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

Question 1

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.

Answer 1

True

Question 2

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.

Answer 2

False

Question 3

Efficient portfolio has the best risk and expected return combination for any given level of risk or return.

Answer 3

True

Question 4

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.

Question 5

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

Question 6

Standard deviation is a measure of market risk.

Question 7

Dollar return fails to consider the scale and timing of investments.

Question 8

One key conclusion of the Capital Asset Pricing Model is that the value 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.

Question 9

A payoff matrix shows the set of possible rates of return on an investment, along with their probabilities of occurrence, and the investment's expected rate of return is found by multiplying each outcome or "state" by its probability.

Question 10

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

Question 11

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

Question 12

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.

Question 13

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

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

Behavioural finance-mixing finance with psychology-tries to explain the occurrence and persistence of securities mispricing.

Question 16

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 17

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

Question 18

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 19

Diversification can reduce the riskiness of a portfolio of stocks.

Question 20

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

Question 21

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 22

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 23

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

Question 24

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.

Question 25

Since the market return represents the expected return on an average stock, that return has 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, which is required to compensate stock investors for assuming an average amount of risk.

Question 26

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

Question 27

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

Question 28

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

Question 29

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

Question 30

If any two assets are perfectly negatively correlated, an equal weighted portfolio of these two assets will result in a portfolio return of zero.

Question 31

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 (r_M - r_RF) 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 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

If you plotted the returns of 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 34

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

Question 35

Because of differences in the expected returns of 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 36

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.

Question 37

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

Question 38

Risk aversion is 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 lower-risk (and therefore lower-expected-return) securities than investors who have more tolerance for risk.

Question 39

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 40

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

Question 41

Diversification obtained within an indexed mutual fund can protect investors from losses during an economic downturn.

Question 42

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

A) bonds, stocks, foreign securities, derivatives, and real estate
B) bonds, stocks, foreign securities, and derivatives
C) bonds, stocks, and foreign securities
D) bonds and stocks

Question 43

Which statement about risk is true?

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) An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

Question 44

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

A) Stock B's required return is double that of Stock A's.
B) If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.
C) An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2.
D) If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B.

Question 45

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 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.

Question 46

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

Question 47

If an incorrect proxy market portfolio is used when developing the security market line, the slope of the line (i.e., beta) will tend to be overestimated.

Question 48

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

A) It is less stable.
B) It is more stable.
C) It is more consistent.
D) It is less consistent.

Question 49

A highly risk-averse investor is considering adding one additional stock to a three-stock portfolio, to form a four-stock portfolio. The three stocks currently held all have b = 1.0 and a perfect positive correlation with the market. Potential new Stocks A and B both have expected returns of 15%, and both 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 matter?

A) either A or B, i.e., the investor should be indifferent as to which of the two
B) Stock A
C) Stock B
D) neither A nor B, as neither has a return sufficient to compensate for risk

Question 50

Diversification among various types of investments (e.g., stocks, bonds, money market securities) provides more protection from economic uncertainty than a diversified portfolio based on holdings only within one of these investment groups.

Question 51

Any change in 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.

Question 52

Characteristic line is used to estimate the market risk with the best fit for a scatter diagram showing the rates of return of an individual risky asset and the market portfolio of risky assets over time.

Question 53

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

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 54

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?

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 55

The CAPM can be viewed as an APT model with one factor.

Question 56

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

Question 57

Which type of correlation will a completely diversified portfolio have with the market portfolio?

A) less than one, because it carries only market risk
B) less than one, because it carries only diversifiable risk
C) equal to one, because it carries only diversifiable risk
D) equal to one, because it carries only market risk

Question 58

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

Question 59

What happens to portfolios that cannot be dominated?

A) They lie on the efficient frontier.
B) They are minimum risk portfolios.
C) They have low correlations.
D) They have maximum expected returns.

Question 60

What happens to the amount of market risk as the number of assets in a portfolio increases?

A) It decreases.
B) It increases.
C) It remains constant.
D) It changes randomly.

Question 61

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, r_A,B = 0). Which of the following statements is correct?

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 62

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, r_XY, is zero. Which statement best describes the characteristics of your two-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%.

Question 63

Which of the following statements is correct?

A) 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.
B) If a stock has a negative beta, its expected return must be negative.
C) 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.
D) According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.

Question 64

Which of the following statements is correct?

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.
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 will be negatively correlated with returns on most other stocks in the market during that 5-year period.
C) Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
D) You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should rebalance your portfolio to include more high-beta stocks.

Question 65

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) Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio.
B) The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk.
C) Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios.
D) The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified.

Question 66

In the absence of a risk-free rate, what is the minimum variance portfolio?

A) It is always efficient.
B) It is never efficient.
C) It is usually efficient.
D) It is usually the optimal portfolio.

Question 67

Which of the following statements is correct?

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, r_RF.

Question 68

Bob has a $50,000 stock portfolio with a beta of 1.2, an expected 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 statement about their combined $100,000 portfolio is true?

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 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 69

What does portfolio effect mean in investment decisions?

A) the degree of correlation between various assets
B) the level of independence between asset returns
C) the relationship between assets and market movements
D) the risk-adjusted discount rates

Question 70

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

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

Question 71

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 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 72

Which of the following statements is correct?

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) Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio.
D) A security's beta measures its nondiversifiable, or market, risk relative to that of an average stock.

Question 73

Which of the following statements is correct?

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) Company-specific (or 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 one-stock portfolio if that one stock has a beta less than 1.0.
D) If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

Question 74

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 than Stock B.
B) In equilibrium, the expected return on Stock B will be greater than that on Stock A.
C) Stock B would be a more desirable addition to a portfolio than Stock A.
D) In equilibrium, the expected return on Stock A will be greater than that on Stock 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) The required return on Portfolio P is equal to the market risk premium (r_M - r_RF).
B) Portfolio P has a beta of 0.7.
C) Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, r_RF.
D) Portfolio P has the same required return as the market (r_M).

Question 76

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.

Question 77

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

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 78

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) Stock Y's return during the coming year will be higher than Stock X's return.
B) If expected inflation increases but the market risk premium is unchanged, the required returns on the two stocks will increase by the same amount.
C) Stock Y's return has a higher standard deviation than Stock X.
D) If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y.

Question 79

Which of the following statements is correct?

A) If a company with a high-beta stock merges with a low-beta company, the best estimate of the new merged company's beta is 1.0.
B) The beta of an "average stock," or "the market," can change over time, sometimes drastically.
C) If a newly issued stock does not have a past history that can be used as a basis 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.
D) 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 than the "true" or "expected future" beta.

Question 80

What is implied when an asset has a negative beta value?

A) It implies that the asset can't exist because negative beta assets are theoretically impossible.
B) It implies that the asset is a necessary component for achieving a fully diversified portfolio.
C) It implies that the asset is a risk-reducing property when added to a portfolio.
D) It implies that the asset has a higher expected return.