Answer Choices:
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.
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.
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: A stock with a beta equal to –1.0 has zero systematic (or market) risk.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
b. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock’s beta was correctly calculated and is stable.
c. If a stock has a negative beta, its expected return must be negative.
d. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
e. According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.
Answer: d. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
Question: If the returns of two firms are negatively correlated, then one of them must have a negative beta.
Answer Choices:
a. True
b. False
Answer: b. False
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 Choices:
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: 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: Diversification will normally reduce the riskiness of a portfolio of stocks.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments’ stand-alone risk.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, the standard deviation.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The CAPM is a multi-period model that takes account of differences in securities’ maturities, and it can be used to determine the required rate of return for any given level of systematic risk.
Answer Choices:
a. True
b. False
Answer: False
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?
Answer Choices:
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%.
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%.