Question 1

Assume that the risk-free rate, r_RF, increases but the market risk premium, (r_M − r_RF), declines, with the net effect being that the overall required return on the market, r_M, remains constant. Which of the following statements is CORRECT? A) The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. B) Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. C) The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. D) The required return of all stocks will fall by the amount of the decline in the market risk premium. E) The required return of all stocks will increase by the amount of the increase in the risk-free rate.

Accepted Answer

When the risk-free rate increases, the required return on each stock increases because investors will demand higher returns to compensate for the increased risk. However, if the market risk premium (the return investors expect to earn over the risk-free rate) declines by the same amount, the net effect is that the overall required return on the market remains constant. Stocks with a beta less than 1.0 are less sensitive to market movements and therefore less risky, so their required return will increase by a smaller amount than the increase in the risk-free rate - therefore, their overall required return will decline. Conversely, stocks with a beta greater than 1.0 are more sensitive to market movements and therefore more risky, so their required return will increase by a larger amount than the increase in the risk-free rate - therefore, their overall required return will increase. Choice A and E are incorrect because the impact on stocks with different betas will be opposite of what these choices suggest. Choice B is incorrect because the required return on each individual stock will be different depending on the stock's beta. Choice D is incorrect because the decline in the market risk premium is not the only factor affecting each stock's required return.

Question 2

For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then
A) the past realized return must be equal to the expected return during the same period.
B) the required return must equal the realized return in all periods.
C) the expected return must be equal to both the required future return and the past realized return.
D) the expected future returns must be equal to the required return.
E) the expected future return must be less than the most recent past realized return.

Accepted Answer

For a stock to be in equilibrium, the expected future returns must equal the required return. This balance ensures that the demand for the stock is equal to its supply, preventing long-term pressure on its price to change.

Question 3

Bloome Co.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?
A) 7.72%
B) 8.12%
C) 8.55%
D) 9.00%
E) 9.50%

Accepted Answer

The answer of Bloome Co.'s stock has a 25% chance...

Question 4

Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? A) The required rate of return will decline for stocks whose betas are less than 1.0. B) The required rate of return on the market, r_M, will not change as a result of these changes. C) The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk D) The required rate of return on a riskless bond will decline. E) The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.

Accepted Answer

An increase in market risk premium will lead to an increase in required rate of return for each individual stock in the market. As a result, the required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. Choice A is incorrect because lower beta stocks are considered less risky and their required rate of return would not decline in a risk-averse market. Choice B is incorrect because an increase in market risk premium would result in a higher required rate of return for the market as a whole. Choice D is incorrect because the risk-free rate has not changed, so the required rate of return on a riskless bond would not decline.

Question 5

You observe the following information regarding Companies X and Y: Given this information, which of the following statements is CORRECT?

A) Company X has a lower coefficient of variation than Company Y.
B) Company X has less market risk than Company Y.
C) Company X's returns will be negative when Y's returns are positive.
D) Company X's stock is a better buy than Company Y's stock.
E) Company X has more diversifiable risk than Company Y.

Accepted Answer

The answer of You observe the following information regarding Companies...

Question 6

How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse?
A) The x-axis intercept would decline, and the slope would increase.
B) The y-axis intercept would increase, and the slope would decline.
C) The SML would be affected only if betas changed.
D) Both the y-axis intercept and the slope would increase, leading to higher required returns.
E) The y-axis intercept would decline, and the slope would increase.

Accepted Answer

The Security Market Line (SML) represents the relationship between expected returns and systematic risk (beta) for assets. A decrease in expected inflation rate would lead to a decrease in the overall required return, which would shift the SML downward. Additionally, if investors become more risk averse, they would demand a higher return for taking on risk, which would lead to an increase in the slope of the SML. Therefore, both the y-axis intercept and the slope would move in opposite directions, resulting in a decline in the y-axis intercept and an increase in the slope of the SML.

Question 7

For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels,
A) The past realized rate of return must be equal to the expected future rate of return; that is, .

B) The required rate of return must equal the past realized rate of return; that is, r = .

C) The expected rate of return must be equal to the required rate of return; that is, = r.

D) All of the above statements must hold for equilibrium to exist; that is = r = .
 
E) None of the above statements is correct.

Accepted Answer

Equilibrium in markets occurs when the expected rate of return is equal to the required rate of return (r). Therefore, statement C is correct. Statements A and B are incorrect because they refer to past realized rate of return, which is not necessarily relevant to the current market equilibrium. Statement D is partially correct but does not add any new insight beyond statement C. Statement E is incorrect as at least one of the statements is correct.

Question 8

Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta?
A) 0.65
B) 0.72
C) 0.80
D) 0.89
E) 0.98

Accepted Answer

The portfolio's beta is calculated as a weighted average of the betas of the individual stocks, based on the proportion of the total investment in each stock. Here, $35,000 is invested in Stock X with a beta of 1.50, and the remainder ($100,000 - $35,000 = $65,000) is invested in Stock Y with a beta of 0.70. The portfolio's beta is thus (35,000/100,000)*1.50 + (65,000/100,000)*0.70 = 0.525 + 0.455 = 0.98.

Question 9

Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P has 50% invested in Stock A and 50% invested in B. Which of the following statements is CORRECT?
A) Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium.
B) Portfolio P has more market risk than Stock A but less market risk than B.
C) Stock A should have a higher expected return than Stock B as viewed by the marginal investor.
D) Portfolio P has a coefficient of variation equal to 2.5.
E) Portfolio P has a standard deviation of 25% and a beta of 1.0.

Accepted Answer

Portfolio P has a beta of (0.8 + 1.2)/2 = 1.0, which is the same as the overall market beta. However, since the portfolio is equally weighted between the two stocks, it will have more market risk than Stock A (beta of 0.8) and less market risk than Stock B (beta of 1.2). Therefore, statement B is correct.

We cannot determine if the two stocks are in equilibrium based on the given information, so statement A is incorrect.

We also cannot determine which stock should have a higher expected return based on the given information, so statement C is incorrect.

The coefficient of variation is the standard deviation of returns divided by the expected return, so we cannot compute it without knowing the expected return for the portfolio. Therefore, statement D is incorrect.

Lastly, statement E is incorrect because the formula for the standard deviation of a portfolio is: 
Portfolio SD = [(wA^2 x SDA^2) + (wB^2 x SDB^2) + 2(wA x wB x rAB x SDA x SDB)^0.5] 
Plugging in the values, we get: 
Portfolio SD = [(0.5^2 x 0.25^2) + (0.5^2 x 0.25^2) + 2(0.5 x 0.5 x 0.6 x 0.25 x 0.25)^0.5] 
Portfolio SD = 0.279 or 27.9%, which is different from the given answer of 25%.

Question 10

Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT?
A) The required return on the market is 10%.
B) The portfolio's required return is less than 11%.
C) If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 2%.
D) If the market risk premium remains unchanged but expected inflation increases by 2%, Gretta's portfolio's required return will increase by more than 2%.
E) If the stock market is efficient, Gretta's portfolio's expected return should equal the expected return on the market, which is 11%.

Accepted Answer

The answer of Gretta's portfolio consists of $700,000 invested in...

Question 11

Which of the following statements is CORRECT?
A) The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
B) If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations.
C) If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.
D) An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.
E) A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.

Accepted Answer

The correct statement is D because the Security Market Line (SML) reflects the relationship between the expected return and the beta of securities. An increase in expected inflation would shift the SML upward uniformly, affecting both riskless assets and average stocks similarly if the real risk-free rate and the market risk premium remain constant.

Question 12

Which of the following statements is CORRECT? A) The slope of the Security Market Line is beta. B) Any stock with a negative beta must in theory have a negative required rate of return, provided r_RF is positive. C) If a stock's beta doubles, its required rate of return must also double. D) If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. E) If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.

Accepted Answer

The correct statement is D, which says that if a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. Beta measures the sensitivity of a stock's returns to the returns of the market. A negative beta indicates that the stock moves in the opposite direction of the market.

Question 13

Which of the following are the factors for the Fama-French model?
A) The excess market return, a debt factor, and a book-to-market factor.
B) The excess market return, a size factor, and a debt.
C) A debt factor, a size factor, and a book-to-market factor.
D) The excess market return, an industrial production factor, and a book-to-market factor.
E) The excess market return, a size factor, and a book-to-market factor.

Accepted Answer

The Fama-French model includes three factors: the excess market return, a size factor, and a book-to-market factor. Option E includes all three of these factors. The other options do not include the correct combination of factors.

Question 14

Which of the following statements is CORRECT?
A) Portfolio diversification reduces the variability of returns on an individual stock.
B) Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.
C) The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs.
D) A stock with a beta of −1.0 has zero market risk if held in a 1-stock portfolio.
E) When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.

Accepted Answer

The SML (Security Market Line) indeed relates a stock's required return to its market risk. While the slope (which represents the market risk premium) and intercept (risk-free rate) of the SML are determined by the market and cannot be directly controlled by a firm's managers, managers can influence their firm's position on the SML through decisions that affect the firm's risk and return characteristics, such as changes in capital structure or investment in different types of assets.

Question 15

Portfolio AB was created by investing in a combination of Stocks A and B. Stock A has a beta of 1.2 and a standard deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is CORRECT?
A) Stock A has more market risk than Stock B but less stand-alone risk.
B) Portfolio AB has more money invested in Stock A than in Stock B.
C) Portfolio AB has the same amount of money invested in each of the two stocks.
D) Portfolio AB has more money invested in Stock B than in Stock A.
E) Stock A has more market risk than Portfolio AB.

Accepted Answer

The answer of Portfolio AB was created by investing in...

Question 16

Suppose that Federal Reserve actions have caused an increase in the risk-free rate, r_RF. Meanwhile, investors are afraid of a recession, so the market risk premium, (r_M − r_RF), has increased. Under these conditions, with other things held constant, which of the following statements is most correct? A) The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0. B) Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices. C) The prices of all stocks would decline, but the decline would be greatest for high-beta stocks. D) The prices of all stocks would increase, but the increase would be greatest for high-beta stocks. E) The required return on all stocks would increase by the same amount.

Accepted Answer

An increase in the risk-free rate and the market risk premium would increase the required return on all stocks (due to the Capital Asset Pricing Model, CAPM, formula: required return = risk-free rate + beta * (market risk premium)). High-beta stocks are more sensitive to market changes, so their prices would decline more as their required returns increase more significantly.

Question 17

Which of the following statements is CORRECT? A) If investors become more risk averse but r_RF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change. B) An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. C) There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. D) Assume that the required rate of return on the market, r_M, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for r_RF. E) If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds.

Accepted Answer

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

Question 18

Shirley Paul's 2-stock portfolio has a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is her portfolio's beta?
A) 1.17
B) 1.23
C) 1.29
D) 1.35
E) 1.42

Accepted Answer

To find the portfolio's beta, we need to weight the betas of each stock by their respective values in the portfolio:

Beta of Stock A = 0.75
Beta of Stock B = 1.42
Value of Stock A = $37,500 / $100,000 = 0.375
Value of Stock B = $62,500 / $100,000 = 0.625

Portfolio beta = (0.375 x 0.75) + (0.625 x 1.42) = 1.17

Question 19

Assume that the market is in equilibrium and that Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13% and a standard deviation of 30%. The risk-free rate is 5% and the market risk premium, r_M − r_RF, is 6%. The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the following statements is CORRECT? A) Since the two stocks have zero correlation, Portfolio AB is riskless. B) Stock B's beta is 1.0000. C) Portfolio AB's required return is 11%. D) Portfolio AB's standard deviation is 25%. E) Stock A's beta is 0.8333.

Accepted Answer

The answer of Assume that the market is in equilibrium...

Question 20

Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return?
A) 9.41%
B) 9.65%
C) 9.90%
D) 10.15%
E) 10.40%

Accepted Answer

The answer of Freedman Flowers' stock has a 50% chance...

Quiz 6: Risk, Return, and the Capital Asset Pricing Model

Assume that the risk-free rate, r_RF, increases but the market risk premium, (r_M − r_RF) , declines, with the net effect being that the overall required return on the market, r_M, remains constant. Which of the following statements is CORRECT?

For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then

Bloome Co.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?

Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?

You observe the following information regarding Companies X and Y: Given this information, which of the following statements is CORRECT?

How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse?

For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels,

Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta?

Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following are the factors for the Fama-French model?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Shirley Paul's 2-stock portfolio has a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is her portfolio's beta?

Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return?

Quiz 6: Risk, Return, and the Capital Asset Pricing Model

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF) , declines, with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT?

For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then

Bloome Co.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?

Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?

You observe the following information regarding Companies X and Y: Given this information, which of the following statements is CORRECT?

How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse?

For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels,

Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta?

Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following are the factors for the Fama-French model?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Shirley Paul's 2-stock portfolio has a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is her portfolio's beta?

Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return?

Assume that the risk-free rate, r_RF, increases but the market risk premium, (r_M − r_RF) , declines, with the net effect being that the overall required return on the market, r_M, remains constant. Which of the following statements is CORRECT?