Question 1

Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?
A) If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase.
B) If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB.
C) If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount.
D) Since the market is in equilibrium, the required returns of the two stocks should be the same.
E) If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase.

Accepted Answer

Beta measures the systematic risk of a stock, which is the risk that cannot be diversified away. The required return on a stock is composed of the risk-free rate of return plus a premium for the systematic risk inherent in the stock. The premium is equal to the market risk premium multiplied by the stock's beta.

In this case, Stock HB has a beta of 1.5, which means it has more systematic risk than the market as a whole, while Stock LB has a beta of 0.5, which means it has less systematic risk than the market.

If both expected inflation and the market risk premium (rM − rRF) increase, the required return on both stocks will increase because the systematic risk of the market as a whole has increased. However, the increase in required return will be greater for Stock HB because it has a higher beta, meaning it is more sensitive to changes in the market risk premium. Therefore, statement B is correct.

On the other hand, if the market risk premium declines while expected inflation remains constant, the required return on Stock HB will decline because its beta is positive, but the required return on Stock LB will increase because its beta is positive. Therefore, statement E is incorrect.

Statement A is incorrect because if the market risk premium declines, the required return on both stocks should decline because both stocks are exposed to market risk in different degrees.

Statement C is incorrect because if the market risk premium and expected inflation increase, the required returns on both stocks should increase, but the increase should be greater for Stock HB, as explained in statement B.

Statement D is incorrect because the required returns on the two stocks are not necessarily equal in an equilibrium market.

Question 2

Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT?
A) An index fund with beta = 1.0 should have a required return of 11%.
B) If a stock has a negative beta, its required return must also be negative.
C) An index fund with beta = 1.0 should have a required return less than 11%.
D) If a stock's beta doubles, its required return must also double.
E) An index fund with beta = 1.0 should have a required return greater than 11%.

Accepted Answer

The answer of Assume that the risk-free rate is 6%...

Question 3

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
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.

Accepted Answer

Small-company stocks generally have the highest returns and highest risk, followed by large-company stocks, long-term corporate bonds, long-term government bonds, and U.S. Treasury bills, which have the lowest returns and risk.

Question 4

During the coming 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?
A) The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.
B) The required return on all stocks will remain unchanged.
C) The required return will fall for all stocks, but it will fall more for stocks with higher betas.
D) The required return for all stocks will fall by the same amount.
E) The required return will fall for all stocks, but it will fall less for stocks with higher betas.

Accepted Answer

The market risk premium is the difference between the expected return on the market and the risk-free rate. If the market risk premium is expected to fall, this means that investors will require a lower return to invest in risky assets such as stocks. However, the degree to which the required return will fall will depend on the stock's beta. Stocks with higher betas are considered more risky, so investors will still require a higher expected return compared to less risky stocks. Therefore, the required return will fall for all stocks, but it will fall more for stocks with higher betas.

Question 5

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?
A) The required return on a stock with beta = 1.0 will not change.
B) The required return on a stock with beta > 1.0 will increase.
C) The return on "the market" will remain constant.
D) The return on "the market" will increase.
E) The required return on a stock with a positive beta < 1.0 will decline.

Accepted Answer

The answer of Assume that the risk-free rate remains constant,...

Question 6

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 the stocks are in equilibrium.)
A) Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns.
B) Stock B has a higher required rate of return than Stock A.
C) Portfolio P has a standard deviation of 22.5%.
D) More information is needed to determine the portfolio's beta.
E) Portfolio P has a beta of 1.0.

Accepted Answer

The answer of Stock A has a beta of 1.2...

Question 7

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) Portfolio P has a standard deviation of 20%.
B) The required return on Portfolio P is equal to the market risk premium (rM − rRF).
C) Portfolio P has a beta of 0.7.
D) Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
E) Portfolio P has the same required return as the market (rM).

Accepted Answer

The answer of Stock X has a beta of 0.7...

Question 8

Which of the following statements is CORRECT?
A) Beta is measured by the slope of the security market line.
B) If the risk-free rate rises, then the market risk premium must also rise.
C) If a company's beta is halved, then its required return will also be halved.
D) If a company's beta doubles, then its required return will also double.
E) The slope of the security market line is equal to the market risk premium, (rM − rRF).

Accepted Answer

The statement that is correct is E) The slope of the security market line is equal to the market risk premium, (rM − rRF). The other statements are incorrect. A) Beta is not measured by the slope of the security market line, but rather is a measure of a stock's volatility in relation to the overall market. B) An increase in the risk-free rate does not necessarily mean that the market risk premium must rise as well. C) A halving of a company's beta does not result in a halving of its required return. D) Doubling a company's beta will result in a higher required return, but not necessarily a doubling of it.

Question 9

Nile Food's 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?
A) If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.
B) If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elba's required return will decline because it has a beta less than 1.0.
C) Since Nile's beta is twice that of Elba's, its required rate of return will also be twice that of Elba's.
D) If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.
E) If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elba's will also decrease, but by more than Nile's because it has a beta less than 1.0.

Accepted Answer

The answer of Nile Food's stock has a beta of...

Question 10

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT?
A) If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.
B) Stock B's required rate of return is twice that of Stock A.
C) If Stock A's required return is 11%, then the market risk premium is 5%.
D) If Stock B's required return is 11%, then the market risk premium is 5%.
E) If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.

Accepted Answer

The answer of The risk-free rate is 6%; Stock A...

Question 11

Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
A) If a stock has a negative beta, its required return under the CAPM would be less than 5%.
B) If a stock's beta doubled, its required return under the CAPM would also double.
C) If a stock's beta doubled, its required return under the CAPM would more than double.
D) If a stock's beta were 1.0, its required return under the CAPM would be 5%.
E) If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%.

Accepted Answer

The answer of Assume that the risk-free rate is 5%....

Question 12

Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?
A) The required return on Portfolio P would increase by 1%.
B) The required return on both stocks would increase by 1%.
C) The required return on Portfolio P would remain unchanged.
D) The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%.
E) The required return for Stock A would fall, but the required return for Stock B would increase.

Accepted Answer

The required return on Portfolio P would increase by 1%. This is because the portfolio beta is a weighted average of the betas of the two stocks, and the beta of Stock B is greater than 1 (indicating higher volatility/risk), while the beta of Stock A is less than 1 (indicating lower volatility/risk). As such, an increase in the market risk premium would have a greater impact on Stock B's required return than on Stock A's required return. Therefore, the overall required return on Portfolio P would increase.

Question 13

Which of the following statements is CORRECT?
A) If a company's beta doubles, then its required rate of return will also double.
B) Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase.
C) If a company's beta were cut in half, then its required rate of return would also be halved.
D) If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will increase.
E) If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 14

Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?
A) The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.
B) The required return would decrease by the same amount for both Stock A and Stock B.
C) The required return would increase for Stock A but decrease for Stock B.
D) The required return on Portfolio P would remain unchanged.
E) The required return would increase for Stock B but decrease for Stock A.

Accepted Answer

The answer of Stock A has a beta of 0.8...

Question 15

Which of the following statements is CORRECT?
A) The slope of the security market line is equal to the market risk premium.
B) Lower beta stocks have higher required returns.
C) A stock's beta indicates its diversifiable risk.
D) Diversifiable risk cannot be completely diversified away.
E) Two securities with the same stand-alone risk must have the same betas.

Accepted Answer

The security market line (SML) represents the relationship between expected return and systematic risk, as measured by beta. The slope of the SML is equal to the market risk premium, which is the additional return expected by investors for taking on one unit of systematic risk.

Question 16

Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?
A) A portfolio consisting of $50,000 invested in Stock X and $50,000 invested in Stock Y will have a required return that exceeds that of the overall market.
B) Stock Y must have a higher expected return and a higher standard deviation than Stock X.
C) If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount.
D) If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y.
E) If expected inflation declines but the market risk premium is unchanged, then the required return on both stocks will decrease but the decrease will be greater for Stock Y.

Accepted Answer

The answer of Stock X has a beta of 0.6,...

Question 17

Assume that in recent years both expected inflation and the market risk premium (rM − rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes?
A) The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.
B) The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.
C) The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0.
D) Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.
E) The required returns on all stocks have fallen by the same amount.

Accepted Answer

A decline in expected inflation and the market risk premium would lead to a decline in the required return on all stocks. However, since all stocks have positive betas, the required return on stocks with higher betas would have decreased by a greater amount, as they are more sensitive to changes in market risk. Therefore, the fall in required returns would be greater for stocks with higher betas, resulting in option B being the most likely outcome.

Question 18

Which of the following statements is CORRECT?
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.

Accepted Answer

The statement correctly reflects the inverse relationship between the slope of the regression line and the required rate of return on a stock according to the CAPM theory. The other statements are incorrect. A) The slope of the SML is determined by the market risk premium, not the value of beta. B) The position of a company on the SML is determined by its beta, not by the manager's decision. D) An increase in investors' risk aversion would result in a decline in the slope of the SML, not an increase. E) The slope of the SML is based on systematic risk, not the use of debt, which affects the beta of a stock.

Question 19

Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
A) If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.
B) The effect of a change in the market risk premium depends on the slope of the yield curve.
C) If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
D) If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
E) The effect of a change in the market risk premium depends on the level of the risk-free rate.

Accepted Answer

The answer of Which of the following statements is CORRECT?...

Question 20

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 returns on all three stocks will increase by the amount of the increase in the market risk premium.
E) The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.

Accepted Answer

The required return on each stock will increase by the market risk premium multiplied by its beta. As Stock A has a lower beta than the market, its required return will increase less than the increase in the market risk premium. Conversely, Stock C has a higher beta than the market, so its required return will increase more than the increase in the market risk premium. The required return for Stock B will increase by the market risk premium multiplied by its beta, so it will increase by an amount equal to the increase in the market risk premium. Choice A is incorrect because the required return of each stock will increase by a different amount, based on its beta. Choice C is incorrect because the returns of all three stocks will increase, but the returns of riskier stocks (such as Stock C) will increase more than the returns of safer stocks (such as Stock A). Choices D and E are incorrect because they make blanket statements that do not account for the differences in the betas of the three stocks.

Quiz 8: Risk and Return

Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?

Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT?

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

During the coming 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?

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?

Which of the following statements is CORRECT?

Nile Food's 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?

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT?

Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?

Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?

Which of the following statements is CORRECT?

Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?

Which of the following statements is CORRECT?

Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?

Assume that in recent years both expected inflation and the market risk premium (rM − rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)