Question 1

What are the two variables whose relationship is represented by the Security Market Line?
A) Diversification and correlation
B) Risk and diversification
C) Beta and risk
D) Beta and expected returns

Accepted Answer

The Security Market Line (SML) represents the relationship between beta and expected returns. Beta measures an asset's volatility in relation to the overall market, and expected returns are the amount of return an investor can expect to receive given the level of risk they take on by investing in that asset. Therefore, the correct answer is D) Beta and expected returns.

Question 2

Which one of the following statements does Arnold consider to be controversial?
A) Shareholders demand a higher return for riskier assets.
B) Systematic risk is measured by beta.
C) Risk- averters are wise to diversify.
D) Investors will not be rewarded for bearing unsystematic risk.

Accepted Answer

B

Question 3

What return would you expect if the risk- free rate of return was 5 per cent, the beta risk is 1.5, and the historical risk premium has been 6 per cent? (Base you calculation on the capital asset pricing model.)
A) 14%
B) 13.5%
C) 11%
D) 16.5%

Accepted Answer

According to the capital asset pricing model, the expected return on an asset equals the risk-free rate plus the product of the market risk premium (historical risk premium) and the asset's beta. Using the given values: Expected return = 5% + (1.5 x 6%) = 14%. Therefore, the answer is A) 14%.

Question 4

The cost of ordinary equity may be estimated by using the
A) discounted payback method.
B) capital asset pricing model.
C) internal rate of return.
D) yield curve.

Accepted Answer

The capital asset pricing model (CAPM) is a widely used method for estimating the cost of equity. It takes into account the risk-free rate, market risk premium, and a company's beta (systematic risk) to calculate the required return investors need for holding the company's stock. The other options listed are not commonly used for estimating the cost of equity.

Question 5

An increase in the beta of a firm indicates , and, all else being the same, results in .
A) an increase in risk; a higher required rate of return and hence a lower share price.
B) a decrease in risk; a higher required rate of return and hence a lower share price.
C) a decrease in risk; a lower required rate of return and hence a higher share price.
D) an increase in risk; a lower required rate of return and hence a higher share price.

Accepted Answer

An increase in beta indicates higher systematic risk or market risk. This means that the stock's return is more sensitive to the overall stock market's fluctuations. As a result, investors demand a higher rate of return to compensate for the increased risk, leading to a lower share price. Therefore, choice A is the best answer.

Question 6

What is the basic predication of the CAPM?
A) Investment risk increases with asset value.
B) The average return on a financial asset decreases with risk.
C) The average return on a financial asset increases with risk.
D) Investment risk decreases with asset value.

Accepted Answer

The basic predication of the CAPM (Capital Asset Pricing Model) is that the average return on a financial asset (such as a stock or bond) increases with the level of risk assumed by the investor. This means that investors expect to be compensated for taking on more risk, and that the return they receive should be commensurate with the degree of risk they are willing to accept.

Question 7

In the capital asset pricing model, the general risk preferences of investors in the marketplace are reflected by
A) the risk- free rate.
B) the difference between the security market line and the risk- free rate.
C) the level of the security market line.
D) the slope of the security market line.

Accepted Answer

In the capital asset pricing model, the slope of the security market line represents the general risk preferences of investors in the marketplace. This slope, also known as beta, measures the sensitivity of a security's return to the overall market return. Higher beta securities are considered riskier and thus have a higher required rate of return. Therefore, the slope of the security market line reflects the market's overall risk preferences.

Question 8

Asset Y has a beta of 1.2. The risk- free rate of return is 6%, while the return on the market portfolio of assets is 12%. The asset's market risk premium is
A) 10 %
B) 6.0%
C) 7.2%
D) 13.2%

Accepted Answer

The answer of Asset Y has a beta of 1.2....

Question 9

For a particular share, a 1 per cent change in the market index generally leads to a return of less than 1 per cent on the company's share. What can be concluded about the value of beta (fi)?
A) fi > 1
B) fi = - 1
C) fi < 1
D) fi = 1

Accepted Answer

Beta (fi) measures a stock's volatility in relation to the overall market. A beta of 1 indicates that the stock's price will move with the market, while a beta less than 1 means that the stock is less volatile than the market. In this case, since a 1% change in the market index leads to a return of less than 1% on the company's share, it means that the company's share is less volatile than the market. Therefore, the value of beta (fi) must be less than 1, which is option C.

Question 10

Which two of the statements accurately relate to unsystematic risk?
A) Unsystematic risk can be accurately measured using beta.
B) Unsystematic risk highlights risks common to all firms.
C) An efficient market will not reward unsystematic risk.
D) Unsystematic risk can be eliminated by diversification.

Accepted Answer

Unsystematic risk is specific to a company or industry and can be eliminated through diversification. It is not rewarded in an efficient market because it can be diversified away. Beta measures systematic risk, not unsystematic risk.

Question 11

Asset P has a beta of 0.9. The risk- free rate of return is 8%, while the return on the market portfolio of assets is 14%. The asset's required rate of return is
A) 13.4%
B) 5.4%
C) 10%
D) 6%

Accepted Answer

The Capital Asset Pricing Model (CAPM) formula is: 
Required Rate of Return = Risk-Free Rate + Beta of Asset x (Market Return - Risk-Free Rate)

Plugging in the numbers given:
Required Rate of Return = 8% + 0.9 x (14% - 8%)
Required Rate of Return = 8% + 0.9 x 6%
Required Rate of Return = 8% + 5.4%
Required Rate of Return = 13.4%

Therefore, the answer is choice letter A.

Question 12

Shares in a company are perfectly correlated with the market return. The risk free rate of return is 5 per cent and the risk premium is 6 per cent. What is the expected return?
A) 30%
B) 11%
C) 1%
D) 1.2%

Accepted Answer

To calculate the expected return, we use the formula: 
Expected Return = Risk Free Rate + Beta * Market Risk Premium

Since the shares are perfectly correlated with the market, the beta will be 1.

Expected Return = 5% + 1 * 6% 
Expected Return = 11%

Therefore, the answer is B) 11%.

Question 13

Using the capital asset pricing model, the cost of ordinary stock equity is the return required by investors as compensation for
A) the specific risk of the firm.
B) price volatility of the stock.
C) the firm's diversifiable risk.
D) the firm's nondiversifiable risk.

Accepted Answer

The capital asset pricing model takes into consideration the nondiversifiable risk of the firm, also known as systematic risk, which is the risk that cannot be eliminated through diversification. The cost of ordinary stock equity is the return required by investors for taking on this type of risk. Therefore, the best choice is D - the firm's nondiversifiable risk.

Question 14

If the beta of a specific share is 1, what is the likely result of a 2 per cent increase in the market index return?
A) A 2 per cent increase in the return on the share
B) A 0.5 per cent decrease in the return on the share
C) A 2 per cent decrease in the return on the share
D) A 0.5 per cent increase in the return on the share

Accepted Answer

A beta of 1 indicates that the share's returns move in line with the market index. Therefore, if the market index return increases by 2%, it is likely that the return on the share will also increase by 2%.

Question 15

Which two of the following highlight technical problems with the CAPM?
A) The market portfolio is unobservable.
B) It is a one- period model estimated at one point in time.
C) It can be used to assess levels of risk.

Accepted Answer

A technical problem with the CAPM is that the market portfolio is unobservable. While the model assumes that all investors hold a diversified portfolio that includes all assets in the market, in reality, there is no single market portfolio that is observable. This makes it difficult to test and apply the model. 
Another technical problem is that the CAPM is a one-period model estimated at one point in time. This means that the model assumes that investors only care about returns and risks over a single period, which may not reflect real-world behavior. Additionally, the model relies on historical data to estimate parameters, which may not be reliable in predicting future returns and risks.

Question 16

Which of the following gives the best definition of the CAPM approach?
A) Unsystematic risk, as measured by beta, is the only factor affecting the level of return required on a share for a completely diversified investor.
B) Systematic risk, as measured by beta, is the only factor affecting the level of return required on a share for a completely diversified investor.
C) Unsystematic risk, as measured by beta, is one of the key factors affecting the level of return required on a share for a completely diversified investor.
D) Systematic risk, as measured by beta, is one of the key factors affecting the level of return required on a share for a completely diversified investor.

Accepted Answer

The CAPM approach states that the only factor affecting the level of return required on a share for a completely diversified investor is systematic risk, which is measured by beta. Unsystematic risk is considered diversifiable and therefore does not affect the required return on the share.

Question 17

Which three of the following are common applications of the CAPM?
A) Assessing the required rate of return on a firm's projects
B) Portfolio selection
C) Identifying incorrect ex ante assumptions in a firm's accession policy
D) Identifying mispriced shares

Accepted Answer

The CAPM is commonly used to assess the required rate of return on a firm's projects, aid in portfolio selection, and identify mispriced shares. It is not typically used to identify incorrect ex ante assumptions in a firm's accession policy.

Question 18

In the formula E(ri) = rf + fi E(rm - rf), what does the term E(rm - rf) represent?
A) The change in share value
B) The average risk premium for shares
C) The risk free rate
D) The increase in share value

Accepted Answer

E(rm - rf) represents the average risk premium for shares. It is the excess return that investors expect to receive for holding a risky asset like shares, over and above the risk-free rate.

Question 19

A firm has a beta of 1.2. The market return equals 14% and the risk- free rate of return equals 6 %. The estimated cost of ordinary equity is
A) 6%
B) 15.6%
C) 14%
D) 7.2%

Accepted Answer

Using the Capital Asset Pricing Model (CAPM):
Cost of Equity = Risk-free rate + Beta * (Market return - Risk-free rate)
Cost of Equity = 6% + 1.2 * (14% - 6%)
Cost of Equity = 6% + 1.2 * 8%
Cost of Equity = 6% + 9.6%
Cost of Equity = 15.6%

Therefore, the estimated cost of ordinary equity is 15.6%, which is option B.

Question 20

What is represented by the symbol rf in the formula ri = rf + fi (rm - rf) ?
A) Risk free rate of return
B) Market rate of return
C) Free market rate of return
D) Fundamental rate of return

Accepted Answer

The symbol rf represents the risk free rate of return in the formula.

Quiz 8: The Capital Asset Pricing Model and Multi-Factor Models

What are the two variables whose relationship is represented by the Security Market Line?

Which one of the following statements does Arnold consider to be controversial?

What return would you expect if the risk- free rate of return was 5 per cent, the beta risk is 1.5, and the historical risk premium has been 6 per cent? (Base you calculation on the capital asset pricing model.)

The cost of ordinary equity may be estimated by using the

An increase in the beta of a firm indicates , and, all else being the same, results in .

What is the basic predication of the CAPM?

In the capital asset pricing model, the general risk preferences of investors in the marketplace are reflected by

Asset Y has a beta of 1.2. The risk- free rate of return is 6%, while the return on the market portfolio of assets is 12%. The asset's market risk premium is

For a particular share, a 1 per cent change in the market index generally leads to a return of less than 1 per cent on the company's share. What can be concluded about the value of beta (fi) ?

Which two of the statements accurately relate to unsystematic risk?

Asset P has a beta of 0.9. The risk- free rate of return is 8%, while the return on the market portfolio of assets is 14%. The asset's required rate of return is

Shares in a company are perfectly correlated with the market return. The risk free rate of return is 5 per cent and the risk premium is 6 per cent. What is the expected return?

Using the capital asset pricing model, the cost of ordinary stock equity is the return required by investors as compensation for

If the beta of a specific share is 1, what is the likely result of a 2 per cent increase in the market index return?

Which two of the following highlight technical problems with the CAPM?

Which of the following gives the best definition of the CAPM approach?

Which three of the following are common applications of the CAPM?

In the formula E(ri) = rf + fi E(rm - rf) , what does the term E(rm - rf) represent?

A firm has a beta of 1.2. The market return equals 14% and the risk- free rate of return equals 6 %. The estimated cost of ordinary equity is

What is represented by the symbol rf in the formula ri = rf + fi (rm - rf) ?