Risk and Return

Question 1 of 20

Stock A has a beta of 1.2 and a standard deviation of 20 percent. Stock B has a beta of 0.8 and a standard deviation of 25 percent. Portfolio P is a $200,000 portfolio consisting of $100,000 invested in Stock A and $100,000 invested in Stock B. Which of the following statements is most correct? (Assume that the required return is determined by the Security Market Line.)

A. a. Stock B has a higher required rate of return than stock A.

B. b. Portfolio P has a standard deviation of 22.5 percent.

C. c. Portfolio P has a beta equal to 1.0.

D. d. Statements a and b are correct.

E. e. Statements a and c are correct.

Question 2 of 20

Which of the following statements is correct?

A. a. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio.

B. b. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the non-market (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless.

C. c. The required return on a firm’s common stock is determined by its systematic (or market) risk. If the systematic 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. d. A security’s beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock.

E. e. 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.

Question 3 of 20

You have developed the following data on three stocks:

Stock Standard Deviation Beta

A 0.15 0.79

B 0.25 0.61

C 0.20 1.29

If you are a risk minimizer, you should 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.

A. A; A

B. A; B

C. B; A

D. C; A

E. C; B

Question 4 of 20

The risk-free rate, rRF, is 6 percent and the market risk premium, (rM – rRF), is 5 percent. Assume that required returns are based on the CAPM. Your $1 million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. Which of the following statements is correct?

A. a. The portfolio’s required return is less than 11 percent.

B. b. If the risk-free rate remains unchanged but the market risk premium increases by 2 percentage points, the required return on your portfolio will increase by more than 2 percentage points.

C. c. If the market risk premium remains unchanged but expected inflation increases by 2 percentage points, the required return on your portfolio will increase by more than 2 percentage points.

D. d. If the stock market is efficient, your portfolio’s expected return should equal the expected return on the market, which is 11 percent.

E. e. None of the above answers is correct.

Question 5 of 20

Which of the following statements is correct?

A. a. Market participants are able to eliminate virtually all market risk if they hold a large diversified portfolio of stocks.

B. b. Market participants are able to eliminate virtually all company specific risk if they hold a large diversified portfolio of stocks.

C. c. It is possible to have a situation where the market risk of a single stock is less than that of a well diversified portfolio.

D. d. Answers a and c are correct.

E. e. Answers b and c are correct.

Question 6 of 20

Inflation, recession, and high interest rates are economic events which are characterized as

A. a. Company-specific risk that can be diversified away.

B. b. Market risk.

C. c. Systematic risk that can be diversified away.

D. d. Diversifiable risk.

E. e. Unsystematic risk that can be diversified away.

Question 7 of 20

Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5 percent rate of inflation in the future. The real risk-free rate is equal to 3 percent and the market risk premium is 5 percent. Mercury has a beta of 2.0, and its realized rate of return has averaged 15 percent over the last 5 years.

A. a. 15%

B. b. 16%

C. c. 17%

D. d. 18%

E. e. 20%

Question 8 of 20

An investor is forming a portfolio by investing $50,000 in stock A which has a beta of 1.50, and $25,000 in stock B which has a beta of 0.90. The return on the market is equal to 6 percent and Treasury bonds have a yield of 4 percent. What is the required rate of return on the investor’s portfolio?

A. a. 6.6%

B. b. 6.8%

C. c. 5.8%

D. d. 7.0%

E. e. None of the answers above is correct.

Question 9 of 20

Ripken Iron Works faces the following probability distribution:

State of the Economy

Boom

Normal

Recession Probability of State

Occurring

0.25

0.50

0.25 Stock’s Expected Return if this State Occurs

25%

15

5

What is the coefficient of variation on the company’s stock? (Assume that the standard deviation is calculated using the population statistic.)

A. 0.06

B. 0.47

C. 0.54

D. 0.67

E. 0.71

Question 10 of 20

Company X has a beta of 1.6, while Company Y’s beta is 0.7. The risk-free rate is 7 percent, and the required rate of return on an average stock is 12 percent. Now the expected rate of inflation built into rRF rises by 1 percentage point, the real risk-free rate remains constant, the required return on the market rises to 14 percent, and betas remain constant. After all of these changes have been reflected in the data, by how much will the required return on Stock X exceed that on Stock Y?

A. a. 3.75%

B. b. 4.20%

C. c. 4.82%

D. d. 5.40%

E. e. 5.75%

Question 11 of 20

If rRF = 5%, rM = 11%, and b = 1.6 for Stock X, what is rx, the required rate of return for Stock X?

A. a. 13.7%

B. b. 16.8%

C. c. 14.6%

D. d. 15.8%

E. e. 12.9%

Question 12 of 20

Jan Middleton owns a 3-stock portfolio with a total investment value equal to $600,000.

Stock

A

B

C

Total Investment

$200,000

200,000

200,000

$600,000 Beta

0.5

1.0

1.5

What is the weighted average beta of Jan’s 3-stock portfolio?

A. 0.8

B. 1.4

C. 1.0

D. 2.4

E. 1.8

Question 13 of 20

Stock A has a beta of 1.6, Stock B has a beta of 0.6, the expected rate of return on an average stock is 12 percent, and the risk-free rate of return is 7 percent. By how much does the required return on the riskier stock exceed the required return on the less risky stock?

A. a. 5.00%

B. b. 4.25%

C. c. 6.00%

D. d. 3.75%

E. e. 4.75%

Question 14 of 20

You are managing a portfolio of 10 stocks which are held in equal dollar amounts. The current beta of the portfolio is 1.55, and the beta of Stock A is 2.0. If Stock A is sold and the proceeds are used to purchase a replacement stock, what does the beta of the replacement stock have to be to change the portfolio beta to 1.7?

A. a. 4.4

B. b. 5.3

C. c. 3.2

D. d. 3.5

E. e. 4.1

Question 15 of 20

Consider the following information for the Alachua Retirement Fund, with a total investment of $6 million.

Stock

A

B

C

D

Total Investment

$600,000

900,000

1,500,000

3,000,000

$6,000,000 Beta

1.2

-0.4

1.5

0.8

The market required rate of return is 12 percent, and the risk-free rate is 6 percent. What is its required rate of return?

A. 8.98%

B. 9.45%

C. 10.50%

D. 11.56%

E. 11.01%

Question 16 of 20

If the risk-free rate is 8 percent, the expected return on the market is 13 percent, and the expected return on Security J is 18 percent, then what is the beta of Security J?

A. a. 1.90

B. b. 2.00

C. c. 2.20

D. d. 1.75

E. e. 2.75

Question 17 of 20

Which is the best measure of risk for an asset held in a well-diversified portfolio?

A. a. Variance

B. b. Standard deviation

C. c. Beta

D. d. Semi-variance

E. e. Expected value

Question 18 of 20

In a portfolio of three different stocks, which of the following could not be true?

A. a. The riskiness of the portfolio is less than the riskiness of each stock held in isolation.

B. b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.

C. c. The beta of the portfolio is less than the beta of each of the individual stocks.

D. d. The beta of the portfolio is greater than the beta of one or two of the individual stocks

E. e. The beta of the portfolio is equal to the beta of one of the individual stocks.

Question 19 of 20

If investors expected inflation to increase in the future, and they also became more risk averse, what could be said about the change in the Security Market Line (SML)?

A. a. The SML would shift up and the slope would increase.

B. b. The SML would shift up and the slope would decrease.

C. c. The SML would shift down and the slope would increase.

D. d. The SML would shift down and the slope would decrease.

E. e. The SML would remain unchanged.

Question 20 of 20

Which of the following statements is correct?

A. a. The SML relates required returns to firms’ market risk. The slope and intercept of this line cannot be controlled by the financial manager.

B. b. The slope of the SML is determined by the value of beta.

C. c. 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, then the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue on into the future.

D. d. If investors become less risk averse, the slope of the Security Market Line will increase.

E. e. Statements a and c are both true.

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