Exam 7: Risk, Return, and the Capital Asset Pricing Model

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.

Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your two-stock portfolio?

As investors become risk averse, the market risk premium and SML becomes .

Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of three average stocks?

Behavioural finance mixing finance with psychology tries to explain the occurrence and persistence of securities mispricing.

A completely diversified portfolio will have a correlation with the market portfolio that is which of the following?

Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is correct?

Risk aversion is a general dislike for risk, and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less-risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold lower-risk (and therefore lower-expected-return) securities than investors who have more tolerance for risk.

An individual stock's diversifiable risk, which is measured by the stock's beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

You observe the following information regarding Companies X and Y: - Company X has a higher expected return than Company Y. - Company X has a lower standard deviation of returns than Company Y. - Company X has a higher beta than Company Y. Given this information, which of the following statements is correct?

Which of the following statements is correct?

Over the past 75 years, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from HIGHEST TO LOWEST risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last?

Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equalling expected returns. Which of the following statements is correct?

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements MUST be true, according to the CAPM?

Which of the following statements is correct?

Returns for the Shields Company over the last three years are shown below. What's the standard deviation of Shields' returns? (Hint: This is a sample, not a complete population, so the sample standard deviation formula should be used.)

If an incorrect proxy market portfolio is used when developing the security market line, the slope of the line (i.e., beta) will tend to be overestimated.

Which of the following statements is correct?

Suppose you have an asset with a return that rises as GDP increases. If the government announces that GDP is unexpectedly higher than was previously thought, how will the asset's return be affected by the announcement?

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.