Question 1

What should you expect to happen if you randomly select stocks and add them to your portfolio?

Accepted Answer

A)  This will reduce the portfolio's unsystematic, or diversifiable, risk. 
B)  This will increase the portfolio's expected rate of return. 
C)  This will reduce the portfolio's beta coefficient and thus its systematic risk. 
D)  This will have no effect on the portfolio's risk. 
A)  This will reduce the portfolio's unsystematic, or diversifiable, risk. 
B)  This will increase the portfolio's expected rate of return. 
C)  This will reduce the portfolio's beta coefficient and thus its systematic risk. 
D)  This will have no effect on the portfolio's risk.

Question 2

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

Accepted Answer

A) True 
 B)False

Question 3

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

Accepted Answer

A)  The return will increase. 
B)  The return will remain unchanged. 
C)  The return will decrease. 
D)  It is undetermined and more information is needed. 
A)  The return will increase. 
B)  The return will remain unchanged. 
C)  The return will decrease. 
D)  It is undetermined and more information is needed.

Question 4

Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, an expected return of 10%, and a standard deviation of 15%. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is correct?

Accepted Answer

A)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. 
B)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. 
C)  Portfolio AB's expected return is 11.0%. 
D)  Portfolio AB's beta is less than 1.2. 
A)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. 
B)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. 
C)  Portfolio AB's expected return is 11.0%. 
D)  Portfolio AB's beta is less than 1.2.

Question 5

Stocks A, B and C have betas of 0.8, 1.0, and 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stock is zero. If market is in equilibrium, which of the following is correct?

Accepted Answer

A)  Portfolio P's expected return is greater than the expected return on Stock B. 
B)  Portfolio P's expected return is equal to the expected return on Stock A. 
C)  Portfolio P's expected return is less than the expected return on Stock B. 
D)  Portfolio P's expected return is equal to the expected return on Stock B. 
A)  Portfolio P's expected return is greater than the expected return on Stock B. 
B)  Portfolio P's expected return is equal to the expected return on Stock A. 
C)  Portfolio P's expected return is less than the expected return on Stock B. 
D)  Portfolio P's expected return is equal to the expected return on Stock B.

Question 6

Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P is a portfolio with 50% invested in Stock A and 50% invested in B. Which of the following statements is correct?

Accepted Answer

A)  Portfolio P has a standard deviation of 25% and a beta of 1.0. 
B)  Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium. 
C)  Portfolio P has more market risk than Stock A but less market risk than Stock B. 
D)  Stock A should have a higher expected return than Stock B as viewed by the marginal investor. 
A)  Portfolio P has a standard deviation of 25% and a beta of 1.0. 
B)  Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium. 
C)  Portfolio P has more market risk than Stock A but less market risk than Stock B. 
D)  Stock A should have a higher expected return than Stock B as viewed by the marginal investor.

Question 7

Which of the following statements is correct?

Accepted Answer

A)  The beta of a portfolio of stocks is always smaller than the beta of any of the individual stocks. 
B)  If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. 
C)  The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future. 
D)  It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF. 
A)  The beta of a portfolio of stocks is always smaller than the beta of any of the individual stocks. 
B)  If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. 
C)  The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future. 
D)  It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.

Question 8

Which of the following statements is correct?

Accepted Answer

A)  The slope of the SML is determined by the value of beta. 
B)  The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by managers. 
C)  Suppose you plotted the returns of a given stock against those of the market, and 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 less than the risk-free rate for a well-diversified investor, assuming investors in the market expect the observed relationship to continue on into the future. 
D)  If investors become less risk averse, the slope of the SML will increase. 
A)  The slope of the SML is determined by the value of beta. 
B)  The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by managers. 
C)  Suppose you plotted the returns of a given stock against those of the market, and 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 less than the risk-free rate for a well-diversified investor, assuming investors in the market expect the observed relationship to continue on into the future. 
D)  If investors become less risk averse, the slope of the SML will increase.

Question 9

"Risk aversion" implies that investors require higher expected returns on risky securities if they are to be induced to purchase them.

Accepted Answer

A) True 
 B)False

Question 10

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.

Accepted Answer

A) True 
 B)False

Question 11

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

Accepted Answer

A) True 
 B)False

Question 12

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM - rRF) declines, with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is correct?

Accepted Answer

A)  The required return of all stocks will increase by the amount of the increase in the risk-free rate. 
B)  The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. 
C)  Since the overall return on the market stays constant, the required return on each individual stock will remain constant. 
D)  The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. 
A)  The required return of all stocks will increase by the amount of the increase in the risk-free rate. 
B)  The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. 
C)  Since the overall return on the market stays constant, the required return on each individual stock will remain constant. 
D)  The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.

Question 13

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and actually reduce the riskiness of a portfolio.

Accepted Answer

A) True 
 B)False

Question 14

Which statement best characterizes economic events such as inflation, recession, and high interest rates?

Accepted Answer

A)  They are systematic risk factors that can be diversified away. 
B)  They are company-specific risk factors that can be diversified away. 
C)  They are among the factors that are responsible for market risk. 
D)  They are risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. 
A)  They are systematic risk factors that can be diversified away. 
B)  They are company-specific risk factors that can be diversified away. 
C)  They are among the factors that are responsible for market risk. 
D)  They are risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.

Question 15

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.

Accepted Answer

A) True 
 B)False

Question 16

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?

Accepted Answer

A)  The required returns on all stocks would have fallen, but the decline would have been greater for stocks with lower betas. 
B)  The required returns on all stocks would have fallen, but the fall would have been greater for stocks with higher betas. 
C)  Required returns would have increased for stocks with betas greater than 1.0 but would have declined for stocks with betas less than 1.0. 
D)  The required returns on all stocks would have fallen by the same amount. 
A)  The required returns on all stocks would have fallen, but the decline would have been greater for stocks with lower betas. 
B)  The required returns on all stocks would have fallen, but the fall would have been greater for stocks with higher betas. 
C)  Required returns would have increased for stocks with betas greater than 1.0 but would have declined for stocks with betas less than 1.0. 
D)  The required returns on all stocks would have fallen by the same amount.

Question 17

Rodriguez Roofing's stock has a beta of 1.23, its required return is 11.25%, and the risk-free rate is 4.30%. What is the required rate of return on the stock market? (Hint: First find the market risk premium.)

Accepted Answer

A)  9.95% 
B)  10.20% 
C)  10.45% 
D)  10.72% 
A)  9.95% 
B)  10.20% 
C)  10.45% 
D)  10.72%

Question 18

Which statement about a stock's beta is correct?

Accepted Answer

A)  If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium. 
B)  A stock with a negative beta must in theory have a negative required rate of return. 
C)  If a stock's beta doubles, its required rate of return must also double. 
D)  If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. 
A)  If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium. 
B)  A stock with a negative beta must in theory have a negative required rate of return. 
C)  If a stock's beta doubles, its required rate of return must also double. 
D)  If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.

Question 19

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 of the stocks if each 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. 
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 of the stocks if each 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.

Question 20

Which of the following statements is correct?

Accepted Answer

A)  If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. 
B)  If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market. 
C)  Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless. 
D)  A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate. 
A)  If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. 
B)  If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market. 
C)  Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless. 
D)  A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

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

What should you expect to happen if you randomly select stocks and add them to your portfolio?

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

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

Which of the following statements is correct?

Which of the following statements is correct?

"Risk aversion" implies that investors require higher expected returns on risky securities if they are to be induced to purchase them.

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.

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

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM - rRF) declines, with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is correct?

A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and actually reduce the riskiness of a portfolio.

Which statement best characterizes economic events such as inflation, recession, and high interest rates?

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.

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?

Rodriguez Roofing's stock has a beta of 1.23, its required return is 11.25%, and the risk-free rate is 4.30%. What is the required rate of return on the stock market? (Hint: First find the market risk premium.)

Which statement about a stock's beta is correct?

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

Which of the following statements is correct?

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Financial Planning and Forecasting Financial Statements

Bonds, Bond Valuation, and Interest Rates

Stocks, Stock Valuation, and Stock Market Equilibrium

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Capital Structure Decisions

Distributions to Shareholders: Dividends and Repurchases

Initial Public Offerings, Investment Banking, and Financial Restructuring

Lease Financing

Capital Market Financing: Hybrid and Other Securities

Working Capital Management and Short-Term Financing

Current Asset Management

Financial Options and Applications in Corporate Finance

Decision Trees, Real Options, and Other Capital Budgeting Topics

Derivatives and Risk Management

International Financial Management

Corporate Valuation, Value-Based Management, and Corporate Governance

Mergers, Acquisitions, and Restructuring

Filters

Assume that the risk-free rate, r_RF, increases but the market risk premium, (r_M - r_RF) declines, with the net effect being that the overall required return on the market, r_M, remains constant. Which of the following statements is correct?

Assume that in recent years both expected inflation and the market risk premium (r_M - r_RF) 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?