Question 1

Don has $3,000 invested in AT&T with an expected return of 11.6 percent; $10,000 in IBM with an expected return of 12.8 percent; and $6,000 in GM with an expected return of 12.2 percent. What is Don's expected return on his portfolio?
A) 12.42%
B) 12.20%
C) 11.81%
D) Cannot be determined

Accepted Answer

To find the expected return of the portfolio, we need to calculate the weighted average of the expected returns of each investment:

[(3,000/19,000) x 11.6%] + [(10,000/19,000) x 12.8%] + [(6,000/19,000) x 12.2%] = 12.42%

Therefore, Don's expected return on his portfolio is 12.42%.

Question 2

A stock has an expected return of 10% and a variance of 25%. Its coefficient of variation is:
A) 2.5.
B) 0.4.
C) 5.0.
D) 2.0.

Accepted Answer

The coefficient of variation (CV) is calculated as the standard deviation divided by the expected return. In this case, the standard deviation (which is the square root of the variance) is the square root of 25%, or 5%. Therefore, the CV is:

CV = 5% / 10% = 0.5

To convert this into a percentage, we multiply by 100%, giving a CV of 50%. However, the answer choices express the CV as a decimal rather than a percentage. Therefore, we divide by 100 to get the final answer:

CV = 0.5 / 100 = 0.005

So, the correct answer is C) 5.0.

Question 3

The security market line can be thought of as expressing relationships between required rates of return and:
A) the time value of money.
B) beta which reflects market risk.
C) total risk.
D) portfolio diversification.

Accepted Answer

The security market line (SML) is a graphical representation of the capital asset pricing model (CAPM), which shows the relationship between required rates of return and beta, which reflects market risk. The SML is used to determine the fair return on an investment based on its level of risk, as measured by beta. The SML is not directly related to the time value of money, total risk, or portfolio diversification.

Question 4

The only component of the CAPM equation that relates specifically to a company is: A) b_X. B) k_M. C) k_RF. D) (k_M - k_RF).

Accepted Answer

The answer of The only component of the CAPM equation...

Question 5

In the CAPM the characteristic line for stock X is:
A) another name for the SML.
B) the regression line relating X's return with the market return from which X's beta is developed.
C) a line between any two data points on a historical plot of X's return against market return.
D) a line of reasoning that characterizes portfolio theory.

Accepted Answer

The characteristic line for stock X is the regression line that shows the relationship between X's return and the market return, from which X's beta is determined. It is a key component of the CAPM, which is used to calculate the expected return on an investment based on its risk (beta). The characteristic line is not another name for the SML (A), nor is it simply a line between two data points (C) or a line of reasoning in portfolio theory (D).

Question 6

The relation between the required rate of return and beta is called the:
A) security market line.
B) capital market line.
C) characteristic line.
D) systematic risk.
E) unsystematic risk.

Accepted Answer

The relation between the required rate of return and beta is called the security market line (SML). The SML represents the expected return of a security as a function of its systematic, or market, risk. The beta of a security measures the volatility, or systematic risk, of that security relative to the overall market. The SML is used to determine whether a security is undervalued or overvalued relative to its required rate of return based on its level of systematic risk.

Question 7

According to the SML, the risk premium for stock X depends on:
A) everything about Company X.
B) Company X's earnings only.
C) only X's market risk.
D) X's total risk as reflected by its beta.

Accepted Answer

DThe Security Market Line (SML) is a concept from the Capital Asset Pricing Model (CAPM) that defines the expected return of an investment as a function of its systematic risk, as measured by beta. Choices C and D are correct because the SML specifically relates a stock's risk premium to its market risk (systematic risk) and not to its total risk or specific company characteristics. Beta reflects the stock's volatility in relation to the overall market, representing the type of risk that cannot be diversified away.

Question 8

Beta measures:
A) business risk.
B) risk aversion.
C) total risk.
D) market risk.

Accepted Answer

Beta measures market risk, specifically the systematic risk associated with the overall market or a particular industry. It does not measure business risk or risk aversion, and while it is an important component of total risk, it is not a measure of total risk itself.

Question 9

The SML represents a stable stock market equilibrium in which:
A) investors are happy because their expected and required rates of return are at least equal.
B) there is not an excess of buyers or sellers and the market remains where it is.
C) a slight disequilibrium with respect to a particular stock produces market forces that tend to equalize the stock's expected and required returns through changes in its price.
D) All of the above

Accepted Answer

All of the options describe the characteristics of a stable stock market equilibrium. In option A, investors are satisfied because they are receiving their expected and required rates of return, indicating that there is no significant overvaluation or undervaluation of stocks. Option B signifies that the market is balanced and there are no excess buyers or sellers, indicating that supply and demand have appropriately balanced at the current price level. Option C highlights that any minor disequilibrium for a specific stock triggers market forces to counterbalance the stock's expected and required returns via changes in its price.

Question 10

If you invest 30% of your funds in AT&T stock with an expected rate of return of 10% and the remainder in GM stock with an expected rate of return of 15%, the expected return on your portfolio is
A) 12.5%.
B) 13.0%.
C) 13.5%.
D) 14.5%.
E) None of the above

Accepted Answer

To calculate the expected return on the portfolio, we need to use weights of the two stocks:

Weight of AT&T = 30% = 0.3
Weight of GM = 70% = 0.7

Expected return on AT&T stock = 10%
Expected return on GM stock = 15%

Expected return on portfolio:
= (Weight of AT&T x Expected return on AT&T) + (Weight of GM x Expected return on GM)
= (0.3 x 10%) + (0.7 x 15%)
= 3% + 10.5%
= 13.5%

Therefore, the answer is C) 13.5%.

Question 11

Although the CAPM is intuitively appealing in that it relates risk and return in a straightforward manner, the model's predictive value is often challenged because:
A) statistical tests have not been conclusive in validating the relationship between beta and return proposed by the CAPM.
B) the CAPM only addresses unsystematic risk, not market risk.
C) beta measures only the stock's coefficient of business-specific risk.
D) All of the above

Accepted Answer

While the CAPM has some intuitive appeal, numerous studies have failed to conclusively validate the model's relationship between beta and return. This has led to challenges to the model's predictive value. The other options listed are not entirely accurate, as the CAPM does address market risk, and beta measures all risk, not just business-specific risk.

Question 12

Betas are determined:
A) from the slope of the SML.
B) by regressing the return on the market against the return on stock X and taking the slope of the regression line.
C) by estimating the future reaction of the stock to market changes.
D) by examining portfolio returns.

Accepted Answer

Betas are determined by regressing the return on the market against the return on a specific stock and taking the slope of the regression line. This measures the degree of systematic risk of the stock relative to the market.

Question 13

The risk premium for an individual security is equal to the:
A) beta times the market return.
B) difference between the market return and the risk free rate times the security's beta.
C) weighted average of the individual security betas in a portfolio.
D) the security's variance divided by the variance of the market.

Accepted Answer

The risk premium for an individual security is the return in excess of the risk-free rate that an investor requires to compensate for the additional risk of holding that security. It is calculated as the difference between the expected return of the market and the risk-free rate, multiplied by the security's beta. Therefore, option B is the correct answer as it represents this formula.

Question 14

According to the Capital Asset Pricing Model a stock's risk premium is:
A) a price premium on low risk stocks that investors are willing to pay for safety.
B) the risk premium on an average stock factored by a measure of the stock's market risk.
C) the risk premium on an average stock factored by a measure of the stock's total risk.
D) extra money paid for high risk stocks because they usually have high returns.

Accepted Answer

The Capital Asset Pricing Model states that a stock's risk premium is determined by the stock's beta (a measure of a stock's market risk) multiplied by the risk premium on an average stock. Therefore, option B correctly states that a stock's risk premium is the risk premium on an average stock factored by a measure of the stock's market risk.

Question 15

The market risk premium is a reflection of the investment community's level of risk aversion. It is calculated by:
A) subtracting the return on the market from the risk-free rate.
B) multiplying the beta of a stock by the result of subtracting the risk-free rate from the return on the market.
C) subtracting the risk-free rate from the return on the market.
D) multiplying beta of a stock by the expected return on the market.

Accepted Answer

The market risk premium is calculated by subtracting the risk-free rate from the return on the market. This is because the risk-free rate represents the return an investor can earn without taking on any risk, while the return on the market represents the overall return of the stock market, which includes both a risk premium and the risk-free rate. The difference between the return on the market and the risk-free rate, then, represents the additional return investors require for taking on market risk.

Question 16

A classic example of a negative beta investment is the stock of a:
A) steel mill because the industry is subject to intense international competition.
B) gold mining company because it's profitability runs opposite to the state of the economy.
C) financial services company because it's in the stock business itself.
D) company in the defense industry because war is always a possibility.

Accepted Answer

A negative beta investment is one that moves in the opposite direction of the overall market. Gold mining companies typically have a negative beta because their profitability is tied to the price of gold, which tends to go up during times of economic uncertainty and market downturns. As a result, their stock prices tend to move in the opposite direction of the broader market.

Question 17

According to the Capital Asset Pricing Model, a stock's risk premium is the:
A) price premium on low risk stocks that investors buy for safety.
B) risk premium on an average stock factored by a measure of the stock's market risk.
C) risk premium on an average stock factored by a measure of the stock's total risk.
D) extra money paid for high risk stocks because of their high average returns.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), a stock's risk premium is the additional return an investor expects to receive above the risk-free rate of return, based on the stock's level of systematic risk. This is measured by the beta coefficient, which reflects the stock's sensitivity to market risk. Therefore, the risk premium on an average stock is factored by a measure of the stock's market risk, making option B the correct answer.

Question 18

Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: $\begin{array}{lll}\text { Price } & \text { Rate of Returin } & \text { Probability } \
\hline
\$ 16 & -20 \% & 0.25 \
20 & 0 \% & 0.30 \
24 & +20 \% & 0.25 \
28 & +40\%&0.20
\end{array}$ Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the expected rate of return on Phoenix Stock.
A) 8%
B) 0%
C) 10%
D) 40%

Accepted Answer

The expected rate of return is calculated by multiplying each rate of return by its probability and summing the results: (-20% * 0.25) + (0% * 0.30) + (20% * 0.25) + (40% * 0.20) = -5% + 0% + 5% + 8% = 8%.

Question 19

Stock A moves up when the portfolio moves up and down when the portfolio moves down. Stock B moves down when the portfolio moves up and up when the portfolio moves down. A and B move up and down about the same amount.
A) A and B are equally risky in a portfolio sense.
B) A is risky because it adds risk to the portfolio, B is not risky because it reduces the portfolio's risk.
C) A's risk can be diversified away.
D) A has some of the personality of B.

Accepted Answer

Stock A is risky because it moves in the same direction as the portfolio, adding to its volatility. Stock B, on the other hand, moves inversely to the portfolio, thus reducing its overall risk.

Question 20

Assume that the Security Market Line (SML) is based on a risk free rate of 5% and a market rate of 11%. What will happen to the SML if the forecast of inflation increases and investors become more risk averse?
A) The SML will shift down and have a steeper slope
B) The SML will shift up and have a less steep slope
C) The SML will shift down and have the same slope
D) The SML will shift down and have a less steep slope
E) The SML will shift up and have a steeper slope

Accepted Answer

An increase in the forecast of inflation typically leads to a higher risk-free rate, causing the SML to shift upwards because the expected return for any level of risk increases. Additionally, if investors become more risk-averse, they will demand a higher return for taking on additional risk, which steepens the slope of the SML. This reflects the increased premium for riskier investments.

Quiz 9: Risk and Return

Don has $3,000 invested in AT&T with an expected return of 11.6 percent; $10,000 in IBM with an expected return of 12.8 percent; and $6,000 in GM with an expected return of 12.2 percent. What is Don's expected return on his portfolio?

A stock has an expected return of 10% and a variance of 25%. Its coefficient of variation is:

The security market line can be thought of as expressing relationships between required rates of return and:

The only component of the CAPM equation that relates specifically to a company is:

In the CAPM the characteristic line for stock X is:

The relation between the required rate of return and beta is called the:

According to the SML, the risk premium for stock X depends on:

Beta measures:

The SML represents a stable stock market equilibrium in which:

If you invest 30% of your funds in AT&T stock with an expected rate of return of 10% and the remainder in GM stock with an expected rate of return of 15%, the expected return on your portfolio is

Although the CAPM is intuitively appealing in that it relates risk and return in a straightforward manner, the model's predictive value is often challenged because:

Betas are determined:

The risk premium for an individual security is equal to the:

According to the Capital Asset Pricing Model a stock's risk premium is:

The market risk premium is a reflection of the investment community's level of risk aversion. It is calculated by:

A classic example of a negative beta investment is the stock of a:

According to the Capital Asset Pricing Model, a stock's risk premium is the:

Stock A moves up when the portfolio moves up and down when the portfolio moves down. Stock B moves down when the portfolio moves up and up when the portfolio moves down. A and B move up and down about the same amount.

Assume that the Security Market Line (SML) is based on a risk free rate of 5% and a market rate of 11%. What will happen to the SML if the forecast of inflation increases and investors become more risk averse?