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Exam 2: Risk and Return: Part I

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Question 41

True/False

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When adding a randomly chosen new stock to an existing portfolio,the higher (or more positive)the degree of correlation between the new stock and stocks already in the portfolio,the less the additional stock will reduce the portfolio's risk.

A) True
B) False

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Question 42

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Which of the following statements is CORRECT?

A) The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
B) If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations.
C) If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.
D) An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.
E) A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.

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

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Question 43

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Donald Gilmore has $100,000 invested in a 2-stock portfolio.$35,000 is invested in Stock X and the remainder is invested in Stock Y.X's beta is 1.50 and Y's beta is 0.70.What is the portfolio's beta?

In portfolio analysis,we often use ex post (historical)returns and standard deviations,despite the fact that we are really interested in ex ante (future)data.

If you randomly select stocks and add them to your portfolio,which of the following statements best describes what you should expect?

Stock A has a beta of 0.7,whereas Stock B has a beta of 1.3.Portfolio P has 50% invested in both A and B.Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?

Portfolio AB was created by investing in a combination of Stocks A and B.Stock A has a beta of 1.2 and a standard deviation of 25%.Stock B has a beta of 1.4 and a standard deviation of 20%.Portfolio AB has a beta of 1.25 and a standard deviation of 18%.Which of the following statements is CORRECT?

Freedman Flowers' stock has a 50% chance of producing a 25% return,a 30% chance of producing a 10% return,and a 20% chance of producing a −28% return.What is the firm's expected rate of return?

You are considering investing in one of the these three stocks: $\begin{array} { c c c } \text { Stock } & \text { Standard Deviation } & \text { Beta } \\\text { A } & 20 \% & 0.59 \\\text { B } & 10 \% & 0.61 \\\text { C } & 12 \% & 1.29\end{array}$ If you are a strict risk minimizer,you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.

Consider the following average annual returns for Stocks A and B and the Market.Which of the possible answers best describes the historical betas for A and B? $\begin{array} { c r c c } \text { Years } &\text { Market } & \text { Stock A }& \text { Stock B } \\\hline 1 & 0.03 & 0.16 & 0.05 \\2 & - 0.05 & 0.20 & 0.05 \\3 & 0.01 & 0.18 & 0.05 \\4 & - 0.10 & 0.25 & 0.05 \\5 & 0.06 & 0.14 & 0.05\end{array}$

Stock A has an expected return of 12%,a beta of 1.2,and a standard deviation of 20%.Stock B also has a beta of 1.2,but its expected return is 10% and its standard deviation is 15%.Portfolio AB has $300,000 invested in Stock A and $100,000 invested in Stock B.The correlation between the two stocks' returns is zero (that is,r_A,B = 0) .Which of the following statements is CORRECT?

Joel Foster is the portfolio manager of the SF Fund,a $3 million hedge fund that contains the following stocks.The required rate of return on the market is 11.00% and the risk-free rate is 5.00%.What rate of return should investors expect (and require) on this fund? $\begin{array}{l}\begin{array} { c c c } \underline{\text { Stock } }&\underline{ \text { Amount } }&\underline{ \text { Beta} } \\\text { A } & \$ 1,075,000 & 1.20 \\\text { B } & 675,000 & 0.50 \\\text { C } & 750,000 & 1.40 \\\text { D } & 500,000 & 0.75\end{array}\\\quad \quad \quad \quad \quad \underline{\$ 3,000,000}\end{array}$

Consider the following information and then calculate the required rate of return for the Universal Investment Fund,which holds 4 stocks.The market's required rate of return is 13.25%,the risk-free rate is 7.00%,and the Fund's assets are as follows: $\begin{array} { c c r } \text { Stock } & \text { Investment } & \text { B eta } \\\text { A } & \$ 200,000 & 1.50 \\\text { B } & \$ 300,000 & - 0.50 \\\text { C } & \$ 500,000 & 1.25 \\\text { D } & \$ 1,000,000 & 0.75\end{array}$

Brodkey Shoes 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?

Ann has a portfolio of 20 average stocks,and Tom has a portfolio of 2 average stocks.Assuming the market is in equilibrium,which of the following statements is CORRECT?

The CAPM is a multi-period model that takes account of differences in securities' maturities,and it can be used to determine the required rate of return for any given level of systematic risk.

If markets are in equilibrium,which of the following conditions will exist?

Ivan Knobel holds a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20.He is in the process of buying 1,000 shares of Syngine Corp at $10 a share and adding it to his portfolio.Syngine has an expected return of 13.0% and a beta of 1.50.The total value of Ivan's current portfolio is $90,000.What will the expected return and beta on the portfolio be after the purchase of the Syngine stock?

You have a portfolio P that consists of 50% Stock X and 50% Stock Y.Stock X has a beta of 0.7 and Stock Y has a beta of 1.3.The standard deviation of each stock's returns is 20%.The stocks' returns are independent of each other,i.e.,the correlation coefficient,r,between them is zero.Given this information,which of the following statements is CORRECT?

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.)