Exam 6: Risk, Return, and the Capital Asset Pricing Model

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.

Correct Answer

verified

Show Answer

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.
E) If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

Correct Answer

verified

Show Answer

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.

Correct Answer

verified

Show Answer

A) A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.
B) The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
C) If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations.
D) If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.
E) An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

A) The expected rate of return must be equal to the required rate of return; that is,= r.
B) The past realized rate of return must be equal to the expected future rate of return; that is,=.
C) The required rate of return must equal the past realized rate of return; that is, r =.
D) All three of the above statements must hold for equilibrium to exist; that is= r =.
E) None of the above statements is correct.

Correct Answer

verified

Show Answer

A) 10.36%
B) 10.62%
C) 10.88%
D) 11.15%
E) 11.43%

Correct Answer

verified

Show Answer

A) The slope of the SML is determined by the value of beta.
B) The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by its managers.
C) Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well diversified investor, assuming investors expect the observed relationship to continue on into the future.
D) If investors become less risk averse, the slope of the Security Market Line will increase.
E) If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock.

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

A) 8.76%
B) 8.98%
C) 9.21%
D) 9.44%
E) 9.68%

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

A) 9.43%
B) 9.67%
C) 9.92%
D) 10.17%
E) 10.42%

Correct Answer

verified

Show Answer

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.

Correct Answer

verified

Show Answer

A) 1.07
B) 1.13
C) 1.18
D) 1.24
E) 1.30

Correct Answer

verified

Show Answer

A) 9.41%
B) 9.65%
C) 9.90%
D) 10.15%
E) 10.40%

Correct Answer

verified

Show Answer