Question 1

What return should be expected from investing in the market portfolio that is expected to yield 18% if the investment includes all of the investor's funds plus 30% of additional funds borrowed at the risk-free rate of 6%?

Accepted Answer

This question requires us to calculate the expected return of a portfolio that includes all of the investor's funds and 30% of additional funds borrowed at the risk-free rate of 6%. To calculate the expected return of the portfolio, we need to use the following formula:

Expected return = (Weight of investment in market portfolio x expected return of market portfolio) + (Weight of investment in risk-free asset x risk-free rate)

In this case, the weight of investment in the market portfolio is 100%, since all of the investor's funds are invested in the market portfolio. The weight of investment in the risk-free asset is 30%, since the investor has borrowed 30% of additional funds at the risk-free rate of 6%.

Using the formula, we get:

Expected return = (1 x 18%) + (0.3 x 6%) = 19.8%

Therefore, the expected return from investing in the market portfolio is 19.8%. The closest answer choice is C, which is 21.6%. This is off by 1.8%, which could be due to rounding.

Question 2

Given the CAPM's noted empirical difficulties,which of the following statements may be correct concerning a low price-earnings ratio stock?

Accepted Answer

A low price-earnings ratio stock may plot above the security market line, indicating it is undervalued and offers a higher expected return for its level of systematic risk.

Question 3

What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is expected to yield 14% and Treasury bills offer 6%?

Accepted Answer

E(R) = 6% + 0.8(14% − 6) = 12.4%

Question 4

The slope of the security market line equals:

Accepted Answer

The answer of The slope of the security market line...

Question 5

What would you recommend to an investor who is considering an investment that,according to its beta,plots below the security market line (SML)?

Accepted Answer

A stock plotting below the SML indicates that it offers a lower return for its level of systematic risk compared to the market, suggesting that the risk is high relative to the return.

Question 6

Why do stock market investors appear not to be concerned with unique risks when calculating expected rates of return?

Accepted Answer

Stock market investors use diversification to manage risks. Unique risks relate to specific stocks and can be diversified away by investing in a wider range of stocks or investing in index funds. Thus, investors assume that unique risks are diversified away and do not consider them when calculating expected rates of return.

Question 7

What happens to expected portfolio return if the portfolio beta increases from 1.0 to 1.5,the risk-free rate decreases from 5 to 4%,and the market risk premium increases from 8 to 9%?

Accepted Answer

The expected portfolio return can be calculated using the Capital Asset Pricing Model (CAPM):
Expected portfolio return = Risk-free rate + Beta*(Market risk premium)

Using the given information, we can calculate the new expected portfolio return:

New beta = 1.5
New risk-free rate = 4%
New market risk premium = 9%

Expected portfolio return = 4% + 1.5*(9%) = 17.5%

Therefore, the expected portfolio return increases from 13 to 17.5%, which is option B.

Question 8

What return should be expected from investing in the market portfolio that is expected to yield 18% if the investment includes all of the investor's funds plus 100% of additional funds borrowed at the risk-free rate of 6%?

Accepted Answer

β_Portfolio = (2 × β_market) + (-1 × β_loan) = (2 × 1) + 0 = 2Expected return = 6% + 2(18% - 6) = 30%

Question 9

Which of the following statements is more likely to be correct concerning the statement,"Stock A has a higher expected return than stock B"?

Accepted Answer

The statement indicates that Stock A has a higher expected return than Stock B which means that Stock A is expected to provide a higher return per unit of risk. The beta of a stock measures its sensitivity to market movements and is a measure of the systematic risk of the stock. Stock A having a higher expected return than Stock B implies that Stock A has a higher beta, and therefore, a higher systematic risk. This makes option D the most likely correct choice. The other options have no direct relation to the statement about the expected returns of the stocks.

Question 10

What is the beta of a portfolio with an expected return of 12% if Treasury bills yield 6% and the market risk premium is 8%?

Accepted Answer

The formula to calculate the beta is:
Beta = (Portfolio's expected return - Risk-free rate) / Market risk premium
Substituting the given values:
Beta = (12% - 6%) / 8% = 0.75
Therefore, the beta of the portfolio is 0.75. Option B is the correct choice.

Question 11

An investor was expecting an 18% return on her portfolio with beta of 1.25 before the market risk premium decreased from 8 to 6%.Based on this change,what return will now be expected on the portfolio?

Accepted Answer

The new expected return on the portfolio can be calculated using the Capital Asset Pricing Model (CAPM) formula:

Expected return = risk-free rate + beta x (market risk premium)

Before the change in market risk premium, the expected return was:

18% = risk-free rate + 1.25 x (8%)

Solving for the risk-free rate, we get:

risk-free rate = 18% - 1.25 x (8%) = 8%

After the change in market risk premium, the expected return can be calculated as:

Expected return = 8% + 1.25 x (6%) = 15.5%

Therefore, the answer is A) 15.5%.

Question 12

What return would be expected by an investor whose portfolio was 25% market portfolio and 75% Treasury bills if the risk-free rate was 7% and the market risk premium was 8%?

Accepted Answer

The answer of What return would be expected by an...

Question 13

A stock's risk premium is equal to the:

Accepted Answer

The risk premium of a stock is calculated as the expected market risk premium (the difference between the expected market return and the risk-free rate) times the stock's beta, which measures its sensitivity to market movements.

Question 14

Investing borrowed funds in a stock portfolio will:

Accepted Answer

Investing borrowed funds will increase the amount of leverage used in the portfolio, which will increase the portfolio's beta. Beta measures the volatility of an individual stock or portfolio relative to the overall market, so a higher beta indicates greater volatility and risk. Therefore, choice A is the correct answer.

Question 15

An investor was expecting an 18% return on his portfolio with beta of 1.25 before the market risk premium increased from 8 to 10%.Based on this change,what return will now be expected on the portfolio?

Accepted Answer

The answer of An investor was expecting an 18% return...

Question 16

What will happen to a stock that offers a lower risk premium than predicted by the CAPM?

Accepted Answer

If a stock offers a lower risk premium than predicted by the CAPM, it is considered overvalued. As a result, its price will decrease until the yield (expected return) aligns with the CAPM prediction.

Question 17

Investment projects that plot above the security market line would be considered to have:

Accepted Answer

Investment projects that plot above the security market line are considered to have a higher expected return than the market. As such, they are deemed attractive investments with positive net present values.

Question 18

Decreases in the risk-free rate will reduce:

Accepted Answer

Decreases in the risk-free rate will reduce the stock's expected return since the risk-free rate is used as a baseline in determining the expected return on any investment. The stock's risk premium, beta, and the market risk premium are not directly affected by changes in the risk-free rate.

Question 19

If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7,then the portfolio beta is:

Accepted Answer

The formula to calculate the portfolio beta is the weighted average of individual stock betas, where the weights are the proportion of investment in each stock. So, the portfolio beta would be (0.5*1.4) + (0.5*0.7) = 1.05

Question 20

What rate of return should an investor expect for a stock that has a beta of 1.25 when the market is expected to yield 14% and Treasury bills offer 6%?

Accepted Answer

The expected rate of return can be calculated using the Capital Asset Pricing Model (CAPM): Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Substituting the given values: 6% + 1.25 * (14% - 6%) = 16%.

Quiz 12: Risk,Return,and Capital Budgeting