Question 1

Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

Accepted Answer

The answer of Under the CAPM, the required rate of...

Question 2

you plotted the returns of a 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 the 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

In the CAPM, a negative beta (slope) implies that the stock moves inversely to the market. For a well-diversified investor, this would suggest a required return less than the risk-free rate, as the stock provides a hedge against market movements.

Question 3

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

Accepted Answer

Beta measures the volatility of a stock in relation to the market. A firm can have a positive beta if its volatility is higher than the market average, even if its returns are negatively correlated with another firm.

Question 4

you plotted the returns on a given stock against those of the market, and if 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 greater than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.

Accepted Answer

If the slope of the regression line is negative, it means that the stock's returns move in the opposite direction of the market's returns. According to the CAPM, the required rate of return for a well-diversified investor on a stock is determined by the beta coefficient, which measures the systematic risk of the stock, not the slope of the regression line. Therefore, a negative slope does not necessarily imply that the required rate of return on the stock should be greater than the risk-free rate.

Question 5

change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

Accepted Answer

This is true because the required rate of return is calculated using the Capital Asset Pricing Model (CAPM), which takes into account the stock's beta. An increase in beta will increase the required rate of return, which will lower the stock's price, and vice versa.

Question 6

portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

Accepted Answer

A portfolio's risk is not measured by the weighted average of the standard deviations of the securities; it is measured by the portfolio's standard deviation, which considers both the individual risks and the correlations between the securities.

Question 7

slope of the SML is determined by investors' aversion to risk The greater the average investor's risk aversion, the steeper the SML.

Accepted Answer

The slope of the SML is determined by the capital asset pricing model (CAPM), which takes into account the risk-free rate, expected market return, and the beta of the security being analyzed. However, the level of risk aversion among investors can influence the positioning of the security on the SML and therefore impact its return.

Question 8

would 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.

Question 9

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 the beta. Beta measures the risk of an individual security relative to the market.

Question 10

managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

Accepted Answer

Company-specific events are unique to a particular firm and can be diversified away through proper portfolio diversification, reducing investment risk.

Question 11

if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.

Accepted Answer

If the correlation is +1.0, the securities move perfectly together, and combining them will not reduce risk. The portfolio risk will be a weighted average of the individual risks, not less than either.

Question 12

firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

Accepted Answer

A firm's beta is affected by various factors including managerial decisions related to capital budgeting and capital structure. For example, increasing debt financing can increase a firm's beta as it increases the financial leverage, while investing in less-risky projects can decrease a firm's beta.

Question 13

CAPM is built on historic conditions, although in most cases we use expected future data in applying it Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility This is one of the strengths of the CAPM.

Accepted Answer

The statement is incorrect. Betas used in the CAPM are calculated using historic data and are subject to changes in future volatility.

Question 14

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

Accepted Answer

If the returns of two firms are negatively correlated, it means that when the return of one firm increases, the return of the other firm tends to decrease. This suggests that the two firms are in different industries or have different business models, and their returns are not driven by the same factors. In such a case, it is possible for one of the firms to have a negative beta, which means that its returns tend to move in the opposite direction of the market.

Question 15

would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

Accepted Answer

The beta of a single security is typically more volatile and subject to fluctuations over time compared to the beta of a well-diversified portfolio. This is because the diversification of the portfolio reduces the impact of idiosyncratic or company-specific risks, making the overall risk and beta of the portfolio more stable over time.

Question 16

an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.

Accepted Answer

Diversification can eliminate diversifiable risk (unsystematic risk), but it cannot eliminate market risk (systematic risk), which affects all stocks.

Question 17

Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value Because of its diversification, Portfolio B will by definition be riskless.

Accepted Answer

While Portfolio B may have less risk than Portfolio A due to its diversification, it is not riskless. There are still market and systematic risks that cannot be eliminated through diversification.

Question 18

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.

Accepted Answer

A well-diversified portfolio reduces the overall risk by spreading it across different stocks and asset classes. Therefore, the individual stock's beta may not be as relevant since its risk contribution may be smaller in the context of a larger portfolio. In contrast, an investor who holds only one stock is taking on more concentrated risk, making the stock's beta a more important measure of risk.

Question 19

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.

Accepted Answer

Although diversification typically reduces risk, it is possible that the one security in Portfolio A is less volatile than some or all of the securities in Portfolio B. Therefore, Portfolio A could have less risk than Portfolio B even though it is not diversified.

Question 20

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

Accepted Answer

A stock with a beta of -1.0 has systematic risk, but it moves inversely to the market. It is negatively correlated with market movements, meaning it tends to rise when the market falls and vice versa.

Quiz 2: Risk and Return: Part I