Deck 6: Risks and Rates of Return

Question 1

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.

Answer 1

True

Question 2

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a
well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM.

Answer 2

True

Question 3

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.

Answer 3

True

Question 4

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

Question 5

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

Question 6

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

Question 7

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Question 8

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

Question 9

An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

Question 10

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk.

Question 11

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

Question 12

"Risk aversion" implies that investors require higher expected returns
1.
on riskier than on less risky securities.

Question 13

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

Question 14

The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

Question 15

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

A) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
B) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
C) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
D) If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.

Question 16

If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

Question 17

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.

Question 18

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

Question 19

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.

Question 20

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.

Question 21

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

Question 22

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.

Question 23

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.

Question 24

Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will by definition be riskless.

Question 25

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 would be better off adding Security AA to a well- diversified portfolio over Security BB.

Question 26

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

Question 27

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 diversifiable risk.

Question 28

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

Question 29

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 thus reduce the riskiness of their portfolios.

Question 30

We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

Question 31

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

Question 32

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.

Question 33

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

A) A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.
B) Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock.
C) The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock.
D) One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free.

Question 34

Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

Question 35

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

Question 36

The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML.

Question 37

Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.

Question 38

If you plotted the returns of a 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 the 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 39

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

Question 40

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.

Question 41

Which of the following statements is CORRECT?

A) An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks.
B) The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
C) It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
D) Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.
E) An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks.

Question 42

Which of the following statements is CORRECT?

A) If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0.
B) Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities.
C) The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically.
D) If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm.
E) During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.

Question 43

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and
B) Which of the possible answers best describes the historical betas for A and B?

Question 44

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

Question 45

Which of the following statements is CORRECT?

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

Question 46

The CAPM is a multi-period model that 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 47

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate.

Question 48

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

Question 49

Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A's portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0.

Question 50

If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM − rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.

Question 51

If you plotted the returns on 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.

Question 52

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

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 53

Which of the following statements is CORRECT?
56)

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 54

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk.

Question 55

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) Strike price.
B) Variability of the stock price.
C) Option's time to maturity.
D) All of the above.

Question 56

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?
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.

A) The beta of a portfolio of stocks is always smaller than the betas 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.
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.

Question 57

Which of the following statements is CORRECT?

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 were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.
C) 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.
D) 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.
E) A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

Question 58

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.

A) Stock A would be a more desirable addition to a portfolio then Stock B.
B) In equilibrium, the expected return on Stock B will be greater than that on Stock A.
C) When held in isolation, Stock A has more risk than Stock B.
D) Stock B would be a more desirable addition to a portfolio than A.
E) In equilibrium, the expected return on Stock A will be greater than that on B.

Question 59

Inflation, recession, and high interest rates are economic events that are best characterized as being

A) systematic risk factors that can be diversified away.
B) company-specific risk factors that can be diversified away.
C) among the factors that are responsible for market risk.
D) risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.
E) irrelevant except to governmental authorities like the Federal Reserve.

Question 60

A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?

A) Either A or B, i.e., the investor should be indifferent between the two.
B) Stock A.
C) Stock B.
D) Neither A nor B, as neither has a return sufficient to compensate for risk.
E) Add A, since its beta must be lower.

Question 61

Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?

A) The portfolio's beta is less than 1.2.
B) The portfolio's expected return is 15%.
C) The portfolio's standard deviation is greater than 20%.
D) The portfolio's beta is greater than 1.2.

Question 62

Bob has a $50,000 stock portfolio with a beta of 1.2, an expected
56)
Return of 10.8%, and a standard deviation of 25%. Becky also has a
$50,000 portfolio, but it has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Bob's and Becky's portfolios is zero. If Bob and Becky marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio?

A) A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected.
B) Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.
C) A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0.
D) A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8.

Question 63

Which of the following statements is CORRECT?

Question 64

Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?

A) The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
B) The expected return of your portfolio is likely to decline.
C) The diversifiable risk will remain the same, but the market risk will likely decline.
D) Both the diversifiable risk and the market risk of your portfolio are likely to decline.
E) The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.

Question 65

In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement always is false?

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 lower than the lowest of the three betas.
D) The beta of the portfolio is lower than the highest of the three betas.
E) None of the above statements is obviously false, because they all could be true, but not necessarily at the same time.

Question 66

Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT?

A) If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2- stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.
B) Stock Y's realized return during the coming year will be higher than Stock X's return.
C) If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
D) Stock Y's return has a higher standard deviation than Stock X.

Question 67

Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio?

A) Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.
B) Adding more such stocks will increase the portfolio's expected rate of return.
C) Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk.
D) Adding more such stocks will have no effect on the portfolio's risk.
E) Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.

Question 68

Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1. Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT?

A) Portfolio AB has a standard deviation of 20%.
B) Portfolio AB's coefficient of variation is greater than 2.0.
C) Portfolio AB's required return is greater than the required return on Stock A.
D) Portfolio ABC's expected return is 10.66667%.
E) Portfolio ABC has a standard deviation of 20%.

Question 69

Which of the following statements is CORRECT?

A) A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.
B) A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations.
C) A two-stock portfolio will always have a lower beta than a one-stock portfolio.
D) If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio.
E) A stock with an above-average standard deviation must also have an above-average beta.

Question 70

Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio?

A) Your portfolio has a standard deviation of 30%, and its expected return is 15%.
B) Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.
C) Your portfolio has a beta equal to 1.6, and its expected return is 15%.
D) Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.
E) Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.

Question 71

Which of the following statements is CORRECT?

A) If the returns on two stocks are perfectly positively correlated and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
B) A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.
C) If a stock has a negative beta, its expected return must be negative.
D) A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
E) According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.

Question 72

Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 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 stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?

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.
E) Portfolio P's expected return is greater than the expected return on Stock C.

Question 73

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?

A) The combined portfolio's expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.
B) The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%.
C) The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.
D) The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%.

Question 74

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

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

Question 75

Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock's returns is 20%. The stocks' returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT?

A) Portfolio P has a standard deviation of 20%.
B) The required return on Portfolio P is equal to the market risk premium (rM − rRF).
C) Portfolio P has a beta of 0.7.
D) Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
E) Portfolio P has the same required return as the market (rM).

Question 76

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?

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 77

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

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 78

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, but its expected return is 10% and its standard deviation is 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?

A) Portfolio AB's standard deviation is 17.5%.
B) The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
C) The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued.
D) Portfolio AB's expected return is 11.0%.
E) Portfolio AB's beta is less than 1.2.

Question 79

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 answers 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?

A) Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills.
B) Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds.
C) Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
D) U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks.
E) Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.

Question 80

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?

A) Portfolio AC has an expected return that is less than 10%.
B) Portfolio AC has an expected return that is greater than 25%.
C) Portfolio AB has a standard deviation that is greater than 25%.
D) Portfolio AB has a standard deviation that is equal to 25%.
E) Portfolio AC has a standard deviation that is less than 25%.