Question 1

Which of the following statements is CORRECT?
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 is equal to the risk-free rate plus the market risk premium adjusted for the asset's beta. Therefore, if the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, 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. This is because stocks with betas less than 1.0 are less sensitive to market movements and require a higher risk premium to compensate for the increase in the risk-free rate.

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 constant?
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 answer of Stock A has a beta of 0.7,...

Question 3

Which of the following statements is CORRECT?
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. This is based on the Capital Asset Pricing Model (CAPM), where the market risk premium is the slope of the line that plots the expected return of assets against their betas (systematic risk).

Question 4

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect being that the overall required return on the market, rM, remains constant Which of the following statements is CORRECT?
A) The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0.
B) Since the overall return on the market stays constant, the required return on each individual stock will also remain constant.
C) The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
D) The required return of all stocks will fall by the amount of the decline in the market risk premium.
E) The required return of all stocks will increase by the amount of the increase in the risk-free rate.

Accepted Answer

The overall required return on the market is composed of the risk-free rate plus the market risk premium, so if the risk-free rate increases but the market risk premium declines, then the impact on the overall required return on the market is uncertain. However, the CAPM equation tells us that the required return on a stock is equal to the risk-free rate plus the stock's beta multiplied by the market risk premium. If the overall required return on the market remains constant, then a decline in the market risk premium will be offset by an increase in the risk-free rate. This means that the required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. This is because low beta stocks are less sensitive to market movements and investors will demand a higher return to compensate for the increase in the risk-free rate, while high beta stocks are more sensitive to market movements and investors will be willing to accept a lower return as the market risk premium declines.

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 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 a stock with beta < 1.0 will decline, as investors are demanding less compensation for taking on market risk. This is because stocks with a beta less than 1 are considered less volatile than the overall market, and investors are therefore willing to accept a lower return for holding these stocks. The required return on a stock with beta > 1.0 will increase, as investors will demand more compensation for taking on the additional market risk. The return on "the market" may or may not change, depending on the extent of the decline in the market risk premium. The required return on a stock with beta = 1.0 will also increase, as this is considered the market risk and investors will demand more compensation for this level of risk.

Question 6

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 question, both expected inflation and the market risk premium have declined, which should result in a decline in required returns for all stocks. However, since all stocks have positive betas, the required return will still be higher than the risk-free rate. Stocks with higher betas are more sensitive to market risk, and their required returns will fall by a greater amount than stocks with lower betas. Therefore, the most likely scenario is that the required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas (Option A).

Question 7

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 for a stock is equal to the risk-free rate plus the stock's beta multiplied by the market risk premium (rRF + beta(rM - rRF)). Since Stock HB has a higher beta, it 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 will increase by a greater amount than that on Stock LB.

Question 8

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) 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

Beta measures a stock's volatility relative to the overall market. A higher beta (Stock Y) indicates more volatility and sensitivity to market movements, including changes in the market risk premium. If the market risk premium declines, both stocks' required returns decrease, but the decrease is more significant for Stock Y due to its higher beta.

Question 9

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 required return for Stock A is calculated using the CAPM formula: rA = rRF + betaA * (rM - rRF). If Stock A's required return is 11%, then 11% = 6% + 1.0 * (rM - rRF), which implies the market risk premium is 5%.

Question 10

Which of the following statements is CORRECT?
A) The slope of the Security Market Line is beta.
B) Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive.
C) If a stock's beta doubles, its required rate of return must also double.
D) If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.
E) If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.

Accepted Answer

A stock's beta measures its sensitivity to market movements. If a stock's returns are negatively correlated with the market, it will have a negative beta.

Question 11

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

If the risk-free rate increases while the market risk premium remains constant, the required return on an average stock will increase because the risk-free rate is a component of the required return calculation.

Question 12

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) 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 Capital Asset Pricing Model (CAPM), the required return on a stock or portfolio is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. Therefore, the required return on an index fund with beta = 1.0 would be 6% + (5% x 1.0) = 11%. Therefore, option E is correct. Option A is incorrect because a negative beta does not necessarily mean that the required return is negative, as the stock can still have unsystematic risk. Option B is incorrect because a beta of 1.0 means that the stock has the same risk as the market, and therefore, it should have a required return equal to the market return, not less than 11%. Option C is incorrect because a doubling of the beta does not lead to a doubling of the required return, but rather to an increase proportional to the market risk premium.

Question 13

Portfolio P has equal amounts invested in each of the three stocks, A, B, and CStock 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 CORRECT?
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 returns on each stock can be determined using the capital asset pricing model (CAPM):
Required Return = Risk-Free Rate + (Market Risk Premium × Beta)

Assuming that the risk-free rate remains unchanged, the required return on each stock will increase by the amount of the increase in the market risk premium. However, since the betas of the stocks are different, the required return on each stock will increase by a different amount.

Stock A has the lowest beta, so its required return will increase by less than the increase in the market risk premium. Stock C has the highest beta, so its required return will increase by more than the increase in the market risk premium. Therefore, choice A is correct.

Question 14

Which of the following statements is CORRECT?
A) 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.
B) 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.
C) If investors become less risk averse, the slope of the Security Market Line will increase.
D) 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.
E) The slope of the SML is determined by the value of beta.

Accepted Answer

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

Question 15

Suppose that Federal Reserve actions have caused an increase in the risk-free rate, rRFMeanwhile, investors are afraid of a recession, so the market risk premium, (rM - rRF), has increased Under these conditions, with other things held constant, which of the following statements is most correct?
A) The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0.
B) Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices.
C) The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
D) The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.
E) The required return on all stocks would increase by the same amount.

Accepted Answer

The increase in the risk-free rate and the market risk premium would raise the required return on all stocks, leading to a decline in stock prices. High-beta stocks would experience a greater decline because they are more sensitive to changes in the market risk premium.

Question 16

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 for 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. However, since Stock B has a higher beta (1.2) compared to Stock A (0.8), the increase in required return will be greater for Stock B.

Question 17

Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock BStock 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 CORRECT? (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

Portfolio P's beta is the weighted average of the betas of Stock A and Stock B. Since both stocks have equal weight in the portfolio and their betas are 1.2 and 0.8 respectively, the portfolio's beta is (1.2+0.8)/2 = 1.0.

Question 18

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

The Capital Asset Pricing Model (CAPM) formula is $R_i = R_f + \beta_i(E[R_m] - R_f)$, where $R_i$ is the expected return of the investment, $R_f$ is the risk-free rate, $\beta_i$ is the beta of the investment, and $E[R_m]$ is the expected return of the market. A negative beta implies that the investment moves in the opposite direction of the market. Therefore, if a stock has a negative beta, its required return under the CAPM would indeed be less than the risk-free rate of 5%, assuming the expected market return is greater than the risk-free rate. This is because the formula would involve subtracting a positive value (since $\beta_i$ is negative and $E[R_m] - R_f$ is positive) from the risk-free rate, leading to a required return less than 5%.

Question 19

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 indeed equal to the market risk premium, which is the difference between the expected market return (rM) and the risk-free rate (rRF).

Question 20

would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse?
A) The x-axis intercept would decline, and the slope would increase.
B) The y-axis intercept would increase, and the slope would decline.
C) The SML would be affected only if betas changed.
D) Both the y-axis intercept and the slope would increase, leading to higher required returns.
E) The y-axis intercept would decline, and the slope would increase.

Accepted Answer

A decrease in expected inflation rate would lead to a decrease in the required return for all investments, causing the SML to shift downward and the y-axis intercept to decline. An increase in investors' risk aversion would cause the slope of the SML to increase, reflecting the higher return required for a given level of risk. Therefore, the y-axis intercept would decline, and the slope would increase.

Quiz 2: Risk and Return: Part I

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?

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF) , declines, with the net effect being that the overall required return on the market, rM, remains constant 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?

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?

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?

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

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?

Which of the following statements is CORRECT?

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?

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?

Which of the following statements is CORRECT?

Suppose that Federal Reserve actions have caused an increase in the risk-free rate, rRFMeanwhile, investors are afraid of a recession, so the market risk premium, (rM - rRF) , has increased Under these conditions, with other things held constant, which of the following statements is most 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?

Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock BStock 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 CORRECT? (Assume that the stocks are in equilibrium.)

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

Which of the following statements is CORRECT?

would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse?