Question 1

Which statement about a stock's beta is correct?
A)If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium.
B)A stock with a negative beta must in theory have a negative required rate of return.
C)If a stock's beta doubles, its required rate of return must also double.
D)If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.

Accepted Answer

Beta measures an asset's sensitivity to market volatility. A negative beta means the stock's returns move in the opposite direction of the market. Therefore, choice D is correct. The other choices are incorrect because they are either too broad or do not accurately reflect the relationship between a stock's beta and required rate of return.

Question 2

Which of the following statements is correct?
A)A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.
B)The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
C)If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.
D)An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required return on a riskless asset and on an average stock, other things held constant.

Accepted Answer

According to the Fisher effect, an increase in expected inflation would lead to an increase in the nominal risk-free rate, which would lead to an increase in the required return on both a riskless asset and on an average stock. Therefore, choice D is correct. Choice A is incorrect because a graph of the SML as applied to individual stocks would show required rates of return on the horizontal axis and betas on the vertical axis. Choice B is incorrect because the CAPM has faced some empirical challenges and its assumptions have been criticized. Choice C is incorrect because an increase in risk aversion would increase the slope of the SML and increase the required return on all stocks, but the increase would be greater for high-beta stocks.

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), the required return on both stocks will decrease by the same amount.
D)If the market risk premium decreases but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y.

Accepted Answer

The required return on a stock is influenced by its beta and the market risk premium. A decrease in the market risk premium will reduce the required return more for Stock Y, which has a higher beta, compared to Stock X.

Question 4

As investors become ____ risk averse,the market risk premium ____ and SML becomes ____.
A)more, increases, steeper.
B)more, decreases, flatter
C)less, increases, flatter.
D)less, decreases, steeper.

Accepted Answer

When investors become more risk-averse, they require a higher return for taking on additional risk, leading to an increase in the market risk premium and a steeper Security Market Line (SML).

Question 5

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 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)Portfolio P has a beta equal to 1.0.

Accepted Answer

To find the standard deviation of the portfolio, we use the formula:
σp = √(wA²σA² + wB²σB² + 2wAwBσAσBρAB)
where wA and wB are the weights of Stock A and Stock B in the portfolio, respectively, σA and σB are the standard deviations of Stock A and Stock B, respectively, and ρAB is the correlation coefficient between the returns on Stock A and Stock B. Since the question does not provide the correlation coefficient, we assume it to be zero (i.e., the returns on Stock A and Stock B are uncorrelated) to obtain:
σp = √(0.5²×0.2² + 0.5²×0.25²) = 0.225 or 22.5%
To find the beta of the portfolio, we use the formula:
βp = wAβA + wBβB
where βA and βB are the betas of Stock A and Stock B, respectively. Substituting the given values, we get:
βp = 0.5×1.2 + 0.5×0.8 = 1.0
Therefore, statement D is correct. Statements A and B cannot be determined from the given information.

Question 6

Assume that investors have recently become more risk averse,so the market risk premium has increased.Also,assume that the risk-free rate and expected inflation have not changed.Which of the following is most likely to occur? A)The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. B)The required rate of return will decline for stocks whose betas are less than 1.0. C)The required rate of return on the market, r_M, will not change as a result of these changes. D)The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium.

Accepted Answer

An increase in the market risk premium will lead to an increase in the required rate of return for all stocks, including the average stock. This is because the market risk premium is a key component of the overall required rate of return for any stock. Therefore, (A) is the most likely outcome. Choices (B) and (D) are not necessarily true because they assume that the betas or required rates of return for individual stocks will change, which may not necessarily be the case. Choice (C) is not true because an increase in the market risk premium would lead to an increase in the required rate of return on the market portfolio.

Question 7

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%? (Assume that the risk-free rate remains 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%.

Accepted Answer

The required return on Portfolio P is the weighted average of the required returns on Stock A and Stock B. Since Stock B has a higher beta, it is more sensitive to market movements and will have a higher required return. Thus, an increase in the market risk premium will have a greater impact on the required return for Stock B than Stock A, leading to an overall increase in the required return for Portfolio P. Therefore, the correct answer is A.

Question 8

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 company-specific risk.
D)Two securities with the same stand-alone risk will have the same betas.

Accepted Answer

The slope of the security market line (SML) represents the market risk premium, which is the additional return investors require for investing in a risky asset compared to a risk-free asset. Therefore, statement A is correct.

B is incorrect as lower beta stocks have lower required returns.

C is incorrect as a stock's beta measures its systematic risk, or the risk that cannot be diversified away by holding a portfolio of assets. Beta does not capture company-specific risk, which is idiosyncratic and can be diversified away in a portfolio of assets.

D is incorrect as two securities with the same stand-alone risk can have different betas if they have different systematic risk. Beta measures systematic risk, which is not solely determined by stand-alone risk.

Question 9

Which of the following statements is correct? A)If the risk-free rate rises, then the market risk premium will 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, (r_M - r_RF).

Accepted Answer

The slope of the security market line (SML) represents the market risk premium, which is the difference between the expected return on the market portfolio and the risk-free rate. This is a fundamental concept in the Capital Asset Pricing Model (CAPM), where the slope (beta) measures the sensitivity of a security's returns to the returns of the market portfolio, and the intercept is the risk-free rate.

Question 10

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 greater than 1.0 will increase.
B)The return on the market will remain constant.
C)The return on the market will increase.
D)The required return on a stock with beta less than 1.0 will decline.

Accepted Answer

The required return on a stock with beta less than 1.0 will decline because as the market risk premium declines, the required return on all stocks decreases. Since stocks with beta less than 1.0 are less risky than the market, they have a lower required return and will benefit from the decline in market risk premium.

Question 11

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 became convinced that there would 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 an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise.

Accepted Answer

The required rate of return for stocks is calculated using the Capital Asset Pricing Model (CAPM), which includes the risk-free rate and the market risk premium. If the risk-free rate increases but the market risk premium declines by the same amount, the overall required rate of return on an average stock will remain unchanged. However, since the market risk premium has declined, stocks with betas less than 1.0 will have a higher required rate of return, as they will be relatively more risky compared to the market. Option A is incorrect because the required rate of return is not directly proportional to the beta of a company. Option B is incorrect because deflation would decrease the required rate of return on stocks, not increase it. Option C is incorrect because cutting a company's beta in half would not necessarily halve its required rate of return.

Question 12

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

Accepted Answer

The required return on a stock is determined by the capital asset pricing model (CAPM), which takes into account the risk-free rate, the market risk premium, and the stock's beta. In this scenario, the risk-free rate is constant, but the market risk premium increases, which means that the required return on both stocks will increase. However, because Stock B has a higher beta than Stock A, the increase in required return will be greater for Stock B. Therefore, the best choice is A. The required return on Portfolio P will also increase, but by a weighted average of the required returns on Stock A and Stock B.

Question 13

Suppose you have an asset with a return that rises as GDP increases.How will the asset's return be affected if the government announces that GDP is unexpectedly higher than was previously thought?
A)The return will increase.
B)The return will remain unchanged.
C)The return will decrease.
D)It is undetermined and more information is needed.

Accepted Answer

If the asset's return is positively correlated with GDP, then an unexpected increase in GDP would lead to an increase in the asset's return. Therefore, the best choice is A.

Question 14

Currently,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)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%.

Accepted Answer

The required return can be calculated using the Capital Asset Pricing Model (CAPM) formula: Required Return = Risk-Free Rate + (Beta * Market Risk Premium). For an index fund with a beta of 1.0, the required return would be 6% + (1.0 * 5%) = 11%.

Question 15

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 return on the average stock will remain unchanged, but the returns of 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 market risk premium multiplied by the stock's beta. Since the betas of the three stocks are different, an increase in the market risk premium will result in different changes in the required returns of each stock.

Stock A has a beta of 0.8, which means it is less sensitive to market fluctuations compared to the average stock. Therefore, its required return will increase by less than the increase in the market risk premium.

Stock C, on the other hand, has a beta of 1.2, which means it is more sensitive to market fluctuations compared to the average stock. Therefore, its required return will increase by more than the increase in the market risk premium.

Portfolio P has equal amounts invested in each of the three stocks, so its required return will be the weighted average of the required returns of the individual stocks. Since Stock A and Stock C have opposite effects on the required return, the required return of Portfolio P will increase by an amount between the required returns of Stock A and Stock C.

Question 16

Nile Foods' stock has a beta of 1.4,while Elba Eateries' stock has a beta of 0.7.Assume that the risk-free rate,r_RF,is 5.5% and the market risk premium,(r_M - r_RF),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 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.

Accepted Answer

The answer of Nile Foods' stock has a beta of...

Question 17

Other things held constant,in which way would the Security Market Line shift if the expected inflation rate decreases and investors also become more risk averse?
A)It would shift down and have a steeper slope.
B)It would shift up and have a less steep slope.
C)It would shift up and keep the same slope.
D)It would shift down and keep the same slope.

Accepted Answer

The Security Market Line (SML) represents the expected return of a security or portfolio in relation to its risk (beta). If the expected inflation rate decreases, the risk-free rate, which is part of the SML equation, would likely decrease, causing the SML to shift down because the expected return for any given level of risk would be lower. If investors become more risk-averse, they would require a higher return for taking on additional risk, which would steepen the slope of the SML, as the premium for bearing risk increases.

Question 18

Assume that the risk-free rate,r_RF,increases but the market risk premium,(r_M - r_RF) declines,with the net effect being that the overall required return on the market,r_M,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 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.

Accepted Answer

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

Question 19

Which of the following statements is correct?
A)When company-specific 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 unfavourable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavourable 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.

Accepted Answer

The Security Market Line (SML) represents the relationship between the expected return of a stock and its market risk (beta). While managers cannot change the slope or intercept of the SML, they can influence their firm's position on it by altering the firm's risk profile.

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 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 in the market expect the observed relationship to continue on into the future.
D)If investors become less risk averse, the slope of the SML will increase.

Accepted Answer

According to CAPM, a negative slope of the regression line indicates that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming investors in the market expect the observed relationship to continue on into the future. Option A is incorrect because beta determines the steepness or slope of the SML. Option B is partly true, but it is not completely accurate as the intercept of the SML is determined by the risk-free rate and market risk premium, which can be influenced by macroeconomic factors or government policies. Option D is incorrect as a decrease in risk aversion of investors will lead to a decline in the slope of the SML.

Quiz 7: Risk, Return, and the Capital Asset Pricing Model

Which statement about a stock's beta is correct?

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?

As investors become risk averse,the market risk premium and SML becomes .

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 stocks are in equilibrium.)

Assume that investors have recently become more risk averse,so the market risk premium has increased.Also,assume that the risk-free rate and expected inflation have not changed.Which of the following is most likely to occur?

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%? (Assume that the risk-free rate remains constant.)

Which of the following statements is correct?

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?

Which of the following statements is correct?

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

Suppose you have an asset with a return that rises as GDP increases.How will the asset's return be affected if the government announces that GDP is unexpectedly higher than was previously thought?

Currently,the risk-free rate is 6% and the market risk premium is 5%.Given this information,which of the following statements is correct?

Nile Foods' stock has a beta of 1.4,while Elba Eateries' stock has a beta of 0.7.Assume that the risk-free rate,r_RF,is 5.5% and the market risk premium,(r_M - r_RF) ,equals 4%.Which of the following statements is correct?

Other things held constant,in which way would the Security Market Line shift if the expected inflation rate decreases and investors also become more risk averse?

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

Which of the following statements is correct?

Which of the following statements is correct?

Quiz 7: Risk, Return, and the Capital Asset Pricing Model

Which statement about a stock's beta is correct?

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?

As investors become ____ risk averse,the market risk premium ____ and SML becomes ____.

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 stocks are in equilibrium.)

Assume that investors have recently become more risk averse,so the market risk premium has increased.Also,assume that the risk-free rate and expected inflation have not changed.Which of the following is most likely to occur?

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%? (Assume that the risk-free rate remains constant.)

Which of the following statements is correct?

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?

Which of the following statements is correct?

Stock A has a beta of 0.8 and Stock B has a beta of 1.2.Fifty percent 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?

Suppose you have an asset with a return that rises as GDP increases.How will the asset's return be affected if the government announces that GDP is unexpectedly higher than was previously thought?

Currently,the risk-free rate is 6% and the market risk premium is 5%.Given this information,which of the following statements is correct?

Nile Foods' 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?

Other things held constant,in which way would the Security Market Line shift if the expected inflation rate decreases and investors also become more risk averse?

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?

Which of the following statements is correct?

As investors become risk averse,the market risk premium and SML becomes .

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

Nile Foods' stock has a beta of 1.4,while Elba Eateries' stock has a beta of 0.7.Assume that the risk-free rate,r_RF,is 5.5% and the market risk premium,(r_M - r_RF) ,equals 4%.Which of the following statements is correct?

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