Question 1

If the price of money (e.g.,interest rates and equity capital costs) increases due to an increase in anticipated inflation,the risk-free rate will also increase.If there is no change in investors' risk aversion,then the market risk premium (r_M - r_RF) will remain constant.Also,if there is no change in stocks' betas,then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.

Accepted Answer

This statement is correct based on the CAPM formula where the required rate of return on a stock is equal to the risk-free rate plus the market risk premium multiplied by the beta of the stock. If there is an increase in the risk-free rate, then the required rate of return on a stock will increase by the same amount. And if there is no change in the market risk premium or stocks' betas, then the market risk premium and required rate of return on each stock will remain constant.

Question 2

We will 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 can be affected by company-specific events and changes in market conditions, making it more volatile and less stable over time. On the other hand, the beta of a diversified portfolio is typically more stable as it is influenced by the overall market trends rather than specific company factors.

Question 3

Bad 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 can be diversified away through proper portfolio diversification, while systematic events affect the entire market and cannot be eliminated through diversification.

Question 4

A highly risk-averse investor is considering adding one additional stock to a three-stock portfolio,to form a four-stock portfolio.The three stocks currently held all have b = 1.0 and a perfect positive correlation with the market.Potential new Stocks A and B both have expected returns of 15%,and both are equally correlated with the market,with r = 0.75.However,Stock A's standard deviation of returns is 12% versus 8% for Stock B.Which stock should this investor add to his or her portfolio,or does the choice matter?

Accepted Answer

Given the investor's high risk aversion, they should prefer Stock B because it has a lower standard deviation of returns (8%) compared to Stock A (12%), indicating lower risk for the same expected return of 15%. Both stocks have the same correlation with the market, so the lower risk of Stock B makes it the preferable choice for a risk-averse investor.

Question 5

If 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 company-specific risk.

Accepted Answer

Diversification can help reduce company-specific risk (also known as unsystematic risk), but it cannot eliminate market risk (systematic risk), which affects all investments broadly.

Question 6

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

Accepted Answer

If the correlation between the returns on two securities is +1.0, combining them in any proportion will not reduce risk because their returns move perfectly in tandem, meaning the portfolio's risk is essentially the average of the individual securities' risks, not less.

Question 7

The CAPM can be viewed as an APT model with one factor.

Accepted Answer

The CAPM and the APT (Arbitrage Pricing Theory) are both asset pricing models used to determine the expected return on an asset. While the CAPM is a single-factor model that only considers the market return as the only factor affecting asset returns, the APT is a multi-factor model that considers multiple sources of systematic risk affecting asset returns, such as changes in interest rates or inflation. Therefore, the CAPM can be viewed as a simplified version of the APT, with only one factor, which is the market return.

Question 8

The 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 historical data, hence they are subject to changes in future volatility. This is considered one of the limitations of the CAPM.

Question 9

The distributions of rates of return for Companies AA and BB are given below:​ $\begin{array}{lcccc}
 \text { State of } & \text {Probability of } \
{\text { Economy }} & \text { State Occurring } & \text { A.A } & \text { B B } \
\hline \text { Boom } & 0.2 & 30 \% & -10 \% \
\text { Normal } & 0.6 & 10 \% & 5 \% \
\text { Recession } & 0.2 & -5 \% & 50 \%
\end{array}$ We can conclude from the above information that any rational risk-averse investor will add Security AA to a well-diversified portfolio over Security BB.

Accepted Answer

A rational risk-averse investor would consider both the expected return and the risk (variability) of returns. The information provided does not give enough detail about the investor's current portfolio diversification, risk tolerance, or how these securities correlate with the rest of the portfolio, making it impossible to conclude definitively that AA is preferred over BB without additional context.

Question 10

Diversification among various types of investments (e.g.,stocks,bonds,money market securities) provides more protection from economic uncertainty than a diversified portfolio based on holdings within only one of these investment groups.

Accepted Answer

Diversification among various types of investments is a key strategy to manage risk and provide more protection from economic uncertainty. Investing in a diversified portfolio across

Question 11

Diversification obtained within an indexed mutual fund can protect investors from losses during an economic downturn.

Accepted Answer

Diversification within an indexed mutual fund can reduce specific risks associated with individual investments, but it does not protect investors from market-wide losses during an economic downturn, as the fund's performance is tied to the performance of the index it tracks, which may decline during such periods.

Question 12

Diversifiable risk is an important factor in the arbitrage pricing model.

Accepted Answer

Diversifiable risk, by definition, can be eliminated through diversification, so the Arbitrage Pricing Theory (APT) focuses on non-diversifiable risk factors that affect all securities to some extent.

Question 13

Characteristic line is used to estimate the market risk with the best fit for a scatter diagram showing the rates of return of an individual risky asset and the market portfolio of risky assets over time.

Accepted Answer

This is correct. The characteristic line is a regression line that represents the linear relationship between an individual stock's returns and the returns of the market as a whole. By estimating the slope and intercept of this line, analysts can determine the stock's beta coefficient, which is a measure of its systematic risk (i.e., the risk associated with changes in the overall market).

Question 14

If an incorrect proxy market portfolio is used when developing the security market line,the slope of the line (i.e.,beta) will tend to be overestimated.

Accepted Answer

The slope of the security market line represents the market risk premium, not beta. Beta is a measure of a stock's volatility in relation to the market, and while the choice of a proxy market portfolio can affect the calculation of individual betas, it does not directly cause the slope of the security market line to be overestimated. The slope is determined by the risk-free rate and the market risk premium.

Question 15

If you plotted the returns of 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

A negative slope of the regression line between the returns of a stock and the market implies that the stock has a negative beta, which means it is negatively correlated with the market. The CAPM assumes that investors are risk-averse and that they are compensated for taking on systematic (market) risk. If a stock has a negative beta, it implies that the investor can reduce their overall risk by adding this stock to a diversified portfolio, and, therefore, they should expect a lower return than the risk-free rate. Thus, the required rate of return on the stock should be less than the risk-free rate, not greater.

Question 16

Since the market return represents the expected return on an average stock,that return has a certain amount of risk.As a result,there exists a market risk premium,which is the amount over and above the risk-free rate,which is required to compensate stock investors for assuming an average amount of risk.

Accepted Answer

This statement is true. The market return does have a certain amount of risk and therefore there exists a market risk premium to compensate investors for the risk they are taking on. The risk-free rate is the rate of return on an investment with no risk, typically the yield on a US Treasury bond.

Question 17

Which type of correlation will a completely diversified portfolio have with the market portfolio?

Accepted Answer

A completely diversified portfolio eliminates diversifiable risk and carries only market risk. Therefore, its returns move perfectly with the market, resulting in a correlation coefficient of one.

Question 18

A 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 actually reduce the riskiness of a portfolio.

Accepted Answer

A portfolio's risk is not measured by the weighted average of the standard deviations of the securities in the portfolio, but rather by the portfolio's overall variance or standard deviation, which takes into account the correlation between the returns of the securities in the portfolio. Diversification can reduce risk, but it's the correlation between the assets, not just their individual risks, that determines the portfolio's total risk.

Question 19

What is the effect on portfolio beta of a larger number of assets in a portfolio and a longer time period?

Accepted Answer

According to the diversification rule, a larger number of assets in a portfolio leads to lower portfolio beta and hence, a more stable portfolio. Similarly, a longer time period also leads to a more stable portfolio by reducing the impact of short-term fluctuations. Therefore, the combination of a larger number of assets in a portfolio and a longer time period results in a more stable portfolio beta.

Question 20

Assume that two investors each hold a portfolio,and that portfolio is their only asset.Investor A's portfolio has a beta of minus 2.0,while Investor B's portfolio has a beta of plus 2.0.Assuming that the unsystematic risks of the stocks in the two portfolios are the same,then the two investors face the same amount of risk.However,the holders of either portfolio could lower their risks,and by exactly the same amount,by adding some "normal" stocks with beta = 1.0.

Accepted Answer

The unsystematic risks of the stocks in the two portfolios are assumed to be the same, meaning that the only difference in risk between the two portfolios is the systematic risk (beta). Adding "normal" stocks with a beta of 1.0 would decrease the systematic risk of both portfolios by the same amount, thus reducing the overall risk equally for both investors.

Quiz 7: Risk, Return, and the Capital Asset Pricing Model