Question 1

The security market line is a graph of the expected return of a stock as a function of its beta with the market.

Accepted Answer

The security market line (SML) is indeed a graph that shows the relationship between the expected return of an individual stock and its beta with respect to the overall market return. The SML is a key tool used in modern portfolio theory to evaluate the performance of an individual stock and to determine whether it is undervalued or overvalued relative to the market.

Question 2

The market or equity risk premium can be estimated by computing the historical average excess return on the market portfolio.

Accepted Answer

The historical average excess return on the market portfolio can be used to estimate the market or equity risk premium. The market risk premium is the additional return an investor expects to earn for taking on the risk of investing in the stock market, and it is typically estimated using historical data on stock market returns.

Question 3

The systematic risk (beta)of a portfolio is ________ by holding more stocks, even if they each had the same systematic risk.

Accepted Answer

The systematic risk (beta) of a portfolio is determined by the market risk of the individual stocks and is not reduced by diversification. Holding more stocks with the same beta does not change the portfolio's overall beta.

Question 4

A portfolio comprises Coke (beta of 1.3)and Wal-Mart (beta of 0.7). The amount invested in Coke is $20,000 and in Wal-Mart is $20,000. What is the beta of the portfolio?

Accepted Answer

C) Compute portfolio weights of Coke and Wal-Mart. Multiply weight of each stock by its beta; 11ea84dc_f536_c42c_9a63_1d987c910c87_TB1316_00_TB1316_00

Question 5

Your estimate of the market risk premium is 6%. The risk-free rate of return is 4%, and General Motors has a beta of 1.6. According to the Capital Asset Pricing Model (CAPM), what is its expected return?

Accepted Answer

According to the CAPM, the expected return of GM can be calculated as follows:

Expected Return = Risk-Free Rate + (Beta x Market Risk Premium)

Expected Return = 4% + (1.6 x 6%)

Expected Return = 4% + 9.6%

Expected Return = 13.6%

Therefore, the expected return of GM according to the CAPM is 13.6%, which is closest to choice C (13.6%).

Question 6

A portfolio comprises Coke (beta of 1.6)and Wal-Mart (beta of 0.6). The amount invested in Coke is $10,000 and in Wal-Mart is $20,000. What is the beta of the portfolio?

Accepted Answer

Beta of portfolio = (amount invested in Coke / total portfolio amount) * beta of Coke + (amount invested in Wal-Mart / total portfolio amount) * beta of Wal-Mart
= (10,000 / 30,000) * 1.6 + (20,000 / 30,000) * 0.6
= 0.533 + 0.4
= 0.933
Therefore, the answer is A) 0.93.

Question 7

UPS, a delivery services company, has a beta of 1.6, and Wal-Mart has a beta of 0.9. The risk-free rate of interest is 6% and the market risk premium is 9%. What is the expected return on a portfolio with 40% of its money in UPS and the balance in Wal-Mart?

Accepted Answer

C) Compute portfolio beta by multiplying weight of each stock by its beta.
Use CAPM to compute expected return of the portfolio.
(0.4 × 1.6) + (0.6 × 0.9) = 1.18; 6% + (1.18 × 9%) = 16.62%

Question 8

Suppose you have $10,000 in cash and you decide to borrow another $10,000 at a(n)6% interest rate to invest in the stock market. You invest the entire $20,000 in an exchange-traded fund (ETF)with a 11% expected return and a 20% volatility. The expected return on your of your investment is closest to ________.

Accepted Answer

A) E[R_xp] = r_f + x(E[R_p] - r_f) = 6% + 20%(11% - 6%) = 7%

Question 9

UPS, a delivery services company, has a beta of 1.4, and Wal-Mart has a beta of 0.9. The risk-free rate of interest is 4% and the market risk premium is 6%. What is the expected return on a portfolio with 50% of its money in UPS and the balance in Wal-Mart?

Accepted Answer

A) Compute portfolio beta by multiplying weight of each stock by its beta.
Use CAPM to compute expected return of the portfolio.
(0.5 × 1.4) + (0.5 × 0.9)= 1.15; 4% + (1.15 × 6%) = 10.9%

Question 10

Historically, the average excess return of the S&P 500 over the return of U.S. Treasury bonds has been ________ and is proxy for the market risk premium.

Accepted Answer

Historically, the average excess return of the S&P 500 over the return of U.S. Treasury bonds has been between 5% and 7%. This represents the market risk premium, which is the additional return investors require to compensate for the risk of investing in the stock market versus the safety of investing in Treasury bonds. Choices A, B, and D are all outside of the historical average.

Question 11

The Capital Asset Pricing Model asserts that the expected return ________.

Accepted Answer

According to the Capital Asset Pricing Model, the expected return is equal to the risk-free rate plus a risk premium for systematic risk. This is because systematic risk, which cannot be diversified away, affects the entire market and therefore must be compensated for with a higher expected return.

Question 12

Suppose you have $10,000 in cash and you decide to borrow another $10,000 at a(n)6% interest rate to invest in the stock market. You invest the entire $20,000 in an exchange-traded fund (ETF)with a 10% expected return and a 20% volatility. Assume that the ETF you invested in returns -10%. Then the realized return on your investment is closest to ________.

Accepted Answer

The initial investment of $20,000 with the return of -10% means that the investment is now worth $18,000. Since the interest rate on the borrowed amount is 6%, the interest expense for the year is $1,200 (6% of $20,000). Therefore, the net return on the investment is -$1,200. The investor's initial investment of $10,000 is now worth $9,400 ($10,000 - $600 interest expense), and the borrowed amount of $10,000 is now worth $9,400. Therefore, the total value of the investment is $18,800. The total return on the investment is -$200, which is a loss of 2% on the initial investment of $10,000. Therefore, the realized return on the investment is -2% * 100% = -2%. Since the -10% return on the ETF is within the expected volatility range, no adjustment is made to the initial expected return of 10%. The realized return is calculated as follows:

Realized Return = (Ending Value - Beginning Value - Interest Expense) / Beginning Value
Realized Return = (-$200) / $10,000
Realized Return = -2%

Question 13

The Capital Asset Pricing Model (CAPM)says that the risk premium on a stock is equal to its beta times the market risk premium.

Accepted Answer

This is the formula for the Capital Asset Pricing Model (CAPM). It states that the expected return on an asset is equal to the risk-free rate plus a risk premium based on the asset's beta and the market risk premium.

Question 14

The expected return is usually ________ the baseline risk-free rate of return that we demand to compensate for inflation and the time value of money.

Accepted Answer

The expected return should be higher than the baseline risk-free rate of return as compensation for taking on additional risk. If the expected return was lower than the risk-free rate, there would be no incentive for investors to take on that additional risk.

Question 15

Your estimate of the market risk premium is 9%. The risk-free rate of return is 3.8% and General Motors has a beta of 1.4. According to the Capital Asset Pricing Model (CAPM), what is its expected return?

Accepted Answer

C) Using the equation for the CAPM, expected return = 3.8% + (1.4 × 9%) = 16.4%

Question 16

Which of the following statements is FALSE?

Accepted Answer

C) Graphically, when the tangent line goes through the risk-free investment (with a beta of zero) and the market (with a beta of one), it is called the security market line (SML).

Question 17

Your estimate of the market risk premium is 7%. The risk-free rate of return is 4%, and General Motors has a beta of 1.4. According to the Capital Asset Pricing Model (CAPM), what is its expected return?

Accepted Answer

According to CAPM, the expected return is equal to the sum of the risk-free rate and the product of the market risk premium and the beta. Using the given values, we have: 
Expected return = 4% + (1.4 * 7%) 
Expected return = 13.8%

Question 18

A stock market comprises 4600 shares of stock A and 1600 shares of stock B. Assume the share prices for stocks A and B are $15 and $30, respectively. If you have $15,000 to invest and you want to hold the market portfolio, how much of your money will you invest in Stock A?

Accepted Answer

B) Multiply the number of shares of each stock by its price and add the values.
Thus, (4600 × $15) + (1600 × $30) = $117,000.
Stock A is worth 4600 × $15 = $69,000;
Proportion of stock A in the market portfolio = $69,000 / $117,000 = 58.974359%;
Value of stock A in portfolio = 58.974359% × 15,000 = $8846.15

Question 19

A portfolio comprises Coke (beta of 1.4)and Wal-Mart (beta of 0.8). The amount invested in Coke is $20,000 and in Wal-Mart is $30,000. What is the beta of the portfolio?

Accepted Answer

A) Compute portfolio weights of Coke and Wal-Mart. Multiply weight of each stock by its beta; 11ea84dc_f536_9d1a_9a63_8de16dfb105c_TB1316_11_TB1316_11

Question 20

UPS, a delivery services company, has a beta of 1.1, and Wal-Mart has a beta of 0.7. The risk-free rate of interest is 4% and the market risk premium is 7%. What is the expected return on a portfolio with 30% of its money in UPS and the balance in Wal-Mart?

Accepted Answer

A) Compute portfolio beta by multiplying weight of each stock by its beta ).
Use CAPM to compute expected return of the portfolio.
(0.3 × 1.1) + (0.7 × 0.7) = 0.82; 4% + (0.82 × 7%) = 9.74%

Quiz 12: Systematic Risk and the Equity Risk Premium

The security market line is a graph of the expected return of a stock as a function of its beta with the market.

The market or equity risk premium can be estimated by computing the historical average excess return on the market portfolio.

The systematic risk (beta) of a portfolio is ________ by holding more stocks, even if they each had the same systematic risk.

A portfolio comprises Coke (beta of 1.3) and Wal-Mart (beta of 0.7) . The amount invested in Coke is $20,000 and in Wal-Mart is $20,000. What is the beta of the portfolio?

Your estimate of the market risk premium is 6%. The risk-free rate of return is 4%, and General Motors has a beta of 1.6. According to the Capital Asset Pricing Model (CAPM) , what is its expected return?

A portfolio comprises Coke (beta of 1.6) and Wal-Mart (beta of 0.6) . The amount invested in Coke is $10,000 and in Wal-Mart is $20,000. What is the beta of the portfolio?