Question 1

Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECTσ

Accepted Answer

A)  if a stock has a negative beta, its required return must also be negative. 
B)  an index fund with beta = 1.0 should have a required return less than 11%. 
C)  if a stock's beta doubles, its required return must also double. 
D)  an index fund with beta = 1.0 should have a required return greater than 11%. 
E)  an index fund with beta = 1.0 should have a required return of 11%.

Question 2

Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly risk averse and has asked for your advice. 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 matterσ

Accepted Answer

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

Question 3

Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.)

Accepted Answer

A)  8.76% 
B)  8.98% 
C)  9.21% 
D)  9.44% 
E)  9.68%

Question 4

Assume that your cousin holds just one stock, Eastman Chemical Bonding (ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for Wilder's Creations and Buildings (WCB). Both companies have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) 
$\begin{array}{lrrr} 
& \underline{ Year }& \underline{\mathrm{ECB}} & \underline{\mathrm{WCB}}\
&2011&40.00 \%&40.00 \%\
& 2012 & -10.00 \% & 15.00 \% \
& 2013 & 35.00 \% & -5.00 \% \
& 2014 & -5.00 \% & -10.00 \% \
& 2015 & 15.00 \% & 35.00 \% \
& & & \
\text { Average return }=  & 15.00 \%& & 15.00 \% \
\text { Standard deviation }=& 22.64 \% && 22.64 \%
\end{array}$

Accepted Answer

A)  3.29% 
B)  3.46% 
C)  3.65% 
D)  3.84% 
E)  4.03%

Question 5

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

Accepted Answer

A) True 
 B)False

Question 6

Ivan Knobel holds a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. He is in the process of buying 1,000 shares of Syngine Corp at $10 a share and adding it to his portfolio. Syngine has an expected return of 13.0% and a beta of 1.50. The total value of Ivan's current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Syngine stock?

Accepted Answer

A)  10.64%; 1.17 
B)  11.20%; 1.23 
C)  11.76%; 1.29 
D)  12.35%; 1.36 
E)  12.97%; 1.42

Question 7

Megan Ross holds the following portfolio: $\begin{array}{lrl}
\text {  Stock }&\text { Investment }&\text { Beta }\
\mathrm{A} & \$ 150,000 & 1.40 \
\mathrm{~B} & 50,000 & 0.80 \
\mathrm{C} & 100,000 & 1.00 \
\mathrm{D} & 75,000 & 1.20\
\text { Total }&\$375,000
\end{array}$
What is the portfolio's beta?

Accepted Answer

A)  1.06 
B)  1.17 
C)  1.29 
D)  1.42 
E)  1.56

Question 8

Which of the following statements is CORRECT?

Accepted Answer

A)  if the risk-free rate rises, then the market risk premium must also rise. 
B)  if a company's beta is halved, then its required return will also be halved. 
C)  if a company's beta doubles, then its required return will also double. 
D)  the slope of the security market line is equal to the market risk premium, (rm - rrf). 
E)  beta is measured by the slope of the security market line.

Question 9

Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

Accepted Answer

A) True 
 B)False

Question 10

Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a -28% return. What is the firm's expected rate of return?

Accepted Answer

A)  9.41% 
B)  9.65% 
C)  9.90% 
D)  10.15% 
E)  10.40%

Question 11

Paul McLaren holds the following portfolio: $\begin{array}{crr}
\text { Stock } &  \text { Investment } &\text { Beta }\
\mathrm{A} &  \$ 150,000&1.40 \
\mathrm{~B} &  50,000&0.80 \
\mathrm{C} &  100,000 &1.00\
\mathrm{D} &  75,000&1.20 \
\text { Total } & \$ 375,000
\end{array}$
Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75. By how much will the portfolio beta change?

Accepted Answer

A)  $0.190 
B)  $0.211 
C)  $0.234 
D)  $0.260 
E) $0.286

Question 12

You have a portfolio P that consists of 50% Stock X and 50% Stock Y. 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. Given this information, which of the following statements is CORRECT?

Accepted Answer

A)  the required return on portfolio p is equal to the market risk premium (rm- rrf). 
B)  portfolio p has a beta of 0.7. 
C)  portfolio p has a beta of 1.0 and a required return that is equal to the riskless rate, rrf. 
D)  portfolio p has the same required return as the market (rm). 
E)  portfolio p has a standard deviation of 20%.

Question 13

If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

Accepted Answer

A) True 
 B)False

Question 14

The distributions of rates of return for Companies AA and BB are given below:
 $$\begin{array} { l l l r } 
\text { State of the } &{ \text { Prabability of } } \
\text { Economy } & \text { This State Occurrine } & \mathrm { AA } & \underline { \mathrm { BB } } \
 \text { Bonm } & 0.2 & 30 \%  &-10 \% \
\text { Narmal } & 0.6 & 10 \% & 5 \% \
\text { Recesfion } & 0.2 & - 5 \% & 50 \%
\end{array}$$ 
We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.

Accepted Answer

A) True 
 B)False

Question 15

Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.

Accepted Answer

A) True 
 B)False

Question 16

Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?

Accepted Answer

A)  if both expected inflation and the market risk premium (rm - rrf) increase, the required return on stock hb will increase by more than that on stock lb. 
B)  if both expected inflation and the market risk premium (rm - rrf) increase, the required returns of both stocks will increase by the same amount. 
C)  since the market is in equilibrium, the required returns of the two stocks should be the same. 
D)  if expected inflation remains constant but the market risk premium (rm- rrf) declines, the required return of stock hb will decline but the required return of stock lb will increase. 
E)  if expected inflation remains constant but the market risk premium (rm - rrf) declines, the required return of stock lb will decline but the required return of stock hb will increase.

Question 17

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.

Accepted Answer

A) True 
 B)False

Question 18

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

Accepted Answer

A) True 
 B)False

Question 19

Recession, inflation, and high interest rates are economic events that are best characterized as being

Accepted Answer

A)  company-specific risk factors that can be diversified away. 
B)  among the factors that are responsible for market risk. 
C)  risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. 
D)  irrelevant except to governmental authorities like the federal reserve. 
E)  systematic risk factors that can be diversified away.

Question 20

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

Accepted Answer

A) True 
 B)False

Exam 2: Risk and Return-Part I

Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECTσ

Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.)

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

Which of the following statements is CORRECT?

Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a -28% return. What is the firm's expected rate of return?

If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.

Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.

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

Recession, inflation, and high interest rates are economic events that are best characterized as being

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.