Question 1

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk.

Accepted Answer

A) True 
 B)False

Question 2

A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?

Accepted Answer

A)  Either A or B, i.e., the investor should be indifferent between the two. 
B)  Stock A. 
C)  Stock B. 
D)  Neither A nor B, as neither has a return sufficient to compensate for risk. 
E)  Add A, since its beta must be lower.

Question 3

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?

Accepted Answer

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 Y's realized return during the coming year will be higher than Stock X'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.

Question 4

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?

Accepted Answer

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%.

Question 5

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Accepted Answer

A) bA > 0; bB = 1. B) bA > +1; bB = 0. C) bA = 0; bB = -1. D) bA < 0; bB = 0. E) bA < -1; bB = 1.

Question 6

Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM − rRF), equals 4%. Which of the following statements is CORRECT?

Accepted Answer

A)  If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta. 
B)  If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elba's required return will decline because it has a beta less than 1.0. 
C)  Since Nile's beta is twice that of Elba's, its required rate of return will also be twice that of Elba's. 
D)  If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase. 
E)  If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elba's will also decrease, but by more than Nile's because it has a beta less than 1.0.

Question 7

Inflation, recession, and high interest rates are economic events that are best characterized as being

Accepted Answer

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 portfolio managers. 
E)  irrelevant except to governmental authorities like the Federal Reserve.

Question 8

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

Accepted Answer

A) True 
 B)False

Question 9

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 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?

Accepted Answer

A)  Portfolio P's expected return is greater than the expected return on Stock B. 
B)  Portfolio P's expected return is equal to the expected return on Stock A. 
C)  Portfolio P's expected return is less than the expected return on Stock B. 
D)  Portfolio P's expected return is equal to the expected return on Stock B. 
E)  Portfolio P's expected return is greater than the expected return on Stock C.

Question 10

Kollo Enterprises has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. What is Kollo's required rate of return?

Accepted Answer

A)  9.43% 
B)  9.67% 
C)  9.92% 
D)  10.17% 
E)  10.42%

Question 11

The slope of the SML is determined by the value of beta.

Accepted Answer

A) True 
 B)False

Question 12

If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM − rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.

Accepted Answer

A) True 
 B)False

Question 13

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM.

Accepted Answer

A) True 
 B)False

Question 14

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?

Accepted Answer

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 return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%. 
E)  The required return for Stock A would fall, but the required return for Stock B would increase.

Question 15

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Accepted Answer

A) True 
 B)False

Question 16

Linke Motors has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%. Based on the SML, what is the firm's required return?

Accepted Answer

A)  13.51% 
B)  13.86% 
C)  14.21% 
D)  14.58% 
E)  14.95%

Question 17

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

Accepted Answer

A) True 
 B)False

Question 18

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?

Accepted Answer

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).

Question 19

Which of the following statements is CORRECT?

Accepted Answer

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 firms' 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.

Question 20

Which of the following statements is CORRECT?

Accepted Answer

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. 
D)  If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. 
E)  During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.

Exam 8: Risk and Rates of Return

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?

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?

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM − rRF) , equals 4%. Which of the following statements is CORRECT?

Inflation, recession, and high interest rates are economic events that are best characterized as being

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

Kollo Enterprises has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. What is Kollo's required rate of return?

The slope of the SML is determined by the value of beta.

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?

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Linke Motors has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%. Based on the SML, what is the firm's required return?

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?