Question 1

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?
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.

Accepted Answer

The answer of Nile Food's stock has a beta of...

Question 2

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?
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%.

Accepted Answer

The answer of Assume that the risk-free rate is 6%...

Question 3

Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?
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, then 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 declines 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.

Accepted Answer

A) This statement is not necessarily true. The required return of a portfolio consisting of different securities depends on their respective betas.
B) This statement may or may not be true. Beta is only one factor that affects expected return and standard deviation.
C) This statement is false. Both stocks have different betas, which means they have different exposures to systematic risk. A change in expected inflation would not affect them in the same way.
D) This statement is true. If the market risk premium declines, the required return on both Stocks X and Y will decrease, but the decrease will be greater for Stock Y, which has a higher beta.
E) This statement is false. A decline in expected inflation would not affect the required return on different stocks in the same way, since they have different betas.

Question 4

Which of the following statements is CORRECT?
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.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 5

During the coming year, the market risk premium (rM − rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT?
A) The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.
B) The required return on all stocks will remain unchanged.
C) The required return will fall for all stocks, but it will fall more for stocks with higher betas.
D) The required return for all stocks will fall by the same amount.
E) The required return will fall for all stocks, but it will fall less for stocks with higher betas.

Accepted Answer

The market risk premium is the difference between the expected return on the market and the risk-free rate. If the market risk premium is expected to fall, this means that investors will require a lower return to invest in risky assets such as stocks. However, the degree to which the required return will fall will depend on the stock's beta. Stocks with higher betas are considered more risky, so investors will still require a higher expected return compared to less risky stocks. Therefore, the required return will fall for all stocks, but it will fall more for stocks with higher betas.

Question 6

Which of the following statements is CORRECT?
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.

Accepted Answer

According to the CAPM, a negative slope of the regression line (i.e. a negative beta) indicates that the stock is less risky than the market as a whole, and therefore should have a lower required rate of return than the risk-free rate. The CAPM assumes that investors expect the observed relationship between the stock and the market to continue into the future.

Question 7

Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
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%.

Accepted Answer

The answer of Assume that the risk-free rate is 5%....

Question 8

Assume that in recent years both expected inflation and the market risk premium (rM − rRF) 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?
A) The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.
B) The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.
C) The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0.
D) Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.
E) The required returns on all stocks have fallen by the same amount.

Accepted Answer

A decline in both expected inflation and the market risk premium would lead to a decline in the required rate of return for all stocks. However, since all stocks have positive betas, higher beta stocks are more sensitive to market movements and thus have a higher required rate of return. Therefore, the fall in required returns would be greater for stocks with higher betas (i.e. greater risk) compared to stocks with lower betas.

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 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?
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.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the required return on a stock is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. Since the betas of the three stocks are different, their required returns will also be different. An increase in the market risk premium will result in an increase in the required return on all stocks.

However, Stock A has a beta of 0.8, which is less than 1.0 (the market beta), and Stock C has a beta of 1.2, which is greater than 1.0. Therefore, 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. The required return on Stock B, which has a beta equal to the market beta, will increase by the same amount as the increase in the market risk premium.

Question 10

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT?
A) If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.
B) Stock B's required rate of return is twice that of Stock A.
C) If Stock A's required return is 11%, then the market risk premium is 5%.
D) If Stock B's required return is 11%, then the market risk premium is 5%.
E) If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.

Accepted Answer

The answer of The risk-free rate is 6%; Stock A...

Question 11

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?
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.

Accepted Answer

The answer of Assume that the risk-free rate remains constant,...

Question 12

Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.)
A) Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns.
B) Stock B has a higher required rate of return than Stock A.
C) Portfolio P has a standard deviation of 22.5%.
D) More information is needed to determine the portfolio's beta.
E) Portfolio P has a beta of 1.0.

Accepted Answer

The answer of Stock A has a beta of 1.2...

Question 13

Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would be affected as follows:
A) The y-axis intercept would decline, and the slope would increase.
B) The x-axis intercept would decline, and the slope would increase.
C) The y-axis intercept would increase, and the slope would decline.
D) The SML would be affected only if betas changed.
E) Both the y-axis intercept and the slope would increase, leading to higher required returns.

Accepted Answer

The answer of Other things held constant, if the expected...

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?
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.

Accepted Answer

Since the market risk premium has increased by 1%, the required return for both Stock A and Stock B would increase by their respective betas times the increase in the market risk premium. However, since Portfolio P is equally invested in both stocks, the beta of the overall portfolio would be the average of the betas of the two stocks (0.7 + 1.3) / 2 = 1. The expected return for Portfolio P would increase by its beta times the increase in the market risk premium, which is 1%. Therefore, the required return on Portfolio P would increase by 1%.

Question 15

Which of the following statements is CORRECT?
A) The slope of the security market line is equal to the market risk premium.
B) Lower beta stocks have higher required returns.
C) A stock's beta indicates its diversifiable risk.
D) Diversifiable risk cannot be completely diversified away.
E) Two securities with the same stand-alone risk must have the same betas.

Accepted Answer

The slope of the security market line (SML) represents the market risk premium, which is the excess return investors require to compensate for the risk of the overall market. Therefore, statement A is correct.
B is incorrect because lower beta stocks have lower required returns, as they are less risky than higher beta stocks.
C is incorrect because a stock's beta measures its systematic risk, or the risk that cannot be diversified away, rather than its diversifiable risk.
D is incorrect because diversifiable risk, also known as unsystematic risk, can be diversified away by holding a portfolio of securities. 
E is incorrect because two securities with the same stand-alone risk can have different betas depending on their sensitivity to market movements.

Question 16

Which of the following statements is CORRECT?
A) Beta is measured by the slope of the security market line.
B) If the risk-free rate rises, then the market risk premium must also rise.
C) If a company's beta is halved, then its required return will also be halved.
D) If a company's beta doubles, then its required return will also double.
E) The slope of the security market line is equal to the market risk premium, (rM − rRF).

Accepted Answer

The statement that is correct is: The slope of the security market line is equal to the market risk premium, (rM − rRF). The other statements are incorrect. Beta is measured by the slope of the security market line, but only in relation to the security's return relative to the market return. If the risk-free rate rises, then the market risk premium does not necessarily have to rise. If a company's beta is halved, then its required return will also decrease, but not necessarily by half. If a company's beta doubles, then its required return will also increase, but not necessarily by double.

Question 17

Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?
A) The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.
B) The required return would decrease by the same amount for both Stock A and Stock B.
C) The required return would increase for Stock A but decrease for Stock B.
D) The required return on Portfolio P would remain unchanged.
E) The required return would increase for Stock B but decrease for Stock A.

Accepted Answer

The answer of Stock A has a beta of 0.8...

Question 18

Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
A) If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.
B) The effect of a change in the market risk premium depends on the slope of the yield curve.
C) If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
D) If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
E) The effect of a change in the market risk premium depends on the level of the risk-free rate.

Accepted Answer

The answer of Which of the following statements is CORRECT?...

Question 19

Over the past 84 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?
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.

Accepted Answer

The question asks us to rank investments from highest to lowest risk (and return) based on the notion that there is a positive correlation between risk and return. The observation that investments with the highest average annual returns tend to have the highest standard deviations of annual returns supports this notion. Therefore, we can eliminate choices B, D, and E because they do not follow this pattern. 
Option A has some correct ordering, but it puts long-term government bonds last, which is incorrect, as they are less risky than U.S. Treasury bills. 
Therefore, the correct answer is C, where the ranking from highest to lowest risk (and return) is: Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.

Question 20

Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?
A) 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.
B) 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.
C) If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount.
D) Since the market is in equilibrium, the required returns of the two stocks should be the same.
E) 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.

Accepted Answer

The required return on each stock is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. If the market risk premium increases, the required return on both stocks will increase. However, because Stock HB has a higher beta, it will experience a greater increase in required return than Stock LB. Similarly, if expected inflation increases, the required return on both stocks will increase, but again Stock HB will have a greater increase in required return due to its higher beta. Therefore, statement B is correct. Statements A, C, and D are incorrect. Statement E is a repetition and does not make sense as it contradicts statement A.

Quiz 8: Risk and Return

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?

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?

Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

During the coming year, the market risk premium (rM − rRF) , is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?

Assume that in recent years both expected inflation and the market risk premium (rM − rRF) 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?

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT?

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?

Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would be affected as follows:

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?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?

Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)

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