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Which of the following statements is CORRECT?


A) If the returns on two stocks are perfectly positively correlated and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
B) A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.
C) If a stock has a negative beta, its expected return must be negative.
D) A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
E) According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.

F) A) and E)
G) A) and D)

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Linke Motors has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%. Based on the SML, what is the firm's required return?


A) 13.51%
B) 13.86%
C) 14.21%
D) 14.58%
E) 14.95%

F) D) and E)
G) B) and E)

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Which of the following statements is CORRECT?


A) If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0.
B) Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities.
C) The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically.
D) If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm.
E) During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.

F) C) and D)
G) A) and B)

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Even 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.

A) True
B) False

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Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?


A) Variance; correlation coefficient.
B) Standard deviation; correlation coefficient.
C) Beta; variance.
D) Coefficient of variation; beta.
E) Beta; beta.

F) B) and E)
G) B) and C)

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Which of the following statements is CORRECT?


A) A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected.
B) Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.
C) A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0.
D) A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8.
E) If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

F) C) and D)
G) A) and D)

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The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

A) True
B) False

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Nagel Equipment has a beta of 0.88 and an expected dividend growth rate of 4.00% per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 12.50%. Using the SML, what is the firm's required rate of return?


A) 11.34%
B) 11.63%
C) 11.92%
D) 12.22%
E) 12.52%

F) A) and D)
G) None of the above

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The distributions of rates of return for Companies AA and BB are given below: State of the Probability of Economy This State Occurring AA BB Boom 0.2 30% -10% Normal 0.6 10% 5% Recession 0.2 -5% 50% We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.

A) True
B) False

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Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% A and 50% B. Which of the following statements is CORRECT?


A) The portfolio's beta is less than 1.2.
B) The portfolio's expected return is 15%.
C) The portfolio's standard deviation is greater than 20%.
D) The portfolio's beta is greater than 1.2.
E) The portfolio's standard deviation is 20%.

F) B) and D)
G) A) and C)

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Which of the following statements is CORRECT?


A) A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.
B) If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless.
C) The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return.
D) Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio.
E) A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

F) B) and C)
G) None of the above

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Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?


A) If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.
B) Stock Y's realized return during the coming year will be higher than Stock X's return.
C) If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
D) Stock Y's return has a higher standard deviation than Stock X.
E) If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y.

F) None of the above
G) C) and D)

Correct Answer

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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 were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.
C) 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.
D) 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.
E) A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

F) A) and B)
G) A) and C)

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Calculate the required rate of return for Climax Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years.


A) 10.29%
B) 10.83%
C) 11.40%
D) 12.00%
E) 12.60%

F) D) and E)
G) A) and E)

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

A) True
B) False

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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 (rM − rRF) 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.

A) True
B) False

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Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

A) True
B) False

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Since the market return represents the expected return on an average stock, the market return reflects 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, that is required to compensate stock investors for assuming an average amount of risk.

A) True
B) False

Correct Answer

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Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)


A) 2.75%
B) 2.89%
C) 3.05%
D) 3.21%
E) 3.38%

F) A) and C)
G) A) and D)

Correct Answer

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Cheng Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of 30%. What is the project's coefficient of variation?


A) 1.20
B) 1.26
C) 1.32
D) 1.39
E) 1.46

F) C) and D)
G) B) and D)

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