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

If you plotted the returns of 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.

The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM.

Yonan Corporation's stock had a required return of 11.50% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Now suppose there is a shift in investor risk aversion, and the market risk premium increases by 2%. The risk-free rate and Yonan's beta remain unchanged. What is Yonan's new required return? (Hint: First calculate the beta, then find the required return.)

A stock has an expected return of 12.60%. Its beta is 1.49 and the risk-free rate is 5.00%. What is the market risk premium?

Which of the following statements is correct?

Assume that the risk-free rate is 5%. Which of the following statements is correct?

Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% A and 50% B. Which of the following statements is correct?

Assume that in recent years both expected inflation and the market risk premium (rM - rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes?

A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation.

J. Harper Inc.'s stock has a 50% chance of producing a 35% return, a 30% chance of producing a 10% return, and a 20% chance of producing a -28% return. What is Harper's expected return?

Ripken Iron Works believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock?

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 was created by investing in a combination of Stocks A and B. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is correct?

The distributions of rates of return for Companies AA and BB are given below: We can conclude from the above information that any rational risk-averse investor will add Security AA to a well-diversified portfolio over Security BB.

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?

Currently, the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is correct?

Which of the following statements is correct?

A mutual fund manager has a $20 million portfolio with a beta of 1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. The manager expects to receive an additional $25.50 million, which she plans to invest in additional stocks. After investing the additional funds, she wants the fund's required and expected return to be 13.00%. What must the average beta of the new stocks be to achieve the target required rate of return?

A stock's beta measures its diversifiable (or company-specific) risk relative to the diversifiable risks of other firms.

Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky.