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Over the past 84 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.

F) All of the above
G) B) and D)

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CCC Corp has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%. Now the required return on an average stock increases by 30.0% (not percentage points) . Neither betas nor the risk-free rate change. What would CCC's new required return be?


A) 14.89%
B) 15.68%
C) 16.50%
D) 17.33%
E) 18.19%

F) None of the above
G) B) and C)

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Tom Noel holds the following portfolio: Tom plans to sell Stock A and replace it with Stock E, which has a beta of 0.75. By how much will the portfolio beta change?


A) -0.190
B) -0.211
C) -0.234
D) -0.260
E) -0.286

F) A) and E)
G) B) and D)

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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.

A) True
B) False

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Which of the following statements is CORRECT?


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.

F) A) and B)
G) A) and C)

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

A) True
B) False

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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%.

F) A) and D)
G) A) and C)

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Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a -18% return. What is the firm's expected rate of return?


A) 7.72%
B) 8.12%
C) 8.55%
D) 9.00%
E) 9.50%

F) A) and E)
G) A) and D)

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Taggart Inc.'s stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a -28% return. What is the firm's expected rate of return?


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

F) A) and C)
G) A) and E)

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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.

A) True
B) False

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Assume that you manage a $10.00 million mutual fund that has a beta of 1.05 and a 9.50% required return. The risk-free rate is 4.20%. You now receive another $5.00 million, which you invest in stocks with an average beta of 0.65. What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.)


A) 8.83%
B) 9.05%
C) 9.27%
D) 9.51%
E) 9.74%

F) C) and D)
G) A) and D)

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

A) True
B) False

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Suppose you hold a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose you decided to sell one of your stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be?


A) 1.17
B) 1.23
C) 1.29
D) 1.36
E) 1.43

F) B) and E)
G) B) and C)

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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.

A) True
B) False

Correct Answer

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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.

F) A) and E)
G) A) and D)

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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.

A) True
B) False

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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 marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B.
E) 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.

F) A) and B)
G) All of the above

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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) 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.

F) A) and E)
G) B) and D)

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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.

A) True
B) False

Correct Answer

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Which of the following statements is CORRECT?


A) If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.
B) The slope of the Security Market Line is beta.
C) Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive.
D) If a stock's beta doubles, its required rate of return must also double.
E) If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.

F) B) and E)
G) C) and D)

Correct Answer

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