Question 1

Systematic risk is measured by:
A)the mean.
B)beta.
C)the geometric average.
D)the standard deviation.
E)the arithmetic average.

Accepted Answer

Beta is a measure of a stock's or portfolio's volatility in relation to the overall market. It indicates the level of systematic risk that cannot be diversified away. Therefore, beta is the appropriate measure for systematic risk. The other choices are measures of return or variability, which may not be directly related to systematic risk.

Question 2

The excess return earned by an asset that has a beta of 1.34 over that earned by a risk-free asset is referred to as the:
A)market risk premium.
B)risk premium.
C)systematic return.
D)total return.
E)real rate of return.

Accepted Answer

The excess return earned by an asset that has a beta of 1.34 over that earned by a risk-free asset is referred to as the risk premium. The market risk premium is the additional return required by investors for taking on the risk of investing in the overall market, while systematic return refers to the portion of a stock's return that is related to general market movements. Total return includes both the risk premium and any other sources of return, such as dividends. The real rate of return adjusts for inflation. None of these definitions fits the given scenario as well as the term "risk premium."

Question 3

The market risk premium is computed by:
A)adding the risk-free rate of return to the inflation rate.
B)adding the risk-free rate of return to the market rate of return.
C)subtracting the risk-free rate of return from the inflation rate.
D)subtracting the risk-free rate of return from the market rate of return.
E)multiplying the risk-free rate of return by a beta of 1.0.

Accepted Answer

The market risk premium represents the extra return investors expect to receive for taking on the risk of investing in the stock market, as opposed to a risk-free asset. It is calculated by subtracting the risk-free rate of return (usually the yield on a government bond) from the expected market rate of return. Therefore, choice D, which subtracts the risk-free rate of return from the market rate of return, is the correct option.

Question 4

The capital asset pricing model (CAPM) assumes which of the following?
I. a risk-free asset has no systematic risk.
II. beta is a reliable estimate of total risk.
III. the reward-to-risk ratio is constant.
IV. the market rate of return can be approximated.
A)I and III only
B)II and IV only
C)I, III, and IV only
D)II, III, and IV only
E)I, II, III, and IV

Accepted Answer

I, III, and IV are correct assumptions of the CAPM. It assumes a risk-free asset has no systematic risk, the reward-to-risk ratio is constant, and the market rate of return can be approximated. However, CAPM does not assume beta is a reliable estimate of total risk; instead, it considers beta as a measure of systematic risk only, not total risk.

Question 5

Which one of the following is most directly affected by the level of systematic risk in a security?
A)variance of the returns
B)standard deviation of the returns
C)expected rate of return
D)risk-free rate
E)market risk premium

Accepted Answer

The expected rate of return is directly affected by the level of systematic risk in a security. Systematic risk, also known as market risk, is the risk that affects all securities in the market, and it is influenced by macroeconomic factors such as inflation, interest rates, and geopolitical events. As a result, securities with higher systematic risk will have a higher expected rate of return to compensate investors for taking on that additional risk. The variance and standard deviation of returns, as well as the risk-free rate and market risk premium, are all indirectly affected by the level of systematic risk.

Question 6

You have a $12,000 portfolio which is invested in stocks A and B, and a risk-free asset. $5,000 is invested in stock A. Stock A has a beta of 1.76 and stock B has a beta of 0.89. How much needs to be invested in stock B if you want a portfolio beta of 1.10?
A) $3,750.00
B) $4,333.33
C) $4,706.20
D) $4,943.82
E) $5,419.27

Accepted Answer

Beta_Portfolio = 1.10 = ($5,000/$12,000)(1.76) + (x/$12,000)(0.89) + (($12,000 - $5,000 - x)/$12,000)(0); x = $4,943.82

Question 7

The _____ of a security divided by the beta of that security is equal to the slope of the security market line if the security is priced fairly.
A)real return
B)actual return
C)nominal return
D)risk premium
E)expected return

Accepted Answer

The answer of The _____ of a security divided by...

Question 8

The intercept point of the security market line is the rate of return which corresponds to:
A)the risk-free rate.
B)the market rate.
C)a return of zero.
D)a return of 1.0 percent.
E)the market risk premium.

Accepted Answer

The intercept point of the security market line (SML) represents the expected rate of return on a risk-free asset (such as a U.S. Treasury bond) which has no systematic risk. Therefore, choice A is correct.

Question 9

The common stock of Manchester & Moore is expected to earn 13 percent in a recession, 6 percent in a normal economy, and lose 4 percent in a booming economy. The probability of a boom is 5 percent while the probability of a recession is 45 percent. What is the expected rate of return on this stock?
A)8.52 percent
B)8.74 percent
C)8.65 percent
D)9.05 percent
E)9.28 percent

Accepted Answer

E(r) = (0.45F1F1F1S1F1F1F10 0.13) + (0.50 F1F1F1S1F1F1F10 0.06) + (0.05 F1F1F1S1F1F1F10 -0.04) = 8.65 percent

Question 10

You want your portfolio beta to be 0.95. Currently, your portfolio consists of $4,000 invested in stock A with a beta of 1.47 and $3,000 in stock B with a beta of 0.54. You have another $9,000 to invest and want to divide it between an asset with a beta of 1.74 and a risk-free asset. How much should you invest in the risk-free asset?
A)$4,316.08
B)$4,425.29
C)$4,902.29
D)$4,574.71
E)$4,683.92

Accepted Answer

Beta_Portfolio = 0.95 = ($4,000/$16,000)(1.47) + ($3,000/$16,000)(0.54) + (x/$16,000)(1.74) + (($9,000 - x)/$16,000)(0); Investment in risk-free asset = $9,000 - $4,425.29 = $4,574.71

Question 11

A stock with an actual return that lies above the security market line has:
A)more systematic risk than the overall market.
B)more risk than that warranted by CAPM.
C)a higher return than expected for the level of risk assumed.
D)less systematic risk than the overall market.
E)a return equivalent to the level of risk assumed.

Accepted Answer

The security market line (SML) represents the relationship between expected return and systematic risk, as depicted by the CAPM. A stock with an actual return that lies above the SML has a higher return than expected for the level of risk assumed, providing investors with excess returns. This implies that the stock is undervalued, and the market has not priced all the information correctly. Thus, choice C is the right answer.

Question 12

Which one of the following statements is correct concerning a portfolio beta?
A)Portfolio betas range between -1.0 and +1.0.
B)A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio.
C)A portfolio beta cannot be computed from the betas of the individual securities comprising the portfolio because some risk is eliminated via diversification.
D)A portfolio of U.S.Treasury bills will have a beta of +1.0.
E)The beta of a market portfolio is equal to zero.

Accepted Answer

A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio. Option A is incorrect because portfolio betas can be greater than +1 or less than -1 if leveraged or short positions are used. Option C is incorrect because diversification does not eliminate all risk, only unsystematic risk. Option D is incorrect because U.S. Treasury bills are considered a risk-free asset with a beta of 0. Option E is incorrect because the beta of a market portfolio is 1.0, not 0.

Question 13

Total risk is measured by _____ and systematic risk is measured by _____.
A)beta; alpha
B)beta; standard deviation
C)alpha; beta
D)standard deviation; beta
E)standard deviation; variance

Accepted Answer

Total risk is measured by standard deviation, which measures the variability of returns. Systematic risk is measured by beta, which measures the sensitivity of an asset's returns to changes in the overall market. Alpha measures the excess return of an asset over its expected return, and variance is the squared deviation from the mean, which is a component of standard deviation. Therefore, the best choice is D, which correctly matches the measures of risk to their types.

Question 14

At a minimum, which of the following would you need to know to estimate the amount of additional reward you will receive for purchasing a risky asset instead of a risk-free asset?
I. asset's standard deviation
II. asset's beta
III. risk-free rate of return
IV. market risk premium
A)I and III only
B)II and IV only
C)III and IV only
D)I, III, and IV only
E)I, II, III, and IV

Accepted Answer

To estimate the amount of additional reward for purchasing a risky asset instead of a risk-free asset, we would need to know the asset's beta (as it measures the risk of the asset compared to the market) and the market risk premium (the excess return that investors demand for taking on the risk of investing in the stock market over the risk-free rate). The standard deviation would be useful in determining the overall volatility of the asset, but it is not essential for this specific calculation. The risk-free rate of return is important as a benchmark for determining the additional reward received for taking on risk. Therefore, the best choice would be to know the asset's beta and the market risk premium only, which is Option B - II and IV only.

Question 15

The market rate of return is 11 percent and the risk-free rate of return is 3 percent. Lexant stock has 3 percent less systematic risk than the market and has an actual return of 12 percent. This stock:
A)is underpriced.
B)is correctly priced.
C)will plot below the security market line.
D)will plot on the security market line.
E)will plot to the right of the overall market on a security market line graph.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the expected return of a stock is calculated as the risk-free rate plus the product of the stock's beta (systematic risk) and the market risk premium (the difference between the market return and the risk-free rate). 
Expected Return = Risk-free rate + Beta*(Market rate - Risk-free rate)
Given that Lexant stock has 3% less systematic risk than the market, its beta would be (1-0.03) = 0.97.
Using the CAPM formula, the expected return of Lexant stock is:
Expected Return = 3% + 0.97*(11%-3%) = 9.54%
However, Lexant stock has an actual return of 12%, which is greater than its expected return of 9.54%. This indicates that the stock is providing excess returns, which implies that it is underpriced. Therefore, the correct answer is A.

Question 16

The systematic risk of the market is measured by:
A)a beta of 1.0.
B)a beta of 0.0.
C)a standard deviation of 1.0.
D)a standard deviation of 0.0.
E)a variance of 1.0.

Accepted Answer

Systematic risk, or market risk, is measured by the beta coefficient. A beta of 1.0 indicates that the security's price will move in line with the market, whereas a beta above 1.0 indicates higher volatility, and a beta below 1.0 indicates lower volatility compared to the market. Therefore, option A is the best choice as it measures systematic risk by a beta of 1.0.

Question 17

According to CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends upon the:
A)amount of total risk assumed and the market risk premium.
B)market risk premium and the amount of systematic risk inherent in the security.
C)risk free rate, the market rate of return, and the standard deviation of the security.
D)beta of the security and the market rate of return.
E)standard deviation of the security and the risk-free rate of return.

Accepted Answer

CAPM states that the amount of reward an investor receives for bearing the risk of an individual security depends upon the market risk premium and the amount of systematic risk inherent in the security, which is measured by beta. The other factors listed in the answer choices may impact the expected return of the security, but they are not specifically included in the CAPM equation.

Question 18

Which one of the following should earn the most risk premium based on CAPM?
A)diversified portfolio with returns similar to the overall market
B)stock with a beta of 1.38
C)stock with a beta of 0.74
D)U.S.Treasury bill
E)portfolio with a beta of 1.01

Accepted Answer

According to CAPM, the stock with the highest beta should earn the most risk premium. A beta of 1.38 indicates that the stock is more volatile than the overall market and therefore has higher systematic risk. The other choices either have lower beta than the market or no systematic risk as in the case of the Treasury bill.

Question 19

Which one of the following will be constant for all securities if the market is efficient and securities are priced fairly?
A)variance
B)standard deviation
C)reward-to-risk ratio
D)beta
E)risk premium

Accepted Answer

In an efficient market where securities are priced fairly, the reward-to-risk ratio should be constant across all securities. This is because any differences in expected returns should be compensated by differences in risk, ensuring that the reward for taking on additional risk is consistent across the market.

Question 20

You recently purchased a stock that is expected to earn 22 percent in a booming economy, 9 percent in a normal economy, and lose 33 percent in a recessionary economy. There is a 5 percent probability of a boom and a 75 percent chance of a normal economy. What is your expected rate of return on this stock?
A)-3.40 percent
B)-2.25 percent
C)1.25 percent
D)2.60 percent
E)3.50 percent

Accepted Answer

E(r) = (0.05 F1F1F1S1F1F1F10 0.22) + (0.75 F1F1F1S1F1F1F10 0.09) + (0.20 F1F1F1S1F1F1F10 -0.33) = 1.25 percent

Quiz 13: Return, Risk, and the Security Market Line

Systematic risk is measured by:

The excess return earned by an asset that has a beta of 1.34 over that earned by a risk-free asset is referred to as the:

The market risk premium is computed by:

The capital asset pricing model (CAPM) assumes which of the following? I. a risk-free asset has no systematic risk. II. beta is a reliable estimate of total risk. III. the reward-to-risk ratio is constant. IV. the market rate of return can be approximated.

Which one of the following is most directly affected by the level of systematic risk in a security?

You have a $12,000 portfolio which is invested in stocks A and B, and a risk-free asset. $5,000 is invested in stock A. Stock A has a beta of 1.76 and stock B has a beta of 0.89. How much needs to be invested in stock B if you want a portfolio beta of 1.10?

The _____ of a security divided by the beta of that security is equal to the slope of the security market line if the security is priced fairly.

The intercept point of the security market line is the rate of return which corresponds to:

The common stock of Manchester & Moore is expected to earn 13 percent in a recession, 6 percent in a normal economy, and lose 4 percent in a booming economy. The probability of a boom is 5 percent while the probability of a recession is 45 percent. What is the expected rate of return on this stock?

A stock with an actual return that lies above the security market line has:

Which one of the following statements is correct concerning a portfolio beta?

Total risk is measured by _ and systematic risk is measured by _.

At a minimum, which of the following would you need to know to estimate the amount of additional reward you will receive for purchasing a risky asset instead of a risk-free asset? I. asset's standard deviation II. asset's beta III. risk-free rate of return IV. market risk premium

The market rate of return is 11 percent and the risk-free rate of return is 3 percent. Lexant stock has 3 percent less systematic risk than the market and has an actual return of 12 percent. This stock:

The systematic risk of the market is measured by:

According to CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends upon the:

Which one of the following should earn the most risk premium based on CAPM?

Which one of the following will be constant for all securities if the market is efficient and securities are priced fairly?