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. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
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: 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.
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 Options:
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: Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?
Answer Options:
a. If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.
b. Stock X’s realized return during the coming year will be higher than Stock Y’s return.
c. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
d. Stock Y’s return has a higher standard deviation than Stock X.
e. If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y.
Answer: C. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
Question: Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Becky also has a $50,000 portfolio, but it has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Bob’s and Becky’s portfolios is zero. If Bob and Becky marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio?
Answer Options:
a. The combined portfolio’s expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.
b. The combined portfolio’s beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios’ standard deviations, 25%.
c. The combined portfolio’s expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.
d. The combined portfolio’s standard deviation will be greater than the simple average of the two portfolios’ standard deviations, 25%.
e. The combined portfolio’s standard deviation will be equal to a simple average of the two portfolios’ standard deviations, 25%.
Answer: B. The combined portfolio’s beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios’ standard deviations, 25%.
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. An index fund with beta = 1.0 should have a required return of 11%.
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. 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?
Answer Options:
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.
Answer: E. If a stock’s returns are negatively correlated with returns on most other stocks, the stock’s beta will be negative.
Question: Which of the following statements is CORRECT?
Answer Options:
a. Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections’ revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc. is beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.
b. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of –0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
c. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
d. You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should rebalance your portfolio to include more high-beta stocks.
e. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline.
Answer: B. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of –0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
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?
Answer Options:
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.
Answer: A. Portfolio P has a standard deviation of 25% and a beta of 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, r_RF. 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, (r_M − r_RF). 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. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
Question: Inflation, recession, and high interest rates are economic events that are best characterized as being
Answer Options:
a. systematic risk factors that can be diversified away.
b. company-specific risk factors that can be diversified away.
c. among the factors that are responsible for market risk.
d. risks that are beyond the control of investors and thus should not be considered by security analysts or investors.
Answer: C. among the factors that are responsible for market risk.
Question: Which of the following statements is CORRECT?
Answer Options:
a. The slope of the SML is determined by the value of beta.
b. The SML shows the relationship between companies’ required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm’s managers, but the position of the company on the line can be influenced by its managers.
c. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression 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 investors expect the observed relationship to continue on into the future.
d. If investors become less risk averse, the slope of the Security Market Line will increase.
e. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock.
Answer: C. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression 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 investors expect the observed relationship to continue on into the future.
Question: Which of the following statements is CORRECT?
Answer Options:
a. If a company with a high beta merges with a low-beta company, the best estimate of the new merged company’s beta is 1.0.
b. Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities.
c. The beta of an “average stock,” which is also “the market beta,” can change over time, sometimes drastically.
Answer: C. The beta of an “average stock,” which is also “the market beta,” can change over time, sometimes drastically.
Question: Which of the following statements is CORRECT?
Answer Options:
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: 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 a weighted average 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 is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?
Answer Options:
a. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
b. The expected return of your portfolio is likely to decline.
c. The diversifiable risk will remain the same, but the market risk will likely decline.
d. Both the diversifiable risk and the market risk of your portfolio are likely to decline.
e. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.
Answer: A. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.