Deck 3: Risk and Return: Part II

Question 1

In a portfolio of three different stocks, which of the following could NOT be true?

A) The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.
B) The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
C) The beta of the portfolio is less than the betas of each of the individual stocks.
D) The beta of the portfolio is greater than the beta of one or two of the individual stocks' betas.
E) None of the above (i.e., they all could be true, but not necessarily at the same time).

Answer 1

C

Question 2

Which of the following statements is CORRECT?

A) The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.
B) The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.
C) The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.
D) The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.
E) The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.

Answer 2

C

Question 3

Which of the following is NOT a potential problem with beta and its estimation?

A) Sometimes a security or project does not have a past history which can be used as a 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 than 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 potentially serious problems.

Answer 3

C

Question 4

Which of the following statements is CORRECT?

A) Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.
B) Richard Roll has argued that it is possible to test the CAPM to see if it is correct.
C) Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM.
D) Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable.
E) The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller.

Question 5

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Question 6

The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

Question 7

We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

Question 8

The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Question 9

The slope of the SML is determined by the value of beta.

Question 10

A stock with a beta equal to -1.0 has zero systematic (or market) risk.

Question 11

Which of the following statements is CORRECT?

A) The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.
B) The slope of the CML is ( M - rRF)/bM.
C) All portfolios that lie on the CML to the right of M are inefficient.
D) All portfolios that lie on the CML to the left of M are inefficient.
E) None of the above statements is correct.

Question 12

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

Question 13

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

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

Question 14

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

A) When held in isolation, Stock A has greater risk than Stock B.
B) Stock B must be a more desirable addition to a portfolio than Stock A.
C) Stock A must be a more desirable addition to a portfolio than Stock B.
D) The expected return on Stock A should be greater than that on Stock B.
E) The expected return on Stock B should be greater than that on Stock A.

Question 15

Which of the following statements is CORRECT?

A) "Characteristic line" is another name for the Security Market Line.
B) The characteristic line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry.
C) The slope of the characteristic line is the stock's standard deviation.
D) The distance of the plot points from the characteristic line is a measure of the stock's market risk.
E) The distance of the plot points from the characteristic line is a measure of the stock's diversifiable risk.

Question 16

Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

Question 17

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

Question 18

If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck's stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

Question 19

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 low standard deviation stock.

Question 20

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

Question 21

Assume an economy in which there are three securities: Stock A with rA = 10% and A = 10%; Stock B with rB = 15% and B = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is most CORRECT?

A) The expected return on the investor's portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.
B) The expected return on the investor's portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%.
C) The expected return on the investor's portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%.
D) The investor's risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%.
E) Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%.

Question 22

You are holding a stock with a beta of 2.0 that is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?

A) 36.10%
B) 38.00%
C) 40.00%
D) 42.00%
E) 44.10%

Question 23

Calculate the required rate of return for Mercury, 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) Mercury has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years.

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

Question 24

You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different common stocks. The portfolio beta is equal to 1.12. You have decided to sell a lead mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a steel company stock (b = 2.00). What is the new beta of the portfolio?

A) 1.1139
B) 1.1700
C) 1.2311
D) 1.2927
E) 1.3573

Question 25

Which of the following are the factors for the Fama-French model?

A) The excess market return, a size factor, and a book-to-market factor.
B) The excess market return, a debt factor, and a book-to-market factor.
C) The excess market return, a size factor, and a debt.
D) A debt factor, a size factor, and a book-to-market factor.
E) The excess market return, an industrial production factor, and a book-to-market factor.