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

For diversified investors, the appropriate measure of risk is how the return on an individual stock moves with the returns of other assets in the portfolio.

Which asset mix would be the best representation of the true market portfolio?

Which of the following statements is correct?

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?

Diversifiable risk is the only risk that affects the required rate of return because nondiversifiable risk can be eliminated.

Diversifiable risk is an important factor in the arbitrage pricing model.

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.

Vera Paper's stock has a beta of 1.40, and its required return is 12.00%. Dell Dairy's stock has a beta of 0.80. If the risk-free rate is 4.75%, what is the required rate of return on Dell's stock?

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all company-specific risk.

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

Other things held constant, in which way would the Security Market Line shift if the expected inflation rate decreases and investors also become more risk averse?

Which statement about risk is true?

If the expected rate of return for a particular stock, as seen by the marginal investor, exceeds its required rate of return, we should soon observe an increase in demand for the stock, and the price will likely increase until a price is established that equates the expected return with the required return. The sooner this equilibrium is reached, the more efficient the market is judged to be.

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 options 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?

Stocks A, B, and C all have an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns that are independent of one another, i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are negatively correlated with one another, i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is correct?

What is the effect on portfolio beta of a larger number of assets in a portfolio and a longer time period?

Unless assets are negatively correlated, combining assets into a portfolio will not reduce portfolio risk.

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