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Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is correct?


A) Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio.
B) The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk.
C) Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios.
D) The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified.

E) None of the above
F) A) and B)

Correct Answer

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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) All of the above
F) C) and D)

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Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?


A) The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
B) The required rate of return will decline for stocks whose betas are less than 1.0.
C) The required rate of return on the market, rM, will not change as a result of these changes.
D) The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium.

E) A) and D)
F) B) and C)

Correct Answer

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

A) True
B) False

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Other things held constant, if the expected inflation rate DECREASES and investors also become MORE risk averse, the Security Market Line would shift in which manner:


A) down and have a steeper slope
B) up and have a less steep slope
C) up and keep the same slope
D) down and keep the same slope

E) A) and D)
F) All of the above

Correct Answer

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Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A's portfolio has a beta of MINUS 2.0, while Investor B's portfolio has a beta of PLUS 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0.

A) True
B) False

Correct Answer

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Which of the following statements is correct?


A) Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.
B) Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta will be negatively correlated with returns on most other stocks in the market during that 5-year period.
C) Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta
Stocks and buy low-beta stocks in order to take advantage of the expected market move.
D) You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should rebalance your portfolio to include more high-beta stocks.

E) B) and D)
F) A) and B)

Correct Answer

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We will generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

A) True
B) False

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The CAPM can be viewed as an APT model with one factor.

A) True
B) False

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Rick Kish has a $100,000 stock portfolio. Thirty-two thousand dollars is invested in a stock with a beta of 0.75 and the remainder is invested in a stock with a beta of 1.38. These are the only two investments in his portfolio. What is his portfolio's beta?


A) 1.18
B) 1.24
C) 1.30
D) 1.36

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

Correct Answer

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

A) True
B) False

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Ritter Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is Ritter's required rate of return?


A) 11.36%
B) 11.65%
C) 11.95%
D) 12.25%

E) B) and C)
F) A) and B)

Correct Answer

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ABC Co. has a beta of 1.30 and an expected dividend growth rate of 5.00% per year. The T-bill rate is 3.00%, and the T-bond rate is 6.00%. The annual return on the stock market during the past three years was 15.00%. Investors expect the annual future stock market return to be 12.00%. Using the SML, what is ABC's required return?


A) 12.8%
B) 13.1%
C) 13.5%
D) 13.8%

E) A) and B)
F) A) and C)

Correct Answer

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Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13% and a standard deviation of 30%. The risk-free rate is 5% and the market risk premium, rM - rRF, is 6%. Assume that the market is in equilibrium. Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the following statements is correct?


A) Stock A's beta is 0.8333.
B) Since the two stocks have zero correlation, Portfolio AB is riskless.
C) Stock B's beta is 1.0000.
D) Portfolio AB's required return is 11%.

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

Correct Answer

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What does an asset having a negative beta value imply?


A) non-existence because negative beta assets are theoretically impossible
B) a necessary component to get a fully diversified portfolio
C) a risk-reducing property when added to a portfolio
D) the higher expected return of this asset

E) A) and C)
F) A) and B)

Correct Answer

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Standard deviation is a measure of market risk.

A) True
B) False

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If any two assets are perfectly negatively correlated, an equal weighted portfolio of these two assets will result in a portfolio return of zero.

A) True
B) False

Correct Answer

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Which of the following statements best describes risk?


A) An investor can eliminate virtually all market risk if he or she holds a very large and well- diversified portfolio of stocks.
B) The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
C) It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
D) An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

E) All of the above
F) None of the above

Correct Answer

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The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, or the risk-free rate.

A) True
B) False

Correct Answer

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

Correct Answer

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