s lower beta than Company Y. Given this information, which of the following statements is CORRECT? a. Company X has more diversifiable risk than Company Y. b. Company X has a lower coefficient of variation than Company Y. c. Company X has less market risk than Company Y. d. Company X’s returns will be negative when Y’s returns are positive. e. Company X’s stock is a better buy than Company Y’s stock.

Correct Answer: b. Company X has a lower coefficient of variation than Company Y.

Question: Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is +0.6. Portfolio P has 50% invested in Stock A and 50% invested in B. Which of the following statements is CORRECT? a. Portfolio P has a standard deviation of 25% and a beta of 1.0. b. Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium. c. Portfolio P has more market risk than Stock A but less market risk than B. d. Stock A should have a higher expected return than Stock B as viewed by the marginal investor. e. Portfolio P has a coefficient of variation equal to 2.5.

Correct Answer: a. Portfolio P has a standard deviation of 25% and a beta of 1.0.

Question: The risk-free rate is 6% and the market risk premium is 5%. Your $1 million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. Which of the following statements is CORRECT? a. If the stock market is efficient, your portfolio’s expected return should equal the expected return on the market, which is 11%. b. The required return on the market is 10%. c. The portfolio’s required return is less than 11%. d. If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio’s required return will increase by more than 2%. e. If the market risk premium remains unchanged but expected inflation increases by 2%, your portfolio’s required return will increase by more than 2%.

Correct Answer: d. If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio’s required return will increase by more than 2%.

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? 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%.

Correct Answer: a. Stock A’s beta is 0.8333.

Question: Stock A has a beta of 1.2 and a standard deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%. Portfolio AB was created by investing in a combination of Stocks A and B. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is CORRECT? a. Stock A has more market risk than Portfolio AB. b. Stock A has more market risk than Stock B but less stand-alone risk. c. Portfolio AB has more money invested in Stock A than in Stock B. d. Portfolio AB has the same amount of money invested in each of the two stocks. e. Portfolio AB has more money invested in Stock B than in Stock A.

Correct Answer: c. Portfolio AB has more money invested in Stock A than in Stock B.

Question: Which of the following statements is CORRECT? a. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor’s standpoint, assuming the investor’s only asset is one or the other of the mutual funds. b. If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change. c. An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. d. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt. e. 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.

Correct Answer: c. An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk.