Question 1

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 2

Which asset mix would be the best representation of the true market portfolio?
A) bonds, stocks, foreign securities, derivatives, and real estate
B) bonds, stocks, foreign securities, and derivatives
C) bonds, stocks, and foreign securities
D) bonds and stocks

Accepted Answer

The true market portfolio, according to financial theory, should include all available asset classes. This includes bonds, stocks, foreign securities, derivatives, and real estate, making option A the best representation.

Question 3

Which statement about risk is true?
A) An investor can eliminate virtually all market risk if he or she holds a very large and well-diversified portfolio of stocks.
B) The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
C) It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
D) An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

Accepted Answer

Diversifiable risk, also known as company-specific risk, can be reduced through diversification. Holding a well-diversified portfolio of stocks can help eliminate virtually all diversifiable risk, but not market risk (also known as systematic risk). Therefore, options A and C are incorrect. Option B is also incorrect because a higher correlation between stocks in a portfolio increases the portfolio's risk, not decreases it.

Question 4

Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is correct?
A) Stock B's required return is double that of Stock A's.
B) If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.
C) An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2.
D) If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B.

Accepted Answer

A) This statement is incorrect because the required return of a stock is not solely based on its beta value.
B) This statement is correct because Stock B has a higher beta, which means it is more sensitive to market risk. Therefore, as investors become more risk-averse, the required return on Stock B will increase more than the required return on Stock A.
C) This statement is incorrect because a portfolio's beta is a weighted average of the betas of its individual securities. Therefore, an equally weighted portfolio of Stocks A and B would have a beta of 1 (not lower than 1.2).
D) This statement is incorrect because Stock A has a lower beta than Stock B, so it will be less affected by changes in the risk-free rate. Therefore, the required return on Stock A will increase by less than that on Stock B.

Question 5

Which of the following statements is correct?
A) If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.
B) If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
C) Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless.
D) A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

Accepted Answer

Option A is incorrect because adding randomly selected stocks to a portfolio does not eliminate all market risk. Option C is incorrect because holding Treasury bonds in a portfolio does not completely eliminate market risk. Option D is incorrect because a portfolio consisting of all stocks in the market would have a required return that is greater than the riskless rate. Option B is correct because a portfolio consisting of stocks with betas less than 1.0 would have less risk than a portfolio consisting of all stocks in the market, and the portfolio would have a beta coefficient equal to the weighted average beta of the stocks in the portfolio.

Question 6

Unless assets are negatively correlated, combining assets into a portfolio will not reduce portfolio risk.

Accepted Answer

Combining assets with low or negative correlation can actually reduce portfolio risk as it diversifies the portfolio and reduces the impact of any single asset on the overall returns of the portfolio.

Question 7

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 8

What is the effect on portfolio beta of a larger number of assets in a portfolio and a longer time period?
A) It is less stable.
B) It is more stable.
C) It is more consistent.
D) It is less consistent.

Accepted Answer

A larger number of assets in a portfolio and a longer time period tend to reduce the effect of individual asset volatility on the overall portfolio, resulting in a more stable portfolio beta.

Question 9

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?
A) either A or B, i.e., the investor should be indifferent as to which of the two
B) Stock A
C) Stock B
D) neither A nor B, as neither has a return sufficient to compensate for risk

Accepted Answer

The investor is highly risk-averse, meaning that they prioritize minimizing risk over maximizing returns. Given that the three existing stocks have b = 1.0 and a perfect positive correlation with the market, the portfolio is already highly correlated with the market and has systemic risk. Therefore, the investor should focus on minimizing unsystematic risk when selecting the additional stock.

To make this decision, we need to compare the risk-return tradeoff of Stock A and Stock B. Both stocks have the same expected return of 15% and are equally correlated with the market. However, Stock A has a higher standard deviation of returns, indicating that it has more unsystematic risk. Since the investor is risk-averse, they should choose the stock with lower unsystematic risk, which is Stock B with a lower standard deviation of returns.

In conclusion, the investor should add Stock B to their portfolio.

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 only within one of these investment groups.

Accepted Answer

Diversification across multiple types of investments helps reduce the risk of economic uncertainty affecting any one particular investment group. This is because different types of investments are impacted differently by economic events and trends. For example, stocks may perform well in a growing economy while bonds may perform better during a recession. Therefore, holding a diversified portfolio across multiple investment types provides more protection against economic uncertainty.

Question 11

Any change in 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.

Accepted Answer

This is because the required rate of return on a stock is determined by the risk-free rate, the market risk premium, and the stock's beta. If the beta changes, the required rate of return will change, and this will affect the stock's price.

Question 12

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 a true statement about characteristic lines. They are used to estimate the beta, or market risk, of an individual asset by plotting its rates of return against the market portfolio's rates of return over time and finding the line of best fit. The slope of this line represents the asset's beta, which measures how closely its returns follow the market's returns.

Question 13

Which statement best characterizes economic events such as inflation, recession, and high interest rates?
A) They are systematic risk factors that can be diversified away.
B) They are company-specific risk factors that can be diversified away.
C) They are among the factors that are responsible for market risk.
D) They are risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.

Accepted Answer

Economic events such as inflation, recession, and high interest rates are among the external factors that affect the market as a whole and are responsible for market risk. They cannot be diversified away and should be considered by security analysts and portfolio managers when making investment decisions.

Question 14

Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P is a portfolio with 50% invested in Stock A and 50% invested in B. Which of the following statements is correct?
A) Portfolio P has a standard deviation of 25% and a beta of 1.0.
B) Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium.
C) Portfolio P has more market risk than Stock A but less market risk than Stock B.
D) Stock A should have a higher expected return than Stock B as viewed by the marginal investor.

Accepted Answer

Portfolio P has a weighted average beta of (0.8+1.2)/2 = 1.0, which is the same as the beta of the market. However, the standard deviation of the portfolio's returns is not equal to the weighted average of the individual stocks' standard deviations because the stocks may not move perfectly in tandem (i.e., they are not perfectly positively correlated). In this case, because the correlation coefficient is less than 1, the standard deviation of the portfolio's returns will be less than the weighted average of the individual stocks' standard deviations. Therefore, Portfolio P has less market risk than Stock B (which has a higher beta) but more market risk than Stock A (which has a lower beta).

Question 15

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

Accepted Answer

The Capital Asset Pricing Model (CAPM) is a single-factor model that considers only the market risk premium as the sole factor that determines asset prices. The Arbitrage Pricing Theory (APT), on the other hand, is a multi-factor model that considers multiple macroeconomic factors that can affect asset prices. Therefore, the CAPM can be viewed as an APT model with only one factor.

Question 16

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

Accepted Answer

Diversifiable risk, also known as company-specific risk, is not a factor in the arbitrage pricing model because it can be diversified away by holding a diversified portfolio. The model focuses on identifying and pricing systematic risk factors that affect all securities in the market.

Question 17

Which type of correlation will a completely diversified portfolio have with the market portfolio?
A) less than one, because it carries only market risk
B) less than one, because it carries only diversifiable risk
C) equal to one, because it carries only diversifiable risk
D) equal to one, because it carries only market risk

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

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, or the risk-free rate.

Accepted Answer

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is equivalent to the risk-free rate.

Question 19

What happens to portfolios that cannot be dominated?
A) They lie on the efficient frontier.
B) They are minimum risk portfolios.
C) They have low correlations.
D) They have maximum expected returns.

Accepted Answer

Portfolios that cannot be dominated by other portfolios lie on the efficient frontier, which represents the set of portfolios with the highest expected return for a given level of risk, or the lowest risk for a given level of expected return. These portfolios are considered optimal and ideal for investors to choose from. While they may not necessarily have maximum expected returns or be minimum risk portfolios, they are the most efficient in terms of risk-return tradeoff.

Question 20

What happens to the amount of market risk as the number of assets in a portfolio increases?
A) It decreases.
B) It increases.
C) It remains constant.
D) It changes randomly.

Accepted Answer

The answer of What happens to the amount of market...

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

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

Which asset mix would be the best representation of the true market portfolio?

Which statement about risk is true?

Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is correct?

Which of the following statements is correct?

Unless assets are negatively correlated, combining assets into a portfolio will not reduce portfolio risk.

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.

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

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 only within one of these investment groups.

Any change in 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.

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.

Which statement best characterizes economic events such as inflation, recession, and high interest rates?

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

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

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

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, or the risk-free rate.

What happens to portfolios that cannot be dominated?

What happens to the amount of market risk as the number of assets in a portfolio increases?