Question 1

Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly risk averse and has asked for your advice. 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 matterσ
A) stock a.
B) stock b.
C) neither a nor b, as neither has a return sufficient to compensate for risk.
D) add a, since its beta must be lower.
E) either a or b, i.e., the investor should be indifferent between the two.

Accepted Answer

With only 4 stocks in the portfolio, unsystematic risk matters, and B has less.

Question 2

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 and intercept of the SML are determined by the market, generally not the actions of a single firm. However, managers can influence their firms' beta, and thus their firms' required returns.

Question 3

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 4

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, 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, as the stock is less risky than the market.

Question 5

The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Accepted Answer

The CAPM is a single-period model, and it does not take account of securities' maturities.

Question 6

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 market risk premium is the additional return that investors require for taking on the risk of investing in the stock market compared to the risk-free rate. This is because the stock market has inherent risks that affect the returns of all stocks, and investors need to be compensated for bearing that risk.

Question 7

Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct.
A) in equilibrium, the expected return on stock b will be greater than that on stock a.
B) when held in isolation, stock a has more risk than stock b.
C) stock b would be a more desirable addition to a portfolio than a.
D) in equilibrium, the expected return on stock a will be greater than that on b.
E) stock a would be a more desirable addition to a portfolio then stock b.

Accepted Answer

According to the CAPM, a higher beta indicates higher systematic risk and thus a higher expected return. Therefore, Stock A, with a beta of 1.7, should have a higher expected return than Stock B, with a beta of 0.7.

Question 8

Which of the following statements is CORRECTσ
A) 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.
B) the beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically.
C) 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.
D) 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.
E) 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.

Accepted Answer

The answer of Which of the following statements is CORRECTσ
A)...

Question 9

Consider the following average annual returns for Stocks A and B and the Market. Which of the possible answers best describes the historical betas for A and B? $\begin{array}{cc} \text { Years }&\text { Market }& \text { Stock A }& \text { Stock B } \ 1&-0.05 & 0.16&0.05 \ 2&0.01 & 0.20 &0.05 \ 3&-0.10 & 0.18&0.05 \ 4&0.06 & 0.25 &0.05 \ 5&0.06& 0.14&0.05 \end{array}$ A) b_^A> +1; b_B = 0. B) b_A = 0; b_B = -1. C) b_A < 0; b_B = 0. D) b_A< -1; b_B = 1. E) b_A > 0; b_B = 1.

Accepted Answer

First, note that B's beta must be zero, so either a or c must be correct. Second, note that A's returns are highest when the market's returns are negative and lowest when the market's returns are positive. This indicates that A's beta is negative. Thus, c must be correct.

Question 10

Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSEσ
A) 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.
B) the beta of an "average stock," or "the market," can change over time, sometimes drastically.
C) sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
D) all of the statements above are true.
E) the fact that a security or project may not have a past history that can be used as the basis for calculating beta.

Accepted Answer

The beta of an "average stock," or "the market," is generally considered to be stable over time, with a beta of 1, as it represents the overall market risk.

Question 11

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

This is true according to the capital asset pricing model (CAPM). The SML represents the relationship between risk and expected return for a given level of market risk, and the intercept represents the risk-free rate, as a portfolio with a beta of zero would have no systematic risk and therefore would simply earn the risk-free rate.

Question 12

If markets are in equilibrium, which of the following conditions will exist?
A) each stock's expected return should equal its required return as seen by the marginal investor.
B) all stocks should have the same expected return as seen by the marginal investor.
C) the expected and required returns on stocks and bonds should be equal.
D) all stocks should have the same realized return during the coming year.
E) each stock's expected return should equal its realized return as seen by the marginal investor.

Accepted Answer

Statement a is true, because if the expected return does not equal the required return, then markets are not in equilibrium.

Question 13

You are considering investing in one of the these three stocks: $\begin{array}{ccc}
\text { Stock } & \text { Standard Deviation } & \text { Beta } \
 \mathrm{A} & 20 \% & 0.59 \
\mathrm{~B} & 10 \% & 0.61 \
\mathrm{C} & 12 \% & 1.29
\end{array}$
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; b.
B) b; a.
C) c; a.
D) c; b.
E) a; a.

Accepted Answer

If held in isolation, choose Stock B for its lowest standard deviation. In a diversified portfolio, choose Stock A for its lowest beta, indicating less market risk.

Question 14

Which of the following statements is CORRECTσ
A) 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.
B) 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.
C) the beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
D) 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.
E) the beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.

Accepted Answer

The beta coefficient of a stock is indeed calculated by regressing past returns on a stock against past market returns. However, the historical beta may not necessarily be the same as the future beta. Option A is incorrect because a zero historical beta does not necessarily mean a riskless portfolio. Option C and E are incorrect because the beta of a portfolio is not always larger or smaller than the betas of individual stocks. Option D is also incorrect because a stock with a beta of 1.0 would have a required rate of return equal to the market rate of return, not the risk-free rate of return.

Question 15

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

This statement is true as per the CAPM formula, the required rate of return on each stock will increase by the same amount as the increase in expected inflation, assuming no change in investors' risk aversion and stocks' betas. The market risk premium remains constant in this scenario.

Question 16

Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A's portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0.

Accepted Answer

Both portfolios would be twice as risky as a portfolio of average stocks. Their risks would decline if they added b = 1.0 stocks, as those stocks would move the portfolios' betas toward 1.0.

Question 17

Stock X has a beta of 0.7 and Stock Y has a beta of 1.7. Which of the following statements must be true, according to the CAPMσ
A) stock y's realized return during the coming year will be higher than stock x's return.
B) 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.
C) stock y's return has a higher standard deviation than stock x.
D) 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.
E) 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.

Accepted Answer

According to the CAPM, a stock's required return is determined by the risk-free rate, the market risk premium, and the stock's beta. Therefore, if the market risk premium is unchanged, both stocks would require the same increase in required return if the expected rate of inflation increases. The other statements are not necessarily true based on the given information.

Question 18

Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true about these securitiesσ (Assume market equilibrium.)
A) stock b must be a more desirable addition to a portfolio than a.
B) stock a must be a more desirable addition to a portfolio than b.
C) the expected return on stock a should be greater than that on b.
D) the expected return on stock b should be greater than that on a.
E) when held in isolation, stock a has more risk than stock b.

Accepted Answer

The answer of Stock A's beta is 1.7 and Stock...

Question 19

Which of the following statements is CORRECT?
A) 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.
B) suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very 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.
C) 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.
D) 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.
E) paid-in-full inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. paid-in-full's revenues, profits, and stock price tend to rise during recessions. this suggests that paid-in-full 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.

Accepted Answer

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

Question 20

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.

Quiz 2: Risk and Return-Part I

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.

The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct.

Which of the following statements is CORRECTσ

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

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.

If markets are in equilibrium, which of the following conditions will exist?

Which of the following statements is CORRECTσ

Stock X has a beta of 0.7 and Stock Y has a beta of 1.7. Which of the following statements must be true, according to the CAPMσ

Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true about these securitiesσ (Assume market equilibrium.)

Which of the following statements is CORRECT?

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.