Deck 11: Return and Risk: the Capital Asset Pricing Model Capm

Question 1

When computing the expected return on a portfolio of stocks the portfolio weights are based on the:

A)number of shares owned in each stock.
B)price per share of each stock.
C)market value of the total shares held in each stock.
D)original amount invested in each stock.
E)cost per share of each stock held.

Answer 1

market value of the total shares held in each stock.

Question 2

Unsystematic risk:

A)can be effectively eliminated through portfolio diversification.
B)is measured by beta.
C)is compensated for by the risk premium.
D)is nondiversifiable.
E)is related to the overall economy.

Answer 2

can be effectively eliminated through portfolio diversification.

Question 3

The portfolio expected return considers which of the following factors?
I.The amount of money currently invested in each individual security
II.Various levels of economic activity
III.The performance of each stock given various economic scenarios
IV.The probability of various states of the economy occurring

A)I and III only
B)II and IV only
C)I,III,and IV only
D)II,III,and IV only
E)I,II,III,and IV only

Answer 3

I,II,III,and IV only

Question 4

Which one of these measures the interrelationship between two securities?

A)Standard deviation
B)Variance
C)Beta
D)Covariance
E)Alpha

Question 5

The primary purpose of portfolio diversification is to:

A)increase returns and risks.
B)eliminate all risks.
C)eliminate asset-specific risk.
D)lower both returns and risks.
E)eliminate systematic risk.

Question 6

Which one of the following is an example of a nondiversifiable risk?

A)A poorly managed firm suddenly goes out of business due to lack of sales
B)A well managed firm reduces its work force and automates several jobs
C)A key employee of a firm suddenly resigns and accepts employment with a key competitor
D)A well respected chairman of the Federal Reserve suddenly resigns
E)A well respected president of a firm suddenly resigns

Question 7

The standard deviation of a portfolio will tend to increase when:

A)the portfolio concentration in a single cyclical industry increases.
B)one of two stocks related to the airline industry is replaced with a third stock that is unrelated to the airline industry.
C)a risky asset in the portfolio is replaced with U.S.Treasury bills.
D)the weights of the various diverse securities become more evenly distributed.
E)short-term bonds are replaced with Treasury Bills.

Question 8

The systematic risk of the market is assigned a:

A)beta of 1.
B)beta of 0.
C)standard deviation of 1.
D)standard deviation of 0.
E)variance of 1.

Question 9

If a stock portfolio is well diversified,then the portfolio variance:

A)must be equal to or greater than the variance of the least risky stock in the portfolio.
B)will be a weighted average of the variances of the individual securities in the portfolio.
C)will equal the variance of the most volatile stock in the portfolio.
D)will be an arithmetic average of the variances of the individual securities in the portfolio.
E)may be less than the variance of the least risky stock in the portfolio.

Question 10

The risk premium for an individual security is computed by:

A)adding the risk-free rate to the security's expected return.
B)multiplying the security's beta by the market risk premium.
C)multiplying the security's beta by the risk-free rate of return.
D)dividing the market risk premium by the beta of the security.
E)dividing the market risk premium by the quantity (1 - beta).

Question 11

The beta of a security is calculated by dividing the:

A)variance of the market by the covariance of the security with the market.
B)correlation of the security with the market by the variance of the security.
C)variance of the market by the correlation of the security with the market.
D)covariance of the security with the market by the variance of the market.
E)covariance of the security with the market by the variance of the security.

Question 12

The expected return on a portfolio:

A)can be greater than the expected return on the best performing security in the portfolio.
B)can be less than the expected return on the worst performing security in the portfolio.
C)is independent of the performance of the overall economy.
D)is limited by the returns on the individual securities within the portfolio.
E)is an arithmetic average of the returns of the individual securities when the weights of those securities are unequal.

Question 13

Which one of the following would tend to indicate that a portfolio is being effectively diversified?

A)A decrease in the portfolio standard deviation
B)An increase in the portfolio rate of return
C)An increase in the portfolio beta
D)An increase in the portfolio standard deviation
E)A constant portfolio beta

Question 14

Which one of the following is the best example of systematic risk?

A)The price of lumber declines sharply
B)Inflation rises unexpectedly
C)Airline pilots go on strike
D)A hurricane hits a tourist destination
E)People become diet conscious and avoid fast food restaurants

Question 15

A security that is fairly priced will have a return that lies _____ the security market line.

A)below
B)on or below
C)on
D)on or above
E)above

Question 16

The principle of diversification tells us that:

A)concentrating an investment in three companies all within the same industry will greatly reduce the overall risk of a portfolio.
B)concentrating an investment in two or three large stocks will eliminate all of a portfolio's risk.
C)spreading an investment across many diverse assets will eliminate all of a portfolio's risk.
D)spreading an investment across many diverse assets will lower a portfolio's level of risk.
E)spreading an investment across five diverse companies will not lower a portfolio's level of risk.

Question 17

Which one of the following statements is correct concerning the standard deviation of a portfolio?

A)Standard deviation is used to determine the amount of risk premium that should apply to a portfolio.
B)The greater the diversification of a portfolio,the greater the standard deviation of that portfolio.
C)Standard deviation measures only the systematic risk of a portfolio.
D)The standard deviation of a portfolio can often be lowered by changing the weights of the securities in the portfolio.
E)The standard deviation of a portfolio is equal to a weighted average of the standard deviations of the individual securities held within the portfolio.

Question 18

Standard deviation measures _____ risk.

A)total
B)nondiversifiable
C)unsystematic
D)economic
E)systematic

Question 19

The intercept point of the security market line is the rate of return that corresponds to:

A)the market rate of return.
B)the beta of the market.
C)a value of one.
D)a value of zero.
E)the risk-free rate of return.

Question 20

Systematic risk is measured by:

A)beta.
B)the arithmetic average.
C)the geometric average.
D)the covariance.
E)the standard deviation.

Question 21

Assume you are looking at a security market line graph.Where would an overpriced stock with a beta of .98 plot on that graph?

A)To the right of the market and below the security market line
B)To the left of the market and below the security market line
C)To the right of the market and above the security market line
D)To the left of the market and above the security market line
E)To the right of the market on the security market line

Question 22

Assume the risk-free rate and the market risk premium are both positive.Trevor currently owns a portfolio comprised of risky and risk-free securities.The portfolio has an expected return of 11.2 percent,a standard deviation of 16.2 percent,and a beta of 1.21.He has decided that he would prefer a higher expected return.Which one of these actions should he take?

A)Replace a stock in his current portfolio with a beta of 1.34 with a stock that has a 1.02 beta
B)Sell a portion of the risky assets and use the proceeds to purchase risk-free securities
C)Lower both the portfolio standard deviation and beta
D)Increase the portfolio weight of the risky assets without affecting the total portfolio value
E)Increase the standard deviation of the portfolio without affecting the portfolio beta

Question 23

You want your portfolio beta to be 1.3.Currently,the portfolio consists of $100 invested in stock A with a beta of 1.5 and $300 in stock B with a beta of .8.You have another $400 to invest and want to divide it between an asset with a beta of 1.7 and a risk-free asset.How much should you invest in the risk-free asset?

A)$17.65
B)$50.25
C)$200.15
D)$382.35
E)$400.00

Question 24

You plotted the monthly rate of return for two securities against time for the past 48 months.If the pattern of the movements of these two sets of returns rose and fell together the majority,but not all of the time,then the securities have:

A)no correlation at all.
B)a weak negative correlation.
C)a strong negative correlation.
D)a strong positive correlation.
E)a perfect positive correlation.

Question 25

The combination of the efficient set of portfolios with a riskless lending and borrowing rate results in:

A)the capital market line which shows that investors will only invest in the riskless asset.
B)the capital market line which shows that investors will invest in a combination of the riskless asset and the tangency portfolio.
C)the security market line which shows that all investors will invest in the riskless asset only.
D)the security market line which shows that all investors will invest in a combination of the riskless asset and the tangency portfolio.
E)the capital market line which shows that investors will invest at the vertical intercept point of that line.

Question 26

Well-diversified portfolios have negligible:

A)systematic risks.
B)unsystematic risks.
C)expected returns.
D)variances.
E)covariances.

Question 27

A stock with a beta of zero would be expected to have a rate of return equal to:

A)the prime rate.
B)the average AAA bond.
C)the market rate.
D)the risk-free rate.
E)zero.

Question 28

A portfolio is comprised of five securities that have individual betas of 1.38,.87,1.02,1.49,and .67.You do not know the portfolio weight of each security.What do you know with certainty?

A)The portfolio beta will not be affected by any change in the portfolio weights.
B)The portfolio beta will not change if an additional security with a beta of 1 is added to the portfolio.
C)The portfolio beta will be greater than the market beta.
D)The portfolio beta will be less than 1.49 and greater than .67.
E)The optimal portfolio beta for any investor must be greater than 0 and less than 1.

Question 29

The risk of an individual security that will be compensated by the market depends upon the:

A)standard deviation of that security.
B)covariance of that security with the market.
C)expected rate of return on that security.
D)security's historical variance.
E)industry most associated with that security.

Question 30

The dominant portfolio with the lowest possible level of risk out of a set of portfolios comprised of two securities is referred to as the:

A)efficient frontier.
B)minimum variance portfolio.
C)upper tail of the efficient set.
D)tangency portfolio.
E)risk-free portfolio.

Question 31

The separation principle states that an investor will:

A)choose any efficient portfolio and invest some amount in the riskless asset to generate the expected return.
B)never choose to invest in the riskless asset because the expected return on the riskless asset is lower over time.
C)invest only in the riskless asset and tangency portfolio choosing the weights of each based on his/her individual risk tolerance.
D)randomly select any efficient portfolio.
E)select a portfolio based solely on his/her desired rate of return while ignoring the associated risks of their selection.

Question 32

A stock with an actual return that lies above the security market line:

A)has less systematic risk than the overall market.
B)has more risk than warranted based on the realized rate of return.
C)has yielded a return equivalent to the level of risk assumed.
D)has more systematic risk than the overall market.
E)has yielded a higher return than expected for the level of risk assumed.

Question 33

According to the capital asset pricing model,the expected return on a security is:

A)negatively and linearly related to the security's beta.
B)positively and linearly related to the security's beta.
C)positively and non-linearly related to the security's beta.
D)positively and linearly related to the security's variance.
E)negatively and non-linearly related to the security's beta.

Question 34

What is the first step an investor takes when making an investment decision according to the separation principle?

A)Determining the mix of risky and risk-free assets he/she will hold
B)Quantifying the amount of risk he/she is willing to accept
C)Estimating future inflation and risk-free rates
D)Determining the portfolio of risky assets that he/she will hold
E)Specifying a desired rate of return

Question 35

The excess return earned by an asset that has a beta of one over that earned by a risk- free asset is referred to as the:

A)market rate of return.
B)systematic return.
C)real rate of return.
D)market risk premium.
E)total return.

Question 36

Mr.Rhoades is the CEO of Daily News.The majority of stockholders do not approve of the decisions made by Mr.Rhoades and have repeatedly requested that he be ousted.Over the last couple of months,it has become apparent that the CEO is going to be replaced by a member of the board,Mr.Bentley,who is highly respected.This morning,the official announcement was made that Mr.Rhoades has stepped down and will be replaced immediately by Mr.Bentley.How is the stock price of the Daily News most apt to react to this announcement?

A)Highly positive and immediate reaction
B)A slow but positive reaction
C)An immediate negative reaction
D)An immediate positive reaction followed by a slight downward drift
E)No reaction

Question 37

The market risk premium is computed by:

A)adding the risk-free rate of return to the inflation rate.
B)adding the risk-free rate of return to the market rate of return.
C)subtracting the risk-free rate of return from the inflation rate.
D)subtracting the risk-free rate of return from the market rate of return.
E)multiplying the risk-free rate of return by a beta of one.

Question 38

You have a portfolio of two risky stocks that has no diversification benefit.The lack of any diversification benefit must be due to the fact that:

A)the returns on the two stocks move perfectly in sync with one another.
B)the returns on the two stocks move perfectly opposite of one another.
C)one security must be a risk-free security.
D)the portfolio is equally weighted between the two stocks.
E)the two stocks are completely unrelated to one another.

Question 39

Assume two securities are negatively correlated.If these two securities are combined into an equally weighted portfolio,the portfolio standard deviation must be:

A)equal to the standard deviation of the overall market.
B)equal to the arithmetic average of the standard deviations of the individual securities.
C)equal to zero.
D)less than the weighted average of the standard deviations of the individual securities.
E)equal to or greater than the lowest standard deviation of the two securities.

Question 40

Amy has a portfolio with a beta of 1.26.She has decided to lower her investment risk.Adding which one of the following securities to her portfolio is most assuredly going to lower the risk of the portfolio?

A)A stock that has a covariance with the market of .89
B)A security that has a standard deviation of 11 percent
C)A security with a beta of 1.58
D)U.S.Treasury bills
E)A mix of small-company and large-company stocks

Question 41

PPO stock has a beta of 1.12 and an expected return of 12.64 percent.The risk-free rate of return is 3.85 percent.What is the expected return on the market?

A)7.85%
B)8.04%
C)11.62%
D)11.70%
E)12.16%

Question 42

You would like to combine a risky stock with a beta of 1.6 with U.S.Treasury bills in such a way that the risk level of the portfolio is equivalent to the risk level of the overall market.What percentage of the portfolio should be invested in the risky asset?

A)16.00%
B)62.50%
C)52.55%
D)47.45%
E)37.5%

Question 43

Stock A will return 15 percent in a normal economy and lose 14 percent in a recession.Stock B deals with inferior goods and will return 7 percent in a normal economy and 18 percent in a recession.There is a 20 percent chance of a recession occurring.What is the standard deviation of a portfolio that is equally weighted between the two stocks?

A)3.60%
B)6.50%
C)1.30%
D).13%
E).36%

Question 44

Alpha stock has a beta of 1.43.The risk-free rate of return is 3.5 percent and the market rate of return is 11 percent.What is the amount of the risk premium on Alpha stock?

A)5.24%
B)5.50%
C)7.50%
D)8.77%
E)10.73%

Question 45

The economy has a 14 percent chance of booming.Otherwise,the economy will be normal.Stock G will return 15 percent in a boom and 8 percent in a normal economy.Stock H will return 9 percent in a boom and 6 percent in a normal economy.What is the variance of a portfolio consisting of $2,500 of stock G and $7,500 of stock H?

A).000167
B).000193
C).002098
D).013879
E).014002

Question 46

RTF stock is expected to return 13 percent in a normal economy and lose 8 percent in a recession.The probability of a recession is 25 percent.What is the variance of the returns on RTF stock?

A).009093
B).008760
C).007864
D).008269
E).009394

Question 47

A portfolio is expected to return 15 percent in a booming economy,12 percent in a normal economy,and lose 9 percent if the economy falls into a recession.The probability of a boom is 25 percent while the probability of a recession is 15 percent.What is the overall portfolio expected return?

A)5.42%
B)6.83%
C)9.60%
D)10.05%
E)10.81%

Question 48

A portfolio consists of 40 percent of Stock S and 60 percent of Stock T.Stock S will return 13 percent if the economy booms and 8 percent if it is normal.Stock T will return 6 percent in a boom and 10 percent in a normal economy.The probability of a boom is 50 percent.What is the portfolio variance?

A).001014
B).000004
C).000040
D).001004
E).000009

Question 49

A stock has an expected return of 14.21 percent.The return on the market is 11.8 percent and the risk-free rate of return is 3.2 percent.What is the beta of this stock?

A).65
B)1.09
C)1.42
D)1.28
E)1.78

Question 50

A portfolio consists of $12,000 of stock K and $23,000 of stock L.Stock K will return 14 percent in a booming economy and 5 percent in a normal economy.Stock L will return 10 percent in a booming economy and 6 percent in a normal economy.The probability of the economy booming is 22 percent.What is the expected rate of return on the portfolio if the economy is normal?

A)5.59%
B)5.62%
C)5.66%
D)5.71%
E)5.74%

Question 51

Stock Q will return 18 percent in a boom and 9 percent in a normal economy.Stock R will return 9 percent in a boom and 5 percent in a normal economy.There is a 75 percent probability the economy will be normal.What is the standard deviation of a portfolio that is invested 40 percent in stock Q and 60 percent in stock R?

A).78%
B)1.41%
C)2.60%
D)6.67%
E)8.01%

Question 52

The expected return on HiLo stock is 12.04 percent while the expected return on the market is 10.52 percent.The beta of HiLo is 1.28.What is the risk-free rate of return?

A)5.09%
B)3.2%
C)3.7%
D)4.2%
E)4.87%

Question 53

You recently purchased a stock that is expected to earn 15 percent in a booming economy,9 percent in a normal economy and lose 5 percent in a recessionary economy.There is a 15 percent probability of a boom,a 75 percent chance of a normal economy,and a 10 percent chance of a recession.What is your expected rate of return on this stock?

A)8.00%
B)7.45%
C)8.50%
D)7.75%
E)9.50%

Question 54

You have a 2-stock portfolio with an expected return of 10.6 percent.Stock A has an expected return of 12 percent while Stock B is expected to return 8 percent.What is the portfolio weight of Stock A?

A)76%
B)72%
C)61%
D)65%
E)68%

Question 55

A portfolio is comprised of 30 percent of stock X,55 percent of stock Y,and 15 percent of stock Z.Stock X has a beta of .87,stock Y has a beta of 1.48,and stock Z has a beta of 1.04.What is the portfolio beta?

A)1.012
B)1.111
C)1.157
D)1.190
E)1.231

Question 56

The Inferior Goods Co.stock is expected to earn 22 percent in a recession,7 percent in a normal economy,and lose 14 percent in a booming economy.The probability of a boom is 20 percent while the probability of a normal economy is 55 percent.What is the expected rate of return on this stock?

A)6.55%
B)12.15%
C)4.75%
D)8.60%
E)11.75%

Question 57

The rate of return on the common stock of Flowers by Flo is expected to be 15 percent in a boom economy,7 percent in a normal economy,and only 3 percent in a recessionary economy.The probabilities of these economic states are 20 percent for a boom,70 percent for a normal economy,and 10 percent for a recession.What is the variance of the returns on this stock?

A).001296
B).001580
C).001963
D).002001
E).002471

Question 58

The market has an expected rate of return of 12.8 percent.The long-term government bond is expected to yield 4.5 percent and the U.S.Treasury bill is expected to yield 3.4 percent.The inflation rate is 3.1 percent.What is the market risk premium?

A)3.4%
B)9.7%
C)6.3%
D)8.3%
E)9.4%

Question 59

KNF stock is quite cyclical.In a boom economy,the stock is expected to return 30 percent in comparison to 12 percent in a normal economy and a negative 17 percent in a recessionary period.The probability of a recession is 25%.There is a 15% chance of a boom economy.What is the standard deviation of the returns this stock?

A)10.15%
B)12.60%
C)15.43%
D)17.46%
E)25.04%

Question 60

The risk-free rate of return is 3.3 percent and the market risk premium is 7.5 percent.What is the expected rate of return on a stock with a beta of 1.62?

A)9.12%
B)10.10%
C)15.45%
D)17.50%
E)15.36%

Question 61

If an optimal portfolio of risky assets can be identified,why should investors mix that portfolio with risk-free securities?

Question 62

A portfolio is equally weighted.Security One has a standard deviation of 10 percent.Security Two has a standard deviation of 8 percent.The securities have a covariance of .4254.What is the portfolio variance?

A).2209
B).0061
C).8549
D).8590
E).2168

Question 63

Draw the security market line (SML)and plot asset C such that it has less risk than the market but plots above the SML,and asset D such that it has more risk than the market and plots below the SML.(Be sure to indicate where the market portfolio is on your graph. )Explain how assets like C or D can plot as they do and explain why such pricing cannot persist in a market that is in equilibrium.

Question 64

The stock of Martin Industries has a beta of 1.02.The risk-free rate of return is 3.7 percent and the market risk premium is 6.85 percent.What is the expected rate of return on Martin Industries stock?

A)10.69%
B)6.91%
C)16.42%
D)14.46%
E)10.19%%

Question 65

Securities with zero or negative correlations are desired by many investors for their portfolio holdings.How might you go about identifying such securities?

Question 66

A portfolio consists of two stocks with Stock A having a weight of 64 percent.Stock A has a standard deviation of 21.22 percent.Stock B has a standard deviation of 16.44 percent.The stocks have a covariance of -.027.What is the portfolio variance?

A).0012
B).0095
C).0049
D).0190
E).0344

Question 67

A portfolio contains four assets.Asset 1 has a beta of .7 and represents 35 percent of the portfolio.Asset 2 has a beta of 1.3 and represents 20 percent of the portfolio.Asset 3 has a beta of 1.1 and is 25 percent of the portfolio.Asset 4 has a beta of 2.16.What is the portfolio beta?

A)1.212
B)1.264
C)1.308
D)1.480
E)1.642

Question 68

The variance of Stock A is .015376,the variance of Stock B is .028561,and the covariance between the two is .0024.What is the correlation coefficient?

A).9284
B).1542
C).5465
D).1145
E).0910

Question 69

There is a 5 percent probability the economy will boom,an 85 percent probability it will be normal,and a 10 percent probability it will be recessionary.For these economic states,Stock A has deviations from its expected returns of .06,.01,and -.08,respectively.Stock B has deviations from its expected returns of .06,.00,and -.05,for the three economic states,respectively.What is the covariance of the two stocks?

A).00058
B).00143
C).00189
D).00074
E).00102

Question 70

There is a 10 percent probability the economy will boom,a 65 percent probability it will be normal,and a 25 percent probability it will be recessionary.For these economic states,Stock A has deviations from its expected returns of .07,.02,and -.12,respectively.Stock B has deviations from its expected returns of .05,.01,and -.04,for the three economic states,respectively.What is the covariance of the two stocks?

A).02049
B).02143
C).00168
D).00116
E).01054

Question 71

Why are some risks diversifiable and some nondiversifiable? Give an example of each.

Question 72

A portfolio is invested 60 percent in one stock and 40 percent in one bond.The bond has an expected return of 7.25 percent.What is the expected rate of return on the stock if the portfolio expected return is 10.40 percent?

A)6.45%
B)9.60%
C)12.50%
D)14.22%
E)10.68%

Question 73

Stock A has a beta of .92 and an expected return of 9.04 percent.Stock B has a beta of 1.04 and an expected return of 9.51 percent.Stock C has a beta of 1.36 and an expected return of 11.68 percent.The risk-free rate is 3 percent and the market risk premium is 6.5 percent.Which of these stocks are underpriced?

A)A only
B)C only
C)A and B only
D)B and C only
E)A and C only

Question 74

A portfolio contains two assets.The first asset represents 25 percent of the portfolio and has a beta of 1.4.If the portfolio beta is 1.25,what is the beta of the second asset?

A)1.10
B)1.36
C)1.20
D)1.40
E)1.27

Question 75

According to the CAPM,the expected return on a risky asset depends on three components.Describe each component,and explain its role in determining expected return.

Question 76

Which one of the following stocks,if any,is correctly priced according to CAPM if the risk-free rate of return is 6.5 percent and the market rate of return is 10.5 percent? Stock A with a beta of .85 and an expected return of 9.22 percent;Stock B with a beta of 1.08 and an expected return of 11.90 percent;Stock C with a beta of 1.69 and an expected return of 15.38 percent;Stock D with a beta of 1.45 and an expected return of 12.30 percent.

A)Stock A
B)Stock B
C)Stock C
D)Stock D
E)None of the stocks are correctly priced according to CAPM.

Question 77

BBG stock has a beta of .86 and an expected return of 9.51 percent.The risk-free rate of return is 3.26 percent and the market rate of return is 11.14 percent.Which one of the following statements is true given this information?

A)BBG stock is correctly priced.
B)The return on BBG stock will graph below the security market line.
C)The expected return on BBG stock based on the capital asset pricing model is 9.88 percent.
D)BBG stock has more systematic risk than the overall market.
E)BBG stock is underpriced.

Question 78

The variance of Stock A is .003969,the variance of Stock B is .007056,and the covariance between the two is .0026.What is the correlation coefficient?

A).9284
B).8542
C).5010
D).4913
E).3510