Question 1

What will happen to a stock that offers a lower return than predicted by the CAPM?

Accepted Answer

According to the CAPM, the expected return of a stock is proportional to its beta. If a stock offers a lower return than predicted by the CAPM, its market price will decrease causing its yield to increase. This means that investors will demand a higher return on their investment, resulting in a decrease in the stock's market price. Therefore, choice C is the correct answer.

Question 2

Investing borrowed funds in a stock portfolio will generally:

Accepted Answer

Investing borrowed funds in a stock portfolio will amplify the volatility of the portfolio, which means that the beta of the portfolio will increase. Beta measures the market risk of an asset or a portfolio. Therefore, option A is the correct answer. Choice B is incorrect because borrowing funds to invest in stocks can increase the volatility of the portfolio, not decrease. Choice C is incorrect because expected returns are determined by the market and investment strategy, not by whether funds are borrowed or not. Choice D is incorrect because investing borrowed funds in a stock portfolio does not affect the market risk premium.

Question 3

Calculate the risk premium on stock C given the following information: risk-free rate = 5%, market return = 13%, stock C beta = 1.3.

Accepted Answer

RP_C = 1.3(13% - 5) = 10.4%

Question 4

Which one of the following statements is more likely to be correct concerning the comment, "Stock A has a higher expected return than Stock B"?

Accepted Answer

The statement "Stock A has a higher expected return than Stock B" implies that Stock A is expected to have a higher return for the amount of risk taken. One commonly used measure of risk is beta, which measures a stock's sensitivity to market movements. Thus, Stock A likely has a higher beta than Stock B. None of the other options mentioned are necessarily related to the expected return of the stocks.

Question 5

If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio beta is:

Accepted Answer

β_Portfolio = .5 × 1.4 + .5 × 0.7 = 1.05

Question 6

Based on your analysis, you believe that Alpha stock which has a beta of 1.32 is going to yield 14.05% this coming year. The market is expected to yield 11.4% and T-bills are yielding 3.8%. According to CAPM, which one of these statements is correct given this information?

Accepted Answer

E(R) = 3.8% + 1.32(11.4% - 3.8) = 13.83%

Question 7

What return should be expected from investing in the market portfolio that is expected to yield 18% if the investment includes all of the investor's funds plus 100% of additional funds borrowed at the risk-free rate of 6%?

Accepted Answer

β_Portfolio = (2 × β_market) + (-1 × β_loan) = (2 × 1) + 0 = 2Expected return = 6% + 2(18% - 6) = 30%

Question 8

A stock's risk premium is equal to the:

Accepted Answer

The risk premium for a stock is the excess return that investors demand for bearing the risk of investing in that particular stock compared to investing in a risk-free asset. It can be calculated as the expected market risk premium times beta, where beta reflects the systematic risk of the stock. Therefore, choice D is the correct answer.

Question 9

A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the market rate of return is 10.6%?

Accepted Answer

E(R) = 13.53% = r_f + 1.4(10.6% - r_f); r_f = 3.275%

Question 10

If Treasury bills yield 6% and the market risk premium is 9%, then a stock with a beta of 1.5 would be expected to yield:

Accepted Answer

E(R) = 6% + 1.5(9%) = 19.5%

Question 11

A portfolio consists of an index mutual fund which represents the overall market and Treasury bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is 7.6%. What is your best estimate of the portfolio expected rate of return?

Accepted Answer

E(R)_Portfolio = (1 - 0.6)(3.2%) + (0.6)[3.2% + 1(7.6%)] = 7.76%

Question 12

What is the expected yield on the market portfolio at a time when Treasury bills yield 6% and a stock with a beta of 1.4 is expected to yield 18%?

Accepted Answer

18% = 6% + 1.4(r_m - 6%); r_m = 14.57%

Question 13

The slope of the security market line equals:

Accepted Answer

The slope of the security market line (SML) equals the market risk premium, which is the difference between the expected return on the market portfolio and the risk-free rate. This slope reflects the compensation investors require for taking on additional market risk.

Question 14

Why do stock market investors seem to ignore unique risks when calculating expected rates of return?

Accepted Answer

Stock market investors assume that unique risks can be diversified away by holding a diversified portfolio of stocks. Therefore, they do not specifically factor in the unique risks of individual stocks when calculating expected rates of return.

Question 15

What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is expected to yield 14% and Treasury bills offer 6%?

Accepted Answer

E(R) = 6% + 0.8(14% - 6) = 12.4%

Question 16

When Treasury bills yield 7% and the expected return on the market is 16%, then the risk premium on an asset is equal to:

Accepted Answer

The risk premium on an asset is calculated as the expected return on the market minus the risk-free rate, which in this case is 16% - 7% = 9%. However, the actual risk premium on an individual asset also depends on its beta, which measures the asset's volatility relative to the market. Therefore, the risk premium on an asset is 9% times the asset's beta.

Question 17

Which one of these statements is correct?

Accepted Answer

CAPM, or the Capital Asset Pricing Model, is a widely used method for valuing stock. A is incorrect because betas are estimates, not exact measurements. B is incorrect because betas can change over time, especially if there are significant changes in market conditions or the company's financial performance. C is incorrect because determining the expected future risk premium involves making predictions about future market conditions, which is inherently difficult and subject to errors.

Question 18

An investor was expecting a return of 14.7% on her portfolio with a beta of 1.13 before the market risk premium decreased from 8 to 7%. Based on this change, what return should she now expect on the portfolio?

Accepted Answer

E(R) = 14.7% + 1.13(7% - 8) = 13.57%

Question 19

What is the beta of a security with an expected return of 12% if Treasury bills yield 6% and the market risk premium is 8%?

Accepted Answer

E(R) = 12% = 6% + β(8%); β = 0.75

Question 20

An investor was expecting a return of 18% on his portfolio with a beta of 1.25 before the market risk premium increased from 8 to 10%. Based on this change, what return should he now expect on the portfolio?

Accepted Answer

E(R) = 18% + 1.25(10% - 8) = 20.5%

Quiz 12: Risk, Return, and Capital Budgeting