Question 1

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk.

Accepted Answer

The statement is true. The market return reflects the average expected return on stocks, which involves a certain amount of risk. As a result, investors require a risk premium over the risk-free rate to compensate for their exposure to risk.

Question 2

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?
A) If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.
B) Stock Y's realized return during the coming year will be higher than Stock X's return.
C) If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
D) Stock Y's return has a higher standard deviation than Stock X.
E) If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y.

Accepted Answer

According to the CAPM, the expected return on a stock is equal to the risk-free rate plus a premium for bearing systematic (market) risk, which is measured by beta. This implies that the required return for a stock increases in proportion to its beta. Therefore, higher-beta stocks should have higher expected returns than lower-beta stocks. Statements A, B, D, and E are not necessarily true according to the CAPM.

Question 3

If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM − rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.

Accepted Answer

The statement correctly describes the relationship between inflation, interest rates, market risk premium, and required rate of return as measured by CAPM.

Question 4

Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?
A) The fact that a security or project may not have a past history that can be used as the basis for calculating beta.
B) Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta.
C) The beta of an "average stock," or "the market," can change over time, sometimes drastically.
D) Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
E) All of the statements above are true.

Accepted Answer

The answer of Which of the following is NOT a...

Question 5

Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?
A) Variance; correlation coefficient.
B) Standard deviation; correlation coefficient.
C) Beta; variance.
D) Coefficient of variation; beta.
E) Beta; beta.

Accepted Answer

The answer of Which is the best measure of risk...

Question 6

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B? A) bA > 0; bB = 1. B) bA > +1; bB = 0. C) bA = 0; bB = -1. D) bA < 0; bB = 0. E) bA < -1; bB = 1.

Accepted Answer

The answer of You have the following data on (1)...

Question 7

Which of the following statements is CORRECT?
A) If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.
B) If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.
C) If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
D) Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless.
E) A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

Accepted Answer

The statement in option C is correct according to the CAPM theory. A portfolio consisting of all stocks with betas less than 1.0 would have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and such a portfolio would have less market risk than a portfolio consisting of all stocks in the market. Option A is incorrect because adding more stocks to a portfolio can diversify unsystematic risk, but not eliminate market risk. Option B is incorrect because investing an equal amount of money in every stock in the market is not the least risky possible portfolio, and it does not minimize the riskiness of the portfolio as measured by its beta. Option D is incorrect because Treasury bonds do not eliminate market risk, and a portfolio with only Treasury bonds would still have interest rate risk. Option E is incorrect because a portfolio consisting of all stocks in the market has a higher risk and a higher expected return than the riskless rate.

Question 8

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate.

Accepted Answer

The Y-axis intercept of the SML represents the required return of a portfolio with zero systematic risk or beta, which is the risk-free rate.

Question 9

If you plotted the returns of a company against those of the market and found that the slope of your 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 that the observed relationship is expected to continue in the future.

Accepted Answer

The answer of If you plotted the returns of a...

Question 10

Which of the following statements is CORRECT?
A) If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0.
B) Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities.
C) The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically.
D) If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm.
E) During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.

Accepted Answer

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

Question 11

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)
A) When held in isolation, Stock A has more risk than Stock B.
B) Stock B must be a more desirable addition to a portfolio than A.
C) Stock A must be a more desirable addition to a portfolio than B.
D) The expected return on Stock A should be greater than that on B.
E) The expected return on Stock B should be greater than that on A.

Accepted Answer

In market equilibrium, a higher beta indicates higher systematic risk, and thus Stock A, with a beta of 1.5, should have a higher expected return than Stock B, with a beta of 0.5, according to the Capital Asset Pricing Model (CAPM).

Question 12

The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.

Accepted Answer

The Y-axis intercept of the Security Market Line (SML) represents the risk-free rate, which is the return expected from an asset with zero market risk, not the required return on an individual asset when the realized return on an average stock is zero.

Question 13

Which of the following statements is CORRECT?
A) An investor can eliminate virtually all market risk if he or she holds a large and well diversified portfolio of stocks.
B) The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
C) It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
D) Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.
E) An investor can eliminate virtually all diversifiable risk if he or she holds a large, well diversified portfolio of stocks.

Accepted Answer

Diversifiable risk, also known as unsystematic risk, can be eliminated by holding a well-diversified portfolio of stocks. This is because unsystematic risk is the risk that is specific to a particular company or industry and can be reduced through diversification. However, market risk, also known as systematic risk, cannot be diversified away and affects the entire market. Therefore, statement A and C are incorrect. The higher the correlation between stocks in a portfolio, the higher the risk inherent in the portfolio, making statement B incorrect. As for statement D, adding additional stocks to a portfolio can still provide benefits in reducing unsystematic risk, although the benefits start to decrease as the number of stocks in the portfolio gets larger.

Question 14

A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?
A) Either A or B, i.e., the investor should be indifferent between the two.
B) Stock A.
C) Stock B.
D) Neither A nor B, as neither has a return sufficient to compensate for risk.
E) Add A, since its beta must be lower.

Accepted Answer

Since the investor is highly risk-averse, it is important to consider not only expected returns but also risk (as measured by standard deviation of returns). Stock B has a lower standard deviation, meaning it is less risky than Stock A. Since both stocks have the same correlation with the market, adding Stock B to the portfolio would provide diversification benefits without adding too much additional risk. Therefore, the best choice for the investor would be to add Stock B to the portfolio.

Question 15

You have the following data on three stocks: If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.
A) A; A.
B) A; B.
C) B; A.
D) C; A.
E) C; B.

Accepted Answer

The answer of You have the following data on three...

Question 16

Which of the following statements is CORRECT?
A) Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.
B) Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
C) Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
D) You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should re-balance your portfolio to include more high-beta stocks.
E) If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline.

Accepted Answer

A negative beta means that the stock's returns have a negative correlation with the market's returns. Therefore, if the returns on the stock with a negative beta were negatively correlated with returns on most other stocks during the 5-year period, its beta would be negative. Option A is incorrect because a high beta indicates that the stock's returns are more volatile than the market returns, not that the company particularly performs well during recessions. Option C is incorrect because if the market is expected to be strong, it does not necessarily mean that high-beta stocks should be sold and low-beta stocks should be bought. Option D is incorrect because if investors become more risk averse, high-beta stocks will likely perform worse than low-beta stocks. Option E is incorrect because the required returns on high-beta stocks are positively related to the market risk premium, not the risk-free rate.

Question 17

If you plotted the returns on a given stock against those of the market, and if 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 greater than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.

Accepted Answer

If the slope of the regression line is negative, it indicates that the stock's returns are negatively correlated with the market returns. According to the CAPM, the required rate of return on the stock for a well-diversified investor would be lower than the risk-free rate in this case, which is contrary to the statement in the question.

Question 18

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.
A) Stock A would be a more desirable addition to a portfolio then Stock B.
B) In equilibrium, the expected return on Stock B will be greater than that on Stock A.
C) When held in isolation, Stock A has more risk than Stock B.
D) Stock B would be a more desirable addition to a portfolio than A.
E) In equilibrium, the expected return on Stock A will be greater than that on B.

Accepted Answer

The answer of Stock A's beta is 1.5 and Stock...

Question 19

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions.

Accepted Answer

The slope of the SML is determined by the market risk premium, which is not directly influenced by a manager's actions. The SML represents the relationship between the expected return of an investment and its beta (systematic risk), where the slope is the market risk premium and the intercept is the risk-free rate, both of which are market-determined factors.

Question 20

Which of the following statements is CORRECT?
A) The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.
B) If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio.
C) The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.
D) The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
E) It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.

Accepted Answer

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

Quiz 8: Risk and Rates of Return

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?

Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?

Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Which of the following statements is CORRECT?

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate.

Which of the following statements is CORRECT?

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.

Which of the following statements is CORRECT?

You have the following data on three stocks: If you are a strict risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.

Which of the following statements is CORRECT?

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions.

Which of the following statements is CORRECT?