Question 1

In historical data, we see 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 lastσ
A) large-company stocks, small-company stocks, long-term corporate bonds, u.s. treasury bills, long-term government bonds.
B) small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, u.s. treasury bills.
C) u.s. treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks.
D) large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, u.s. treasury bills.
E) small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, u.s. treasury bills.

Accepted Answer

The answer of In historical data, we see that investments...

Question 2

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 constantσ
A) the required return on both stocks would increase by 1%.
B) the required return on portfolio p would remain unchanged.
C) the required return on stock a would increase by more than 1%, while the return on stock b would increase by less than 1%.
D) the required return for stock a would fall, but the required return for stock b would increase.
E) the required return on portfolio p would increase by 1%.

Accepted Answer

The required return on a portfolio is the weighted average of the required returns on the individual assets in the portfolio, with the weights being the proportions of the portfolio invested in each asset. In this case, the portfolio is invested 50% in Stock A and 50% in Stock B, so the required return on the portfolio is the average of the required returns on Stocks A and B. If the market risk premium increases by 1% but the risk-free rate remains constant, then the required return on both Stocks A and B will increase by 1%. This is because the market risk premium is the difference between the expected return on the market and the risk-free rate, and if the market risk premium increases, then the expected return on the market must also increase. Since the required return on a stock is the sum of the risk-free rate and the market risk premium times the stock's beta, if the market risk premium increases, then the required return on the stock will also increase. Therefore, the required return on portfolio P will also increase by 1%.

Question 3

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

Accepted Answer

A negative beta indicates that the stock moves inversely to the market, suggesting a required return lower than the risk-free rate of 5% under the CAPM.

Question 4

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

Accepted Answer

According to the CAPM model, the required return on a security is equal to the risk-free rate plus the market risk premium multiplied by the security's beta. Therefore, for an index fund with a beta of 1.0, its required return would be:
6% + (1.0 x 5%) = 11%
Therefore, the correct statement is that an index fund with beta = 1.0 should have a required return of 11%.

Question 5

Portfolio P has equal amounts invested in each of the three stocks, A, B, and C. 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. 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 CORRECTσ
A) 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.
B) 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.
C) the required returns on all three stocks will increase by the amount of the increase in the market risk premium.
D) 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.
E) the required return of all stocks will remain unchanged since there was no change in their betas.

Accepted Answer

The required return on a stock is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. When the market risk premium increases, the required returns on all stocks will increase. However, the increase will be greater for stocks with higher betas. Therefore, 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. The required return on the average stock will not necessarily remain unchanged since it depends on the weights of each stock in Portfolio P.

Question 6

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

Accepted Answer

The slope of the security market line (SML) is equal to the market risk premium, which is the difference between the expected market return (rm) and the risk-free rate (rrf).

Question 7

You have a portfolio P that consists of 50% Stock X and 50% Stock Y. 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. Given this information, which of the following statements is CORRECT?
A) the required return on portfolio p is equal to the market risk premium (rm- rrf).
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, rrf.
D) portfolio p has the same required return as the market (rm).
E) portfolio p has a standard deviation of 20%.

Accepted Answer

The answer of You have a portfolio P that consists...

Question 8

Which of the following statements is CORRECTσ (Assume that the risk-free rate is a constant.)
A) the effect of a change in the market risk premium depends on the slope of the yield curve.
B) if the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
C) 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.
D) the effect of a change in the market risk premium depends on the level of the risk-free rate.
E) 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.

Accepted Answer

The required return on a stock is calculated using the Capital Asset Pricing Model (CAPM), which is: Required Return = Risk-Free Rate + Beta * Market Risk Premium. If the market risk premium increases by 1%, the required return will increase by 1% for a stock with a beta of 1.0.

Question 9

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) stock b's required rate of return is twice that of stock a.
B) if stock a's required return is 11%, then the market risk premium is 5%.
C) if stock b's required return is 11%, then the market risk premium is 5%.
D) 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.
E) 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.

Accepted Answer

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

Question 10

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 decrease by the same amount for both stock a and stock b.
B) the required return would increase for stock a but decrease for stock b.
C) the required return on portfolio p would remain unchanged.
D) the required return would increase for stock b but decrease for stock a.
E) the required return would increase for both stocks but the increase would be greater for stock b than for stock a.

Accepted Answer

The required return on a stock is calculated using the Capital Asset Pricing Model (CAPM): r = rRF + beta * (rM - rRF). An increase in the market risk premium (rM - rRF) will increase the required return for both stocks, but the increase will be greater for Stock B because it has a higher beta (1.2) compared to Stock A (0.8).

Question 11

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 fall has been greater for stocks with higher betas.
B) 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.
C) required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.
D) the required returns on all stocks have fallen by the same amount.
E) the required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.

Accepted Answer

According to the CAPM, the required return on a stock is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. If both expected inflation and the market risk premium have declined, this would lead to a decline in the required returns on all stocks. However, since all stocks have positive betas, the fall in required returns would be greater for stocks with higher betas (more systematic risk) because they are more sensitive to changes in the market risk premium. Thus, choice A is the best answer.

Question 12

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

Accepted Answer

The slope of the security market line (SML) represents the market risk premium, which is the additional return expected from holding a risky market portfolio instead of risk-free assets.

Question 13

Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?
A) 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.
B) if both expected inflation and the market risk premium (rm - rrf) increase, the required returns of both stocks will increase by the same amount.
C) since the market is in equilibrium, the required returns of the two stocks should be the same.
D) 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.
E) 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.

Accepted Answer

The required return on a stock is influenced by its beta. A higher beta means the stock is more sensitive to changes in the market risk premium. Therefore, if both expected inflation and the market risk premium increase, the required return on Stock HB (with a higher beta of 1.5) will increase more than that on Stock LB (with a lower beta of 0.5).

Question 14

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

Accepted Answer

When the market risk premium declines, the required return on stocks will also decline. Since stocks with beta < 1.0 are less risky than the market, the decline in the market risk premium will have a greater impact on their required return, causing it to decline. Therefore, the required return on stocks with beta < 1.0 will decline. The required return on a stock with beta > 1.0 will increase because they are riskier than the market and need to compensate investors for taking on more risk. The return on "the market" will remain constant because it represents an average of all stocks and does not change based on changes in the market risk premium. The required return on a stock with beta = 1.0 will also decline, but the decline will be smaller than the decline for stocks with beta < 1.0.

Question 15

Suppose that during the coming year, the risk free rate, rRF, is expected to remain the same, while the market risk premium (rM - rRF), is expected to fall. Given this forecast, which of the following statements is CORRECT?
A) the required return on all stocks will remain unchanged.
B) the required return will fall for all stocks, but it will fall more for stocks with higher betas.
C) the required return for all stocks will fall by the same amount.
D) the required return will fall for all stocks, but it will fall less for stocks with higher betas.
E) 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.

Accepted Answer

The required return on a stock is calculated using the Capital Asset Pricing Model (CAPM): r = rRF + β(rM - rRF). If the market risk premium (rM - rRF) falls, the required return will decrease for all stocks. However, stocks with higher betas will experience a larger decrease in required return because the change in the market risk premium is multiplied by the beta.

Question 16

Which of the following statements is CORRECTσ
A) 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.
B) if a company's beta were cut in half, then its required rate of return would also be halved.
C) 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.
D) 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.
E) if a company's beta doubles, then its required rate of return will also double.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the required rate of return on an asset equals the risk-free rate plus a premium for bearing market risk (market risk premium) multiplied by the asset's beta. Therefore, if the risk-free rate increases while the market risk premium declines by the same amount, the required rate of return on an average stock will remain unchanged as there will be an offsetting effect. However, stocks with lower betas will experience an increase in required returns while stocks with higher betas will experience a decrease in required returns. Therefore, statement D is the correct option.

Question 17

Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. 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%. Which of the following statements is CORRECTσ (Assume that the stocks are in equilibrium.)
A) stock b has a higher required rate of return than stock a.
B) portfolio p has a standard deviation of 22.5%.
C) more information is needed to determine the portfolio's beta.
D) portfolio p has a beta of 1.0.
E) stock a's returns are less highly correlated with the returns on most other stocks than are b's returns.

Accepted Answer

The portfolio beta is the weighted average of the individual betas: (0.5 * 1.2) + (0.5 * 0.8) = 1.0.

Question 18

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, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $300,000 invested in Stock A and $100,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECTσ
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.
E) portfolio ab's standard deviation is 17.5%.

Accepted Answer

Stock A's expected return is higher than Stock B's, but both have the same beta. According to CAPM, stocks with the same beta should have the same expected return if they are in equilibrium. Therefore, if Stock A is correctly valued, Stock B is overvalued.

Question 19

Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECTσ
A) stock y must have a higher expected return and a higher standard deviation than stock x.
B) if expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount.
C) 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.
D) 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.
E) 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.

Accepted Answer

The required return on both stocks is determined by the risk-free rate, the market risk premium, and the stock's beta. However, the beta of stock Y is higher than that of stock X, which means stock Y is riskier than stock X. Therefore, according to the CAPM model, stock Y should have a higher required return than stock X.

Option A is incorrect because the expected return and standard deviation are not solely determined by beta but also by other factors such as the risk-free rate and the market risk premium.

Option B is incorrect because an increase in expected inflation will increase the required return on both stocks as investors demand higher returns to compensate for the higher inflation risk.

Option D is incorrect because a decrease in expected inflation will lower the required return on both stocks as investors demand less compensation for the lower inflation risk.

Option E is irrelevant as it does not relate to the statement about beta and required return.

Question 20

Dixon Food's stock has a beta of 1.4, while Clark Café's 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 market risk premium increases but the risk-free rate remains unchanged, dixon's required return will increase because it has a beta greater than 1.0 but clark's required return will decline because it has a beta less than 1.0.
B) since dixon's beta is twice that of clark's, its required rate of return will also be twice that of clark's.
C) if the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.
D) if the market risk premium decreases but the risk-free rate remains unchanged, dixon's required return will decrease because it has a beta greater than 1.0 and clark's will also decrease, but by more than dixon's because it has a beta less than 1.0.
E) 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 dixon since it has a higher beta.

Accepted Answer

The required return on an average stock is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. Therefore, an increase in the risk-free rate will cause the required return on all stocks to increase, holding everything else constant. The other statements are either incorrect or incomplete.

Quiz 2: Risk and Return-Part I

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 constantσ

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

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

Which of the following statements is CORRECT?

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

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?

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?

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 CORRECTσ

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

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

Suppose that during the coming year, the risk free rate, rRF, is expected to remain the same, while the market risk premium (rM - rRF) , is expected to fall. Given this forecast, which of the following statements is CORRECT?

Which of the following statements is CORRECTσ

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

Dixon Food's stock has a beta of 1.4, while Clark Café's 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?