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

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Question 41

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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 equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero) . Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is correct?

A) The required return of all stocks will remain unchanged since there was no change in their betas.
B) The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium.
C) The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A)
Will decrease.
D) The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.

E) A) and C)
F) None of the above

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Question 42

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Which of the following 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

E) None of the above
F) A) and C)

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Question 43

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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?

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

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.

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

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.

Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is correct? (Assume that stocks are in equilibrium.)

Nile Foods' stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk- free rate, rRF, is 5.5% and the market risk premium, (rM - rRF) , equals 4%. Which of the following statements is correct?

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

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

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.

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

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.

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

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

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.

During the next year, the market risk premium, (rM - rRF) , is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is correct?

Hocking Manufacturing Company has a beta of 0.65, while Levine Industries has a beta of 1.40. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between Hocking's and Levine's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)

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.