Question 1

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 2

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

The answer of Stock X has a beta of 0.6,...

Question 3

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 required return on a stock is calculated using the Capital Asset Pricing Model (CAPM): r = rRF + beta * (rM - rRF). An increase in the market risk premium (rM - rRF) will increase the required return for both stocks, but since Stock B has a higher beta, the increase will be greater for Stock B than for Stock A.

Question 4

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 security market line represents the relationship between a security's required return and its beta, with the slope of the line equal to the market risk premium.

Question 5

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 required return on a security or portfolio can be calculated using the following formula:

Required Return = Risk-Free Rate + Beta x Market Risk Premium

Using the information provided, we can calculate the required return for an index fund with beta = 1.0 as follows:

Required Return = 6% + 1.0 x 5% = 11%

Therefore, the correct statement is that an index fund with beta = 1.0 should have a required return of 11%.

Question 6

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

The required return on a portfolio can be calculated using the Capital Asset Pricing Model (CAPM):
Required return on Portfolio P = risk-free rate + beta of A*(market risk premium) + beta of B*(market risk premium)

Since the market risk premium increased by 1%, both beta values would be affected differently. Stock A has a beta of 0.7, which means it is less sensitive to market movements and would experience a smaller increase in required return. Stock B has a beta of 1.3, which means it is more sensitive to market movements and would experience a larger increase in required return.

As a result, the overall required return on Portfolio P would increase, but the effect on each stock would be different. The required return on Portfolio P would increase by 1%, as stated in choice A.

Question 7

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 8

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

The required return on each stock will increase by the product of the stock's beta and the increase in the market risk premium. Stock A's required return will increase by 0.8 times the increase in the market risk premium, while Stock C's required return will increase by 1.2 times the increase in the market risk premium. Stock B's required return will increase by the increase in the market risk premium since its beta is 1.0. Therefore, B is the correct answer.

Question 9

Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed's actions would lead to a recession, and that led to an increase in the market risk premium, (rM - rRF). Under these conditions, with other things held constant, which of the following statements is most correct?
A) The required return on all stocks would increase by the same amount.
B) The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0.
C) Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices.
D) The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
E) The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.

Accepted Answer

The increase in the risk-free rate and the market risk premium would lead to higher required returns, particularly affecting high-beta stocks more significantly, causing their prices to decline more than low-beta stocks.

Question 10

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 11

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT?
A) The required return of all stocks will increase by the amount of the increase in the risk-free rate.
B) The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0.
C) Since the overall return on the market stays constant, the required return on each individual stock will also remain constant.
D) The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
E) The required return of all stocks will fall by the amount of the decline in the market risk premium.

Accepted Answer

The answer of Assume that the risk-free rate, rRF, increases...

Question 12

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 E - "The slope of the security market line is equal to the market risk premium, (rM − rRF)". A is incorrect because beta is measured by the slope of the security characteristic line, not the security market line. B is incorrect because a change in the risk-free rate does not necessarily mean a corresponding change in the market risk premium. C and D are incorrect because changes in a company's beta do not directly result in proportional changes in its required return.

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 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 of a stock is equal to the risk-free rate plus the product of the stock's beta and the market risk premium (rM − rRF). Therefore, the required return of Stock HB will be more sensitive to changes in the market risk premium than the required return of Stock LB due to their different betas. Thus, if both expected inflation and the market risk premium increase, the required return on Stock HB will increase by more than that on Stock LB.

Question 15

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 16

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 17

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 18

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 19

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

When expected inflation and the market risk premium decline, the required return on equity (Ks) also declines. As a result, the required returns on all stocks would likely have fallen. However, since all stocks have positive betas, the fall in required returns would have been greater for stocks with higher betas. This is because the market risk premium is a key component of the CAPM equation, and stocks with higher betas are more sensitive to changes in the market risk premium.

Question 20

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, the slope of the Security Market Line (SML) is determined by the market risk premium and the beta of an asset, not the value of beta alone (Option A is incorrect). The SML shows the relationship between companies' required returns and their systematic risks, not diversifiable risks (Option B is incorrect). A negative slope of the regression line between the returns of a stock and the market would indicate a negative beta, which means the required rate of return on the stock would be less than the risk-free rate, but this statement assumes investors expect the relationship to continue into the future (Option C is correct). If investors become less risk-averse, the slope of the SML would decrease, not increase (Option D is incorrect). An increase in a company's use of debt would increase its beta and its required return according to the CAPM, not the slope of the SML itself (Option E is incorrect).

Quiz 8: Risk and Return

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?

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 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT?

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?

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?

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?

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF) , declines with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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 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?

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 remains constant, but the market risk premium declines. Which of the following is most likely to occur?

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?

Which of the following statements is CORRECT?