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Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Omega Corp at $10 a share and adding it to your portfolio. Omega has an expected return of 13.0% and a beta of 1.50. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Omega stock?


A) 10.64%; 1.17
B) 11.20%; 1.23
C) 11.76%; 1.29
D) 12.35%; 1.36
E) 12.97%; 1.42

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

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The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML.

A) True
B) False

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Which of the following statements is CORRECT?


A) Beta is measured by the slope of the security market line.
B) If the risk-free rate rises, then the market risk premium must also rise.
C) If a company's beta is halved, then its required return will also be halved.
D) If a company's beta doubles, then its required return will also double.
E) The slope of the security market line is equal to the market risk premium, (rM − rRF) .

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

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Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?


A) The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
B) The expected return of your portfolio is likely to decline.
C) The diversifiable risk will remain the same, but the market risk will likely decline.
D) Both the diversifiable risk and the market risk of your portfolio are likely to decline.
E) The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.

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

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For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?


A) The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.
B) The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
C) The beta of the portfolio is less than the average of the betas of the individual stocks.
D) The beta of the portfolio is equal to the average of the betas of the individual stocks.
E) The beta of the portfolio is larger than the average of the betas of the individual stocks.

F) C) and D)
G) C) and E)

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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 C)
G) A) and B)

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Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)


A) If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.
B) The effect of a change in the market risk premium depends on the slope of the yield curve.
C) If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
D) If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
E) The effect of a change in the market risk premium depends on the level of the risk-free rate.

F) B) and E)
G) A) and E)

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Levine Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What is the investment's coefficient of variation?


A) 0.67
B) 0.73
C) 0.81
D) 0.89
E) 0.98

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

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A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and 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 not matter?


A) Either A or B, i.e., the investor should be indifferent between the two.
B) Stock A.
C) Stock B.
D) Neither A nor B, as neither has a return sufficient to compensate for risk.
E) Add A, since its beta must be lower.

F) A) and B)
G) All of the above

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Which of the following statements is CORRECT?


A) The slope of the security market line is equal to the market risk premium.
B) Lower beta stocks have higher required returns.
C) A stock's beta indicates its diversifiable risk.
D) Diversifiable risk cannot be completely diversified away.
E) Two securities with the same stand-alone risk must have the same betas.

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

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Desreumaux Inc's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium?


A) 5.80%
B) 5.95%
C) 6.09%
D) 6.25%
E) 6.40%

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

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If the returns of two firms are negatively correlated, then one of them must have a negative beta.

A) True
B) False

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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 of all stocks will increase by the amount of the increase in the risk-free rate.
B) 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.
C) Since the overall return on the market stays constant, the required return on each individual stock will also remain constant.
D) 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.
E) The required return of all stocks will fall by the amount of the decline in the market risk premium.

F) C) and E)
G) A) and E)

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We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

A) True
B) False

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Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

A) True
B) False

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Magee Inc.'s manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.)


A) 17.69%
B) 18.62%
C) 19.55%
D) 20.52%
E) 21.55%

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

Correct Answer

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Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.


A) Stock A would be a more desirable addition to a portfolio then Stock B.
B) In equilibrium, the expected return on Stock B will be greater than that on Stock A.
C) When held in isolation, Stock A has more risk than Stock B.
D) Stock B would be a more desirable addition to a portfolio than A.
E) In equilibrium, the expected return on Stock A will be greater than that on B.

F) A) and B)
G) B) and E)

Correct Answer

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According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

A) True
B) False

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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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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) 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.
B) Stock Y must have a higher expected return and a higher standard deviation than Stock X.
C) If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount.
D) 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.
E) 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.

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

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