Question 1

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

Accepted Answer

A) True 
 B)False

Question 2

Diversification will normally reduce the riskiness of a portfolio of stocks.

Accepted Answer

A) True 
 B)False

Question 3

Tom O'Brien has a 2-stock portfolio with 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 his portfolio's beta?

Accepted Answer

A)  1.17 
B)  1.23 
C)  1.29 
D)  1.35 
E)  1.42 
A)  1.17 
B)  1.23 
C)  1.29 
D)  1.35 
E)  1.42

Question 4

Generally, the SML is used to find the required return, but on occasion the required return is given and we must solve for one of the other variables. We warn our students before the test that to answer a number of the questions they will have to transform the SML equation to solve for beta, the market risk premium, the risk-free rate, or the market return.
-Maxwell Inc.'s 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?

Accepted Answer

A)  9.41% 
B)  9.65% 
C)  9.90% 
D)  10.15% 
E)  10.40% 
A)  9.41% 
B)  9.65% 
C)  9.90% 
D)  10.15% 
E)  10.40%

Question 5

For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?

Accepted Answer

A)  The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation. 
B)  The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. 
C)  The beta of the portfolio is less than the average of the betas of the individual stocks. 
D)  The beta of the portfolio is equal to the average of the betas of the individual stocks. 
E)  The beta of the portfolio is larger than the average of the betas of the individual stocks. 
A)  The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation. 
B)  The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. 
C)  The beta of the portfolio is less than the average of the betas of the individual stocks. 
D)  The beta of the portfolio is equal to the average of the betas of the individual stocks. 
E)  The beta of the portfolio is larger than the average of the betas of the individual stocks.

Question 6

Someone who is risk averse has 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 securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.

Accepted Answer

A) True 
 B)False

Question 7

Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

Accepted Answer

A)  Variance; correlation coefficient. 
B)  Standard deviation; correlation coefficient. 
C)  Beta; variance. 
D)  Coefficient of variation; beta. 
A)  Variance; correlation coefficient. 
B)  Standard deviation; correlation coefficient. 
C)  Beta; variance. 
D)  Coefficient of variation; beta.

Question 8

Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?

Accepted Answer

A)  Portfolio P has a beta that is greater than 1.2. 
B)  Portfolio P has a standard deviation that is greater than 25%. 
C)  Portfolio P has an expected return that is less than 12%. 
D)  Portfolio P has a standard deviation that is less than 25%. 
E)  Portfolio P has a beta that is less than 1.2. 
A)  Portfolio P has a beta that is greater than 1.2. 
B)  Portfolio P has a standard deviation that is greater than 25%. 
C)  Portfolio P has an expected return that is less than 12%. 
D)  Portfolio P has a standard deviation that is less than 25%. 
E)  Portfolio P has a beta that is less than 1.2.

Question 9

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

Accepted Answer

A) True 
 B)False

Question 10

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

Accepted Answer

A)  The fact that a security or project may not have a past history that can be used as the basis for calculating beta. 
B)  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. 
C)  The beta of an "average stock," or "the market," can change over time, sometimes drastically. 
D)  Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. 
E)  All of the statements above are true. 
A)  The fact that a security or project may not have a past history that can be used as the basis for calculating beta. 
B)  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. 
C)  The beta of an "average stock," or "the market," can change over time, sometimes drastically. 
D)  Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. 
E)  All of the statements above are true.

Question 11

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is
0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation.

Accepted Answer

A) True 
 B)False

Question 12

Suppose you hold a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose you decided to sell one of your stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be?

Accepted Answer

A)  1.17 
B)  1.23 
C)  1.29 
D)  1.36 
E)  1.43 
A)  1.17 
B)  1.23 
C)  1.29 
D)  1.36 
E)  1.43

Question 13

Mike Flannery holds the following portfolio: 
 
the portfolio's beta?

Accepted Answer

A)  $ 1.06 $ 
B)  $ 1.17 $ 
C)  $ 1.29 $ 
D)  $ 1.42 $ 
E)  $ 1.56 $ 
A)  $ 1.06 $ 
B)  $ 1.17 $ 
C)  $ 1.29 $ 
D)  $ 1.42 $ 
E)  $ 1.56 $

Question 14

Assume that your uncle holds just one stock, East Coast Bank (ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for West Coast Bank (WCB). Both banks have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your uncle's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.)

Accepted Answer

A)  3.29% 
B)  3.46% 
C)  3.65% 
D)  3.84% 
E)  4.03% 
A)  3.29% 
B)  3.46% 
C)  3.65% 
D)  3.84% 
E)  4.03%

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)  Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections 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. 
B)  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. 
C)  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. 
D)  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. 
A)  Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections 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. 
B)  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. 
C)  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. 
D)  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.

Question 16

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.

Accepted Answer

A) True 
 B)False

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. 
B)  If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. 
C)  The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. 
D)  Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. 
E)  A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. 
A)  A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. 
B)  If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. 
C)  The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. 
D)  Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. 
E)  A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

Question 18

Moerdyk Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?

Accepted Answer

A)  11.36% 
B)  11.65% 
C)  11.95% 
D)  12.25% 
E)  12.55% 
A)  11.36% 
B)  11.65% 
C)  11.95% 
D)  12.25% 
E)  12.55%

Question 19

Which of the following statements is CORRECT? (Assume that the risk- free rate is a constant.)

Accepted Answer

A)  If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0. 
B)  The effect of a change in the market risk premium depends on the slope of the yield curve. 
C)  If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. 
D)  If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. 
A)  If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0. 
B)  The effect of a change in the market risk premium depends on the slope of the yield curve. 
C)  If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. 
D)  If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.

Question 20

Calculate the required rate of return for Climax Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years.

Accepted Answer

A)  10.29% 
B)  10.83% 
C)  11.40% 
D)  12.00% 
E)  12.60% 
A)  10.29% 
B)  10.83% 
C)  11.40% 
D)  12.00% 
E)  12.60%

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

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

Diversification will normally reduce the riskiness of a portfolio of stocks.

Tom O'Brien has a 2-stock portfolio with 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 his portfolio's beta?

For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?

Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

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

Mike Flannery holds the following portfolio: the portfolio's beta?

Which of the following statements is CORRECT?

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.

Which of the following statements is CORRECT?

Moerdyk Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?

Which of the following statements is CORRECT? (Assume that the risk- free rate is a constant.)

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, Bond Valuation, and Interest Rates

Stocks, Stock Valuation, and Stock Market Equilibrium

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Financial Planning and Forecasting Financial Statements

Corporate Valuation, Value-Based Management and Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Working Capital Management

Multinational Financial Management

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Initial Public Offerings, Investment Banking, and Financial Restructuring

Mergers, Lbos, Divestitures, and Holding Companies

Bankruptcy, Reorganization, and Liquidation

Derivatives and Risk Management

Portfolio Theory, Asset Pricing Models, and Behavioral Finance

Real Options

Analysis of Capital Structure Theory

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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