Answer Options:
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. If two “normal” or “typical” stocks were combined to form a 2-stock portfolio, the portfolio’s expected return would be a weighted average of the stocks’ expected returns, but the portfolio’s standard deviation would probably be greater than the average of the stocks’ standard deviations.
d. If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.
e. An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.
Answer: E. An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.
Question: The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.
Answer Options:
a. True
b. False
Answer: b. False
Question: Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?
Answer Options:
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.
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 Options:
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 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 X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?
Answer Options:
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.
Question: Over the past 88 years, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last?
Answer Options:
a. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills.
b. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds.
c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
d. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks.
e. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
Answer: C. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
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 Options:
a. Portfolio P has a standard deviation of 20%.
b. The required return on Portfolio P is equal to the market risk premium (r_M – r_RF).
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, r_RF.
e. Portfolio P has the same required return as the market (r_M).
Answer: E. Portfolio P has the same required return as the market (r_M).
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 Options:
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: Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT?
Answer Options:
a. The required return of all stocks will remain unchanged since there was no change in their betas.
b. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium.
c. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease.
d. The required returns on all three stocks will increase by the amount of the increase in the market risk premium.
e. The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.
Answer: B. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium.
Question: Stocks A, B, and C all have an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns that are independent of one another, i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are negatively correlated with one another, i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is CORRECT?
Answer Options:
a. Portfolio AC has an expected return that is less than 10%.
b. Portfolio AC has an expected return that is greater than 25%.
c. Portfolio AB has a standard deviation that is greater than 25%.
d. Portfolio AB has a standard deviation that is equal to 25%.
e. Portfolio AC has a standard deviation that is less than 25%.
Answer: E. Portfolio AC has a standard deviation that is less than 25%.
Question: Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
Answer Options:
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: Assume that in recent years both expected inflation and the market risk premium (r_M − r_RF) 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 Options:
a. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.
b. The required return on all stocks has increased, but the increase has been smaller for stocks with higher betas.
c. The required returns on all stocks have remained the same.
d. The required returns on all stocks have increased, but the increase has been greater for stocks with lower betas.
e. The required returns on all stocks have fallen, but the decline has been greater for stocks with higher betas.
Answer: A. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.