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Chapter 6

Risk and Rates of Return

True/False

1. By investing in different securities, an investor can lower his exposure to risk.

Difficulty: Easy

Keywords: diversification

2. Total risk equals unique security risk times systematic risk.

Difficulty: Moderate

Keywords: total risk

3. A security with a beta of zero has a required rate of return equal to the overall market rate of return.

Difficulty: Moderate

Keywords: security market line

4. The term structure of interest rates measures the relationship between a stock’s rate of return and length of time to maturity.

Difficulty: Moderate

Keywords: term structure of interest rates

5. The market value of an asset is determined by the demand and supply forces working together in the market.

Difficulty: Moderate

Keywords: market vale of an asset

6. The required rate of return for an asset is equal to the risk-free rate plus a risk premium.

Difficulty: Moderate

Keywords: required rate of return

7. Beta is a measurement of the relationship between a security’s returns and the general market’s returns.

Difficulty: Easy

Keywords: beta

8. In general, the required rate of return is a function of (1) the time value of money, (2) the risk of an asset, and (3) the investor’s attitude toward risk.

Difficulty: Moderate

Keywords: required rate of return

9. The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in terms of beta.

Difficulty: Moderate

Keywords: CAPM

10. The relevant risk to an investor is that portion of the variability of returns that cannot be diversified away.

Difficulty: Moderate

Keywords: relevant risk

11. The expected cash flow of an investment takes the condition of the economy into consideration.

Difficulty: Moderate

Keywords: expected cash flow

12. Stocks with higher betas are usually more stable than stocks with lower betas.

Difficulty: Moderate

Keywords: beta

13. A stock with a beta of 1.0 would earn the risk-free rate.

Difficulty: Easy

Keywords: risk-free rate, beta

14. Unsystematic risk can be eliminated through diversification.

Difficulty: Easy

Keywords: unsystematic risk

15. Beta is a measure of systematic risk.

Difficulty: Easy

Keywords: beta, systematic risk

16. The real rate of interest represents the nominal rate of interest plus the expected rate of inflation over the maturity of a fixed income security.

Difficulty: Moderate

Keywords: real rate of interest

17. Cash flows should be used to measure returns for preferred stock and common stock; however, accounting profits should be used to measure returns for debt.

Difficulty: Moderate

Keywords: cash flows versus accounting profits

18. The greater the dispersion of possible returns, the riskier is the investment.

Difficulty: Easy

Keywords: standard deviation, risk

19. The market rewards assuming additional unsystematic risk with additional returns.

Difficulty: Moderate

Keywords: market reward, unsystematic risk

20. The market rewards assuming additional systematic risk with additional returns.

Difficulty: Moderate

Keywords: market reward, systematic risk

21. The slope of the characteristic line indicates the average movement in the stock price of a particular firm in response to a movement in the general market.

Difficulty: Moderate

Keywords: characteristic line, beta

22. Betas for individual stocks tend to be stable.

Difficulty: Moderate

Keywords: beta

23. The minimum rate of return necessary to attract an investor to purchase a security is the investor’s required rate of return.

Difficulty: Easy

Keywords: minimum rate of return

24. A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.

Difficulty: Moderate

Keywords: beta and risk

25. For the most part, there has been a positive relation between risk and return historically.

Difficulty: Moderate

Keywords: risk and return

26. Only investments in long-term corporate bonds have served as inflation hedges in the long run.

Difficulty: Moderate

Keywords: hedging inflation

27. The benefit from diversification is far greater when the diversification occurs across asset types.

Difficulty: Moderate

Keywords: diversification

28. Investing in foreign stocks is one way to improve diversification of a portfolio.

Difficulty: Moderate

Keywords: foreign securities and diversification

Multiple Choice

29. The capital asset pricing model:

a. provides a risk-return trade-off in which risk is measured in terms of the market returns.

b. provides a risk-return trade-off in which risk is measured in terms of beta.

c. measures risk as the coefficient of variation between security and market rates of return.

d. depicts the total risk of a security.

Difficulty: Moderate

Keywords: CAPM

30. The appropriate measure for risk according to the capital asset pricing model is:

a. the standard deviation of a firm’s cash flows.

b. alpha.

c. beta.

d. probability of correlation.

Difficulty: Easy

Keywords: beta

31. The risk-return relationship for each financial asset is shown on:

a. the capital market line.

b. the New York Stock Exchange market line.

c. the security market line.

d. none of the above.

Difficulty: Easy

Keywords: security market line

32. You have invested in a project that has the following payoff schedule:

Probability of

Payoff Occurrence

$40 .15

$50 .20

$60 .30

$70 .30

$80 .05

What is the expected value of the investment’s payoff? (Round to the nearest $1.)

a. $60

b. $65

c. $58

d. $70

Difficulty: Moderate

Keywords: expected value

1. Which of the following investments is clearly preferred to the others?

Return Risk

A 18% 20%

B 20% 20%

C 20% 18%

a. Investment A

b. Investment B

c. Investment C

d. Cannot be determined

Difficulty: Moderate

Keywords: risk and return

34. Which of the following investments is clearly preferred to the others?

Return Risk

A 14% 12%

B 22% 20%

C 18% 16%

a. Investment A

b. Investment B

c. Investment C

d. Cannot be determined

Difficulty: Moderate

Keywords: risk and return

35. You are considering investing in Ford Motor Company. Which of the following is an example of diversifiable risk?

a. Risk resulting from the possibility of a stock market crash

b. Risk resulting from uncertainty regarding a possible strike

against Ford

c. Risk resulting from an expected recession

d. Risk resulting from interest rates decreasing

Difficulty: Moderate

Keywords: diversifiable risk

36. You are considering investing in U.S. Steel. Which of the following is an example of nondiversifiable risk?

a. Risk resulting from foreign expropriation of U.S. Steel property

b. Risk resulting from oil exploration by Marathan Oil (a U.S. Steel

subsidy)

c. Risk resulting from a strike against U.S. Steel

d. None of the above

Difficulty: Moderate

Keywords: nondiversifiable risk

37. You are considering buying some stock in Continental Grain. Which of the following is an example of nondiversifiable risk?

a. Risk resulting from a general decline in the stock market

b. Risk resulting from a news release that several of Continental’s

grain silos were tainted

c. Risk resulting from an explosion in a grain elevator owned by

Continental

d. Risk resulting from an impending lawsuit against Continental

Difficulty: Moderate

Keywords: non-diversifiable risk

38. Sterling Incorporated has a beta of 1.0. If the expected return on the market is 12%, what is the expected return on Sterling Incorporated’s stock?

a. 9%

b. 10%

c. 12%

d. Insufficient information is provided

Difficulty: Moderate

Keywords: expected return, CAPM

39. Siebling Manufacturing Company’s common stock has a beta of .8. If the expected risk-free return is 7% and the market offers a premium of 8% over the risk-free rate, what is the expected return on Siebling’s common stock?

a. 7.8%

b. 13.4%

c. 14.4%

d. 8.7%

Difficulty: Moderate

Keywords: expected return, CAPM

40. Huit Industries’ common stock has an expected return of 14.4% and a beta of 1.2. If the expected risk-free return is 8%, what is the expected return for the market (round your answerwer to the nearest .1%)?

a. 7.7%

b. 9.6%

c. 12.0%

d. 13.3%

Difficulty: Moderate

Keywords: expected return, CAPM

41. Tanzlin Manufacturing’s common stock has a beta of 1.5. If the expected risk-free return is 9% and the expected return on the market is 14%, what is the expected return on the stock?

a. 13.5%

b. 21.0%

c. 16.5%

d. 21.5%

Difficulty: Moderate

Keywords: expected return, CAPM

42. Which of the following has a beta of zero?

a. A risk-free asset

b. The market

c. A high-risk asset

d. Both a & b

Difficulty: Easy

Keywords: beta, risk-free rate

43. If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a 40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what is the expected rate of return?

a. 12%

b. 13%

c. 14%

d. 15%

Difficulty: Moderate

Keywords: expected rate of return

44. The standard deviation for the above investment would be:

a. 2.24.

b. 2.56.

c. 2.83.

d. 2.98.

Difficulty: Moderate

Keywords: standard deviation

45. Beta is a statistical measure of:

a. hyperbolic.

b. total risk.

c. the standard deviation.

d. the relationship between an investment’s returns and the market return.

Difficulty: Easy

Keywords: beta

46. Given the capital asset pricing model, a security with a beta of 1.5 should return _____________, if the risk-free rate is 6% and the market return is 11%.

a. 13.5%

b. 14.0%

c. 14.5%

d. 15.0%

Difficulty: Moderate

Keywords: required rate of return, CAPM

47. You are considering investing in a project with the following possible outcomes:

Probability of Investment

States Occurrence Returns

State 1: Economic boom 15% 16%

State 2: Economic growth 45% 12%

State 3: Economic decline 25% 5%

State 4: Depression 15% -5%

Calculate the expected rate of return and standard deviation of returns for this investment.

a. 9.8%, 7.0%

b. 7.0%, 43.6%

c. 8.3%, 6.6%

d. 8.3%, 16.1%

Difficulty: Moderate

Keywords: expected rate of return, standard deviation

48. A stock’s beta is a measure of its:

a. systematic risk.

b. unsystematic risk.

c. company-specific risk.

d. diversifiable risk.

Difficulty: Easy

Keywords: systematic risk, beta

49. If you hold a portfolio made up of the following stocks:

Investment Value Beta

Stock A $2,000 1.5

Stock B $5,000 1.2

Stock C $3,000 .8

What is the beta of the portfolio?

a. 1.17

b. 1.14

c. 1.32

d. Can’t be determined from information given

Difficulty: Moderate

Keywords: portfolio beta

50. You are going to invest all of your funds in one of three projects with the following distribution of possible returns:

Project 1 Project 2

Standard Deviation 12% Standard Deviation 19.5%

Probability Return Probability Return

50% Chance 20% 30% Chance 30%

50% Chance -4% 40% Chance 10%

30% Chance -20%

Project 3

Standard Deviation 12%

Probability Return

10% Chance 30%

40% Chance 15%

40% Chance 10%

10% Chance -21%

If you are a risk-averse investor, which one should you choose?

a. Project 1

b. Project 2

c. Project 3

Difficulty: Moderate

Keywords: choosing between investment alternatives

51. The security market line (SML) relates risk to return, for a given set of market conditions. If expected inflation increases, which of the following would most likely occur?

1. The market risk premium would increase.
2. Beta would increase.
3. The slope of the SML would increase.
4. The SML line would shift up.

Difficulty: Hard

Keywords: shifts in the security market line, expected inflation

52. Changes in the general economy, such as changes in interest rates or tax laws, represent what type of risk?

a. Firm-specific risk

b. Market risk

c. Unsystematic risk

d. Diversifiable risk

Difficulty: Easy

Keywords: market risk

53. The security market line (SML) relates risk to return, for a given set of market conditions. If risk aversion increases, which of the following would most likely occur?

1. The market risk premium would increase.
2. Beta would increase.
3. The slope of the SML would increase.
4. The SML line would shift up.

Difficulty: Hard

Keywords: Shifts in the security market line, risk aversion

54. The Elvis Alive Corporation, makers of Elvis memorabilia, has a beta of 2.35. The return on the market portfolio is 13%, and the risk-free rate is 7%. According to CAPM, what is the risk premium on a stock with a beta of 1.0?

a. 11.75%

b. 18.75%

c. 6%

d. 13%

Difficulty: Moderate

Keywords: CAPM, risk premium

55. Bell Weather, Inc. has a beta of 1.25. The return on the market portfolio is 12.5%, and the risk-free rate is 5%. According to CAPM, what is the required return on this stock?

a. 20.62%

b. 9.37%

c. 14.37%

d. 15.62%

Difficulty: Moderate

Keywords: required rate of return, CAPM

56. A stock with a beta greater than 1.0 has returns that are __________ volatile than the market, and a stock with a beta of less than 1.0 exhibits returns which are ____________ volatile than those of the market portfolio.

a. more, more

b. more, less

c. less, more

d. less, less

Difficulty: Moderate

Keywords: beta, volatility of returns

57. You hold a portfolio with the following securities:

Percent

Security of Portfolio Beta Return

X Corporation 20% 1.35 14%

Y Corporation 35% .95 10%

Z Corporation 45% .75 8%

Compute the expected return and beta for the portfolio.

a. 10.67%, 1.02

b. 9.9%, 1.02

c. 34.4%, .94

d. 9.9%, .94

Difficulty: Moderate

Keywords: portfolio expected return, portfolio beta

58. The prices for the Guns and Hoses Corporation for the first quarter of 1992 are given below. Find the holding period return for February.

Month End Price

January $135.28

February $119.40

March $141.57

a. 18.56%

b. 13.30%

c. -11.73%

d. 8.83%

Difficulty: Moderate

Keywords: holding period return

59. The beta of ABC Co. stock is the slope of:

a. the security market line.

b. the characteristic line for a plot of returns on the S&P 500 versus returns on short-term Treasury bills.

c. the arbitrage pricing line.

d. the characteristic line for a plot of ABC Co. returns against the returns of the market portfolio for the same period.

Difficulty: Moderate

Keywords: security market line slope, beta

60. The rate on six-month T-bills is currently 5%. Andvark Company stock has a beta of 1.69 and a required rate of return of 15.4%. According to CAPM, determine the return on the market portfolio.

a. 11.15%

b. 6.15%

c. 17.07%

d. 14.11%

Difficulty: Moderate

Keywords: return on market portfolio, CAPM

61. The return on the market portfolio is currently 13%. Battmobile Corporation stockholders require a rate of return of 21%, and the stock has a beta of 3.5. According to CAPM, determine the risk-free rate.

a. 7%

b. 14.7%

c. 9.8%

d. 24.2%

Difficulty: Hard

Keywords: risk-free rate, CAPM

62. You are thinking of adding one of two investments to an already well diversified portfolio.

Security A Security B

Expected return = 12% Expected return = 12%

Standard deviation of returns = 20.9% Standard deviation of returns = 10.1%

Beta = .8 Beta = 2

If you are a risk-averse investor:

a. security A is the better choice.

b. security B is the better choice.

c. either security would be acceptable.

d. cannot be determined with information given.

Difficulty: Moderate

Keywords: choosing between investment alternatives, asset allocation

63. The market (systematic) risk associated with an individual stock is most closely identified with the:

1. variance of the returns of the stock.
2. variance of the returns of the market.
3. beta of the stock.
4. standard deviation of the stock.

Difficulty: Moderate

Keywords: beta, market risk

64. Of the following types of securities, which is typically considered most risky?

a. Long-term corporate bonds

b. Long-term government bonds

c. Common stocks of large companies

d. U.S. Treasury bills

Difficulty: Easy

Keywords: risk and historical returns

65. Of the following alternative investments, which would be expected to have the highest return?

a. U.S. Treasury bonds

b. Common stocks of small firms

c. U.S. Treasury bills

d. Long-term corporate bonds

Difficulty: Easy

Keywords: historical returns

66. Of the following alternative investments, which would be expected to have the lowest return?

a. U.S. Treasury bonds

b. Common stocks of small firms

c. U.S. Treasury bills

d. Long-term corporate bonds

Difficulty: Easy

Keywords: historical returns

67. Of the following alternative investments, which would be expected to have the lowest risk?

a. U.S. Treasury bills

b. Common stocks of small firms

c. U.S. Treasury bonds

d. Long-term corporate bonds

Difficulty: Easy

Keywords: risk and historical returns

68. Which of the following is NOT an example of systematic risk?

1. Inflation
2. Recession
3. Management risk
4. Interest rate risk

Difficulty: Easy

Keywords: types of systematic risk

69. Wilson, Inc. is expecting the following returns on their stock and related probabilities. Calculate Wilson’s expected return.

State Probability Return

Boom 30% 30%

Normal 70% 10%

1. 16%
2. 14%
3. 12%
4. 10%

Difficulty: Moderate

Keywords: expected return

83. Hefty stock has a beta of 1.2. If the risk-free rate is 7% and the market risk premium is 6.5%, what is the required rate of return on Hefty?

a. 14.8%

b. 14.4%

c. 12.4%

d. 13.5%

Difficulty: Moderate

Keywords: required rate of return, CAPM

70. What type of risk can investors reduce through diversification?

a. All risk

b. Systematic risk only

c. Unsystematic risk only

d. Uncertainty

Difficulty: Moderate

Keywords: unsystematic risk, diversification of risk

71. The market risk premium is measured by:

a. beta.

b. market return less risk-free rate.

c. T-bill rate.

d. standard deviation.

Difficulty: Moderate

Keywords: market risk premium, CAPM

Use the following information, which describes the possible outcomes from investing in a particular asset, to answer questions 86 and 87.

State of the Economy Probability of the States Percentage Returns

Economic recession 25% 5%

Moderate economic growth 55% 10%

Strong economic growth 20% 13%

72. The expected return from investing in the asset is:

a. 9.00%.

b. 9.35%.

c. 10.00%.

d. 10.55%.

Difficulty: Moderate

Keywords: expected return

73. The standard deviation of returns is:

a. 8.00%.

b. 7.63%.

c. 4.68%.

d. 2.76%.

Difficulty: Moderate

Keywords: standard deviation

74. What is the expected rate of return for an investment that has the following expected scenario? If there is an 18% probability of a recession, 2.0% return; if there is a 65% probability of a moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2% return.

a. 11.25%

b. 7.33%

c. 8.95%

d. 9.59%

Difficulty: Moderate

Keywords: expected return

75. What is the expected return on an investment that has the following expected scenario? If there is a 10% probability of a booming economy, $250 return; if there is a 70% probability of a moderate economy, $154 return; if there is a 20% probability of a declining economy, $50 return.

a. $154.00

b. $142.80

c. $ 65.00

d. $ 15.12

Difficulty: Moderate

Keywords: expected return

Use the following information, which describes the expected return and standard deviation for three different assets, to answer questions 90 and 91.

Asset X Asset Y Asset Z

Expected return 9.5% 8.8% 9.5%

Standard deviation 4.9% 5.5% 5.5%

76. If an investor must choose between investing in either Asset X or Asset Y, then:

a. she will always choose Asset X over Asset Y.

b. she will always choose Asset Y over Asset X.

c. she will be indifferent between investing in Asset X and Asset Y.

d. none of the above.

Difficulty: Moderate

Keywords: choosing between alternatives, risk and return

77. If an investor must choose between investing in either Asset X or Asset Z, then:

a. he will always choose Asset X over Asset Z.

b. he will always choose Asset Z over Asset X.

c. he will be indifferent between investing in Asset X and Asset Z.

d. none of the above.

Difficulty: Moderate

Keywords: choosing between alternatives, risk and return

78. Marjen stock has a required return of 20%. The expected market return is 15%, and the beta of Marjen’s stock is 1.5. Calculate the risk-free rate.

1. 4%
2. 5%
3. 6%
4. 7%

Difficulty: Moderate

Keywords: risk-free rate, CAPM

79. Which of the following is not an example of factors that affect systematic risk?

a. Changes in general interest rates

b. A firm wins a lawsuit dealing with patent infringement

c. Our country declares war in the Persian Gulf

d. Environmental awareness increases throughout the country

Difficulty: Moderate

Keywords: systematic risk

80. Which of the following statements is true?

a. A stock with a beta of zero has a very low level of systematic risk.

b. A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.

c. A stock with a beta less than 1.0 has lower nondiversifiable risk than a stock with a beta of 1.0.

d. A stock with a beta less than 1.0 has higher nondiversifiable risk than a stock with a beta of 1.0.

Difficulty: Moderate

Keywords: beta

81. You are thinking about purchasing 1,000 shares of stock in the following firms:

Number of Shares Firm’s Beta

Firm A 100 0.75

Firm B 200 1.47

Firm C 200 0.82

Firm D 600 1.60

If you purchase the number of shares specified, then the beta of your portfolio will be:

a. 1.16.

b. 1.35.

c. 1.00.

d. .85.

e. Cannot be determined with information given.

Difficulty: Moderate

Keywords: portfolio beta

Use the following information to answer questions 97 to 100.

Beta

Market 1

Firm A 1.25

Firm B 0.6

Market Return 10% Risk Free Rate 2%

82. The market risk premium is:

a. 2%.

b. 4%.

c. 6%.

d. 8%.

Difficulty: Moderate

Keywords: market risk premium

83. Firm A’s risk premium is:

a. 2%.

b. 4%.

c. 6%.

d. 8%.

e. 10%.

Difficulty: Moderate

Keywords: risk premium

84. Firm B’s risk premium is:

a. 2.66%.

b. 4.8%.

c. 6.3%.

d. 8.1%.

Difficulty: Moderate

Keywords: risk premium

85. The required rate of return for Firm A is:

a. 4%.

b. 8%.

c. 12%.

d. 16%.

e. Cannot be determined with information given.

Difficulty: Moderate

Keywords: required rate of return

86. Currently, the expected return on the market is 12.5% and the required rate of return for Alpha, Inc. is 12.5%. Therefore, Alpha’s beta must be:

a. less than 1.0.

b. greater than 1.0.

c. equal to 1.0.

d. unknown based on the information provided.

Difficulty: Moderate

Keywords: beta, CAPM

87. Which of the following best measures the risk of holding an asset in isolation (i.e., stand-alone risk)?

a. The mean co-variance

b. The standard deviation

c. The coefficient of optimization

d. The standard asset pricing model

e. The omegatron

Difficulty: Moderate

Keywords: standard deviation

88. What is a practical measure that is used to quantify the risk of a single investment?

a. The systematic variation

b. The Fisher effect

c. The IRP

d. The standard deviation

Difficulty: Moderate

Keywords: standard deviation

89. What is the standard deviation of an investment that has the following expected scenario? If there is an 18% probability of a recession, 2.0% return; if there is a 65% probability of a moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2% return.

a. 3.68%

b. 1.23%

c. 8.47%

d. 6.66%

Difficulty: Moderate

Keywords: standard deviation

90. You are considering investing in a firm that has the following possible outcomes:

Economic boom: probability of 25%; return of 25%

Economic growth: probability of 60%; return of 15%

Economic decline: probability of 15%; return of -5%

What is the expected rate of return on the investment?

a. 15.0%

b. 11.7%

c. 14.5%

d. 25.0%

Difficulty: Moderate

Keywords: expected rate of return

91. Investment risk is:

a. the probability of achieving a return that is greater than what was expected.

b. the probability of achieving a beta coefficient that is less than what was expected.

c. the probability of achieving a return that is less than what was expected.

d. the probability of achieving a standard deviation that is less than what was expected.

Difficulty: Moderate

Keywords: investment risk

92. Which of the following best measures the risk of holding an asset as part of a properly diversified portfolio?

a. The mean co-variance

b. The standard asset pricing model

c. The coefficient of optimization

d. The beta coefficient

Difficulty: Moderate

Keywords: beta

93. Calculate the current beta for Mercury, Inc. The rate on 30-year U.S. Treasury bonds is currently 8%. The market risk premium is 5%. Mercury returned 18% to its stockholders in the latest year.

a. 1.00

b. 1.75

c. 1.25

d. 2.00

e. 1.50

Difficulty: Moderate

Keywords: beta, CAPM

94. Which of the following is an adequate method of achieving portfolio diversification?

a. Invest in various bonds and stocks.

b. Invest in stocks of different industries.

c. Invest internationally.

d. All of the above.

e. None of the above.

Difficulty: Easy

Keywords: diversification

95. You have been employed by Telemetry Medical Instruments (TMI) for seven years and participate in their 401 (k) plan by having 5% of your paycheck invested in the plan. You have been so impressed with the performance of the company’s stock that you currently have all of your 401 (k) money invested in TMI’s common stock. What does prudent investment management suggest that you do about risk?

a. Close out your 401 (k) and put the money in the bank.

b. Increase your payroll deduction from 5% to 10% but keep all funds invested in TMI.

c. Close out your 401 (k) and invest in T-bills.

d. Take some of your investment out of TMI’s common stock and invest it in the stocks and bonds of other firms.

Difficulty: Moderate

Keywords: diversification

96. You bought Chemtron stock for $45 a year ago. It is selling for $54 today. What is your holding period return?

a. 9%

b. 11%

c. 6%

d. 20%

Difficulty: Moderate

Keywords: holding period return

97. You purchased the stock of Sargent Motors at a price of $75.75 one year ago today. If you sell the stock today for $89.00, what is your holding period return?

a. 35.00%

b. 12.50%

c. 17.50%

d. 25.00%

Difficulty: Moderate

Keywords: expected return

98. The rate of return on the S&P 500 is 16.2%. Epsilon has a beta of 1.85. If the T-bond rate is 5.9%, what should investors expect as a rate of return on Epsilon’s stock?

a. 16.2%

b. 22.1%

c. 18.5%

d. 25.0%

Difficulty: Moderate

Keywords: expected return

99. Which of the following statements is correct?

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

b. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification, we would expect Portfolio B to have lower risk.

c. If an investor buys enough stocks, he or she can, through diversification, eliminate all market risk.

d. Diversification can be achieved by purchasing stocks that are perfectly positively correlated.

Difficulty: Moderate

Keywords: portfolio diversification

100. Which of the following statements is true?

a. Systematic, or market, risk can be reduced through diversification.

b. Both systematic and unsystematic risk can be reduced through diversification.

c. Unsystematic, or company, risk can be reduced through diversification.

d. Neither systematic nor unsystematic risk can be reduced through diversification.

Difficulty: Moderate

Keywords: unsystematic risk, company-specific risk

101. Which of the following statements is true?

a. An average stock has a beta of 1.0.

b. A stock having a beta of greater than 1.0 is a higher-than-average-risk stock.

c. A stock having a beta of less than 1.0 is a lower-than-average-risk stock.

d. All of the above.

e. None of the above.

Difficulty: Moderate

Keywords: beta

102. Which of the following is a good measure of the relationship between an investment’s returns and the market’s returns?

a. The beta coefficient

b. The standard variation

c. The CPI

d. The S&P 500 Index

Difficulty: Moderate

Keywords: beta

103. Which of the following is generally used to measure the market when calculating betas?

a. The Dow Jones Transportations

b. The Standard & Poors 500

c. The Value Line Quantam Index

d. The Lehman Brothers Bond Index

Difficulty: Moderate

Keywords: market return

104. Your broker mailed you your year-end statement. You have $25,000 invested in Dow Chemical, $18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The annualized returns for these stocks is 16.5% for Dow, 12.0% for GM, 18.5% for Microsoft, and 15.3% for Nike. What is the return of your entire portfolio?

a. 15.60%

b. 18.55%

c. 16.25%

d. 9.00%

Difficulty: Moderate

Keywords: portfolio return

105. Your broker mailed you your year-end statement. You have $25,000 invested in Dow Chemical, $18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The betas for each of your stocks are 1.55 for Dow, 1.12 for GM, 2.39 for Microsoft, and .76 for Nike. What is the beta of your portfolio?

a. 1.46

b. 1.70

c. 2.60

d. 0.41

Difficulty: Moderate

Keywords: portfolio beta

106. You are considering a portfolio of three stocks with 30% of your money invested in company X, 45% of your money invested in company Y, and 25% of your money invested in company Z. If the betas for each stock are 1.22 for company X, 1.46 for company Y, and 1.03 for company Z, what is the portfolio beta?

a. 1.24

b. 1.00

c. 1.28

d. 1.33

Difficulty: Moderate

Keywords: portfolio beta

107. The risk-free rate is currently 6.5%. Acid Battery Company stockholders require a rate of return of 27.5%, and the stock has a beta of 2.1. What is the current market risk premium?

a. 6.90%

b. 21.00%

c. 13.65%

d. 10.00%

Difficulty: Moderate

Keywords: market risk premium

108. U.S. Treasury bonds currently yield 6%. Consolidated Industries stock has a beta of 1.5. The rate of return on the S&P 500 is presently 18%. What is the rate of return that Consolidated Industries stockholders require?

a. 6%

b. 24%

c. 18%

d. 27%

Difficulty: Moderate

Keywords: required rate of return, CAPM

109. Amalgamated Aluminum stock has a beta of 1.2. Today’s market risk premium is 13%. Amalgamated Aluminum stockholders require a rate of return of 22%. What is the present risk-free rate?

a. 6.40%

b. 22.00%

c. 4.60%

d. 15.60%

Difficulty: Moderate

Keywords: risk-free rate, CAPM

110. If investors expected inflation to increase in the future, what would happen to the security market line (SML)?

a. The slope of the SML would rise.

b. The SML would shift downward, but the slope would remain the same.

c. The slope of the SML would fall.

d. The SML would shift up, but the slope would remain the same.

Difficulty: Moderate

Keywords: security market line

111. What would happen if investors became more risk averse?

a. The slope of the SML would rise.

b. The SML would shift downward but the slope would remain the same.

c. The slope of the SML would fall.

d. The SML would shift downward and the slope of the SML would fall.

Difficulty: Moderate

Keywords: security market line

112. According to the experts, a model portfolio should consist of a mix of securities that over the long run should look something like this: cash or money market accounts, 5%; bonds, 25%; domestic stocks, 35%; international stocks, 35%. What is the determination of the proportions of various securities within a portfolio referred to as?

a. Risk assessment

b. Capital asset modeling

c. Beta selection

d. Portfolio regression

e. Asset allocation

Difficulty: Moderate

Keywords: asset allocation

Short Answer

113. Briefly discuss why there is no reason to believe that the market will reward investors with additional returns for assuming unsystematic risk.

Through diversification, risk can be lowered without sacrificing returns. The market rewards investors for the systematic risk that cannot be eliminated through proper asset allocation in a diversified portfolio.

Difficulty: Moderate

Keywords: diversification

114. Provide an intuitive discussion of beta and its importance for measuring risk.

Difficulty: Moderate

Keywords: beta as a measure of risk

115. You are considering a security with the following possible rates of return:

Probability Return (%)

0.20 9.6

0.30 12.0

0.30 14.4

0.20 16.8

a. Calculate the expected rate of return.

b. Calculate the standard deviation of the returns.

a. R = (0.2)(9.6) + (0.3)(12.0) + (0.3)(14.4) + (0.2 )(16.8) = 13.2%

b. s(R) = [(9.6 - 13.2)2 (0.2) + (12 - 13.2)2(0.3)

+ (14.4 - 13.2)2(0.3) + (16.8 - 13.2)2(0.2)]1/2 = 2.459%

Difficulty: Moderate

Keywords: expected return and standard deviation

116. The return for the market during the next period is expected to be 16%; the risk-free rate is 10%. Calculate the required rate of return for a stock with a beta of 1.5.

Difficulty: Moderate

Keywords: required return, CAPM

117. Asset A has a required return of 18% and a beta of 1.4. The expected market return is 14%. What is the risk-free rate? Plot the security market line.

K = Krf + (Km-Krf)b

18% = X + (14% - X)1.4

18% - X =19.6% - 1.4X

.4X = 1.6%

X = 4% = Risk-free Rate = Krf

Difficulty: Hard

Keywords: risk-free rate, CAPM, SML

118. The stock of the Preston Corporation is expected to pay a dividend of $6 during the coming year. Dividends are expected to grow far into the future at 8%. Investors have recently evaluated future market return variance to be 0.0016 and the covariance of returns for Preston and the market as 0.00352. Assuming a required market return of 14% and a risk-free rate of 6%, at what price should the stock of Preston sell?

Beta = 0.00352/0.0016 = 2.2

K = 0.06 + 2.2(0.14 - 0.06)

K = 0.236

P = $6/(0.236 - 0.08) = $6/0.156 = $38.46

Difficulty: Hard

Keywords: stock price and beta

119. Security A has an expected rate of return of 22% and a beta of 2.5. Security B has a beta of 1.20. If the Treasury bill rate is 10%, what is the expected rate of return for security B?

RA = RF + BA(Rm - Rf)

.22 = .10 + 2.5 (Rm - .10)

.12 = 2.5 (Rm - .10) = 2.5 Rm - .25

.37 = 2.5 Rm

.148 = Rm

RB = Rf + BB(Rm - Rf)

RB = .10 + 1.20(.148 - .10)

RB = .1576

Difficulty: Moderate

Keywords: expected rate of return, CAPM

120. Using the following information for McDonovan, Inc.’s stock, calculate their expected return and standard deviation.

State Probability Return

Boom 20% 40%

Normal 60% 15%

Recession 20% (20%)

= 8% + 9% - 4% = 13%

σi = ( ∑(Ki – K )²Pi)^.5

σi = ((40%-13%)²(.2) + (15%-13%)² (.6) + (-20%-13%)² (.2))^.5 = 19.13%

Difficulty: Moderate

Keywords: expected return, standard deviation

121. AA & Co. has a beta of .656. If the expected market return is 13.2% and the risk-free rate is 5.7%, what is the appropriate required return of AA & Co. using the CAPM model?

Required Rate of Return = Risk-Free Rate + (Market Return - Risk-Free Rate) × Beta = 5.7% + (13.2% - 5.7%) × 0.656 = 10.62%

Difficulty: Moderate

Keywords: required return, CAPM

122. Given the anticipated rate of inflation (i) of 6.3% and the real rate of interest (R) of 4.7%, find the nominal rate of interest (r).

r = R + i + iR

r = .047 + 0.63 + (.063)(.047)

r = 11.3%

Difficulty: Moderate

Keywords: anticipate rate of inflation

123. If provided the nominal rate of interest (r) of 14.2% and the anticipated rate of inflation (i) of 5.5%, what is the real rate of interest (R)?

r = R + i + iR

.142 = R + .055 + (.055)(R)

.142 - .055 = 1.055R + .055 - .055

.087 = 1.055R

R = 8.2%

Difficulty: Moderate

Keywords: real rate of interest

124. Given the anticipated rate of inflation (i) of 6.13% and the real rate of interest (R) of 7.56%, what is the true inflation premium?

Difficulty: Moderate

Keywords: inflation premium