Question 1

The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

Accepted Answer

The Y-axis intercept of the Security Market Line (SML) indicates the risk-free rate, which is the return expected from an asset with zero market risk, not the return on an individual asset when the realized return on an average stock is zero.

Question 2

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

Accepted Answer

The slope of the Security Market Line (SML) is determined by the market risk premium, not by the value of beta. Beta measures the sensitivity of a security's returns to the returns of the market, but the slope of the SML is the difference between the expected return on the market portfolio and the risk-free rate, which represents the market risk premium.

Question 3

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.

Accepted Answer

When investors hold only one stock, they are more vulnerable to the risks associated with that stock, so they require a higher rate of return to compensate. However, in a portfolio, the low standard deviation stock could provide diversification benefits that lower the overall risk of the portfolio, allowing investors to accept a lower required rate of return. Therefore, it is possible that the required return could be higher on the low standard deviation stock when held in a portfolio.

Question 4

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

Accepted Answer

The slope of the SML is determined by the market risk premium, which is not directly influenced by managerial actions of individual firms. The SML reflects the relationship between systematic risk and expected return for all assets in the market, not the influence of individual firm actions.

Question 5

Which of the following is NOT a potential problem with beta and its estimation?

Accepted Answer

The beta of "the market" is typically considered to be 1 and does not change over time, as it represents the overall market risk.

Question 6

We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

Accepted Answer

The beta of a diversified portfolio is generally more stable over time than the beta of a single security because diversification reduces the impact of individual security volatility on the portfolio.

Question 7

A stock with a beta equal to -1.0 has zero systematic (or market) risk.

Accepted Answer

A stock with a beta of -1.0 is perfectly negatively correlated with the market, meaning it moves in the opposite direction of the market but still has systematic risk, as its performance is related to market movements.

Question 8

Which of the following statements is CORRECT?

Accepted Answer

The slope of the Capital Market Line (CML) is calculated as (M - rRF)/σM, where M is the expected return of the market portfolio, rRF is the risk-free rate, and σM is the standard deviation of the market portfolio.

Question 9

Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

Accepted Answer

Arbitrage Pricing Theory (APT) posits that multiple factors affect stock returns, but it does not specify which factors; instead, it allows for various economic, financial, and firm-specific factors beyond just market returns, dividend yields, and changes in inflation.

Question 10

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Accepted Answer

The answer of If the returns of two firms are...

Question 11

The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

Accepted Answer

The Capital Asset Pricing Model (CAPM) is a single-period model that does not account for differences in securities' maturities. It is used to determine the required rate of return for a security based on its level of systematic risk, without considering the maturity of the security.

Question 12

You have the following data on three stocks:As a risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.

Accepted Answer

The answer of You have the following data on three...

Question 13

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

Accepted Answer

The answer of Stock A's beta is 1.5 and Stock...

Question 14

In a portfolio of three different stocks, which of the following could NOT be true?

Accepted Answer

The answer of In a portfolio of three different stocks,...

Question 15

If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck's stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

Accepted Answer

The answer of If you plotted the returns of Selleck...

Question 16

Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

Accepted Answer

The answer of Which is the best measure of risk...

Question 17

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative.

Accepted Answer

Beta measures the sensitivity of a stock's returns to the overall market. It is possible for a firm to have a positive beta, meaning its returns move in the same direction as the overall market, even if its returns have a negative correlation with those of another firm.

Question 18

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

Accepted Answer

We use historical returns and standard deviations in portfolio analysis to estimate future expected returns and risks. While ex ante data would be ideal, it is not available as we cannot predict the future with certainty.

Question 19

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Accepted Answer

The answer of You have the following data on (1)...

Question 20

For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels),

Accepted Answer

Equilibrium occurs when there is no pressure for prices to change, which means that expected rate of return (what investors believe they will earn) must be equal to the required rate of return (the minimum return investors demand for their investment). If the expected rate of return is higher than the required rate of return, demand for the asset will increase, driving up the price; conversely, if the expected rate of return is lower, demand will decrease, driving down the price. Therefore, for markets to be in equilibrium, the expected rate of return and the required rate of return must align.

Quiz 24: Portfolio Theory, Asset Pricing Models, and Behavioral Finance