FIN 221 Chapter 8 Intro Exercises

Which of the following statements is CORRECT? a. If you formed a portfolio that included a large number of low-beta stocks (stocks with betas less than 1.0 but greater than -1.0), the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, so the portfolio would have less risk than a portfolio that consisted of all stocks in the market. b. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all the market risk from the portfolio. c. Market risk can be eliminated by forming a large portfolio, and if some bonds are held in the portfolio, the portfolio can be made to be completely riskless. d. 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 portfolio would include some shares in each of them. e. A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

a. If you formed a portfolio that included a large number of low-beta stocks (stocks with betas less than 1.0 but greater than -1.0), the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, so the portfolio would have less risk than a portfolio that consisted of all stocks in the market.

Which of the following statements is CORRECT? a. The beta coefficient of a stock is normally found by running a regression of past stock returns against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. b. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks. c. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. Your 1-stock portfolio would be even less risky if the stock had a negative beta. d. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. e. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.

a. The beta coefficient of a stock is normally found by running a regression of past stock returns against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta.

Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Becky has a $50,000 portfolio with a beta of 0.8, an expected return of 9.2%, and her standard deviation is also 25%. The correlation coefficient, r, between Bob's and Becky's portfolios is zero. Bob and Becky are engaged to be married. Which of the following best describes their combined $100,000 portfolio? a. The combined portfolio's beta will be equal to a simple average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%. b. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%. c. The combined portfolio's expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. d. The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. e. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%.

a. The combined portfolio's beta will be equal to a simple average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%.

What would happen if risk aversion on the part of investors increased? a. The market risk premium would increase. b. The risk-free rate would decrease. c. The market risk premium would decrease. d. The risk-free rate would increase.

a. The market risk premium would increase.

According to the CAPM/SML Equation, what would happen if inflation increased (all else constant)? a. The required returns of all stocks would increase by the same amount. b. The required returns of all stocks would decrease by the same amount. c. The required returns of higher beta stocks would increase more than those of lower beta stocks. d. The required returns of lower beta stocks would increase more than those of higher beta stocks.

a. The required returns of all stocks would increase by the same amount.

Which of the following would be the CAPM return for a stock with a beta of 1? a. the market return b. the risk-free rate c. the stock risk premium d. the market risk premium

a. the market return

What is the beta of the market portfolio? a. 0.0 b. 1.0 c. 0.5 d. 2.0

b. 1.0

Which of the following statements is CORRECT? a. If investors became 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. b. An increase in expected inflation could be expected to increase the required return on a riskless asset and on an average stock by the same amount, other things held constant. c. 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. d. 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. e. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.

b. An increase in expected inflation could be expected to increase the required return on a riskless asset and on an average stock by the same amount, other things held constant.

Currently, the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a. If a stock's beta doubles, its required return must also double. b. An index fund with beta = 1.0 should have a required return of 11%. c. If a stock has a negative beta, its required return must also be negative. d. An index fund with beta = 1.0 should have a required return greater than 11%. e. An index fund with beta = 1.0 should have a required return loess than 11%.

b. An index fund with beta = 1.0 should have a required return of 11%.

Which of the following measures the risk associated with the returns or cash flows of a single asset? a. correlation coefficient b. standard deviation c. beta d. none of the above

b. standard deviation

Which of the following statements is CORRECT? a. 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. b. If investors became 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. c. An increase in expected inflation could be expected to increase the required return on a riskless asset and on an average stock by the same amount, other things held constant. d. 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. e. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.

c. An increase in expected inflation could be expected to increase the required return on a riskless asset and on an average stock by the same amount, other things held constant.

Which of the following statements is CORRECT? a. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0. b. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8. c. Company-specific (or diversifiable) risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk. d. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio correct. e. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected.

c. Company-specific (or diversifiable) risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.

Which of the following statements is CORRECT? a. If a stock's beta doubles, its required rate of return must double. b. The slope of the security market line is beta. c. If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. d. If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium. e. A stock with a negative beta must in theory have a negative required rate of return.

c. If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.

Over the past 75 years, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of their annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following lists correctly ranks investments from highest to lowest returns and risk (thus, the highest risk security should be shown first, the lowest risk securities shown last)? a. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks. b. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. d. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds. e. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills.

c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.

Which of the following describes an undervalued stock? a. The stock's expected return and required return are the same. b. The stock's expected return is less than the risk-free rate. c. The stock's expected return is greater than its required return. d. The stock's expected return is less than its required return.

c. The stock's expected return is greater than its required return.

Which of the following statements is CORRECT? a. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk at all. b. 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. c. An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks. d. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks. e. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.

d. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks.

What does the return for a stock given by the CAPM/SML Equation represent? a. The maximum return that an investor should demand for the stock. b. The historical return for the stock. c. The holding period return for the stock. d. The minimum return that an investor should demand for the stock.

d. The minimum return that an investor should demand for the stock.

Assume that the risk-free rate remains constant, but that the market risk premium declines. Which of the following is likely to occur? a. The return on "the market" will remain constant. b. The return on "the market" will increase. c. The required return on a stock with a beta > 1.0 will increase. d. The required return on a stock with a beta < 1.0 will decline. e. The required return on a stock with a beta = 1.0 will remain the same.

d. The required return on a stock with a beta < 1.0 will decline.

Which of the following is expected for a stock whose expected return is less than its required return? a. The stock's price will go up. b. The stock's price will stay the same. c. The stock's price will go down. d. The stock's expected return will increase. e. Both C and D are expected.

e. Both C and D are expected.

Nile Foods' stock has a beta of 1.4, while Elbe Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM - rRF), equals 4%. Which of the following statements is CORRECT? a. If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elbe's will also decrease, and by more than Nile's because it has a beta less than 1.0. b. Since Nile's beta is twice that of Elbe's, its required rate of return will also be twice that of Elbe's. c. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta. d. If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elbe's will decline because it has a beta less than 1.0. e. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.

e. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.

Nile Foods' stock has a beta of 1.4, while Elbe Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM - rRF), equals 4%. Which of the following statements is CORRECT? a. If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elbe's will decline because it has a beta less than 1.0. b. Since Nile's beta is twice that of Elbe's, its required rate of return will also be twice that of Elbe's. c. If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elbe's will also decrease, and by more than Nile's because it has a beta less than 1.0. d. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta. e. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.

e. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.