FIN3400 Ch 10 SMARTBOOK

Using returns for what length of time is most common when computing beta?

Three to five years

Which one of these correctly defines a portfolio beta? Assume varying amounts are invested in each security.

Weighted average of the individual security betas

Which of the following are sources for finding the beta of a stock? Select all that apply.

-Yahoo! Finance -Zacks -Value Line Investment Survey

Which one of these best illustrates a probability distribution at it relates to next year's economy?

40 percent chance of recession; 60 percent chance of a normal economy

What type of security, if any, has a zero beta?

A risk-free security

What type of relationship exists between risk and risk premiums?

Direct Rationale: There is a direct relationship between risk and reward. The risk premium is the reward.

Which one of these is a necessary condition for a securities market to be efficient?

Free and readily available information to all market participants

Beta is a a measure of a stock's sensitivity to which type of risk?

Market risk

The risk premium is the reward for accepting which type of risk?

Market risk Rationale: The risk premium is the reward for accepting market, or systematic, risk.

Which one of these statements applies to the efficient market hypothesis (EMH)?

Security prices fully reflect all available information.

Which one of these defines the standard deviation of expected returns given multiple economic states?

Square root of the sum of each return's squared deviation from the average × Probability of that return Rationale: σ = Square root of the sum of each return's squared deviation from the average × Probability of that return

If the market is weak-form efficient, it renders useless which of the following?

technical analysis

Firm A acquires riskier Firm B. What effect will this have on Firm A's beta?

It will increase Firm's A beta so it lies somewhere between Firm A's original beta and Firm B's beta. Rationale: Since beta measures market risk which is nondiversifiable, no risk will be eliminated by the acquisition.

Which of these correctly state a condition necessary for efficient securities markets to exist? Select all that apply.

-Free and readily available information for all participants -Many buyers and sellers

How is the range of beta values defined for a portfolio of risky assets? Select all that apply.

-The highest possible portfolio beta is defined as the highest beta of any security held in the portfolio. Rationale: Since the portfolio beta is a weighted average of the security betas, it cannot be higher than the highest security beta. -The lowest possible portfolio beta is defined as the lowest beta of any security held in the portfolio. Rationale: Since the portfolio beta is a weighed average of the security betas, it cannot be lower than the lowest security beta.

Which of these are characteristics of the security market line (SML)? Select all that apply.

-Linear function -Upward-sloping function -Passes through the market rate of return

What does a beta of 1.2 indicate?

A stock has 20 percent more market risk than the market portfolio

How is risk premium defined?

Required return - Risk-free rate

Which one of these formulas correctly computes the return required by an investor?

i = (D1/P0) + g

How is a portfolio beta computed when the portfolio consists of $800 in stock A with a beta of 2.6 and $600 in a risk-free asset?

βP = ($800/$1,400)(2.6) + ($600/$1,400)(0)

Beta measures which of these?

Comovement between a stock and the market portfolio

Asset pricing can be described as which type of process?

Process of directly specifying an equation that relates a stock's required return to an appropriate risk premium

Which one of these is the most effective means of lowering the beta of a portfolio?

Replace the highest beta security with a risk-free asset

Why do managers need to understand shareholder's required returns? Select all that apply.

Managers must understand that increasing the risk level of a firm will increase the returns required by investors. Managers must include shareholder returns in new project analysis. Managers must ensure firms adequately reward their investors.

Terry loves taking risks and has sufficient assets to be able to "bet on the market". A stock with which one of these betas will tend to appeal the most to Terry?

2.46 Rationale: The higher the beta, the riskier the stock. Terry will prefer high-beta stocks.

What information is needed to compute a beta for Stock A?

Historical returns for both Stock A and the market portfolio

How is a stock market bubble defined?

Period of overinflated prices followed by a dramatic collapse in prices

Which two points define the capital market line?

Risk-free rate and point of tangency with the efficient frontier

Which one of these correctly defines a level of market efficiency?

Semi-strong form: Prices reflect all historical and public information

What does a beta of 1.0 mean for an individual security?

The security has the same amount of market risk as the market portfolio.

What does it mean if a stock plots on a security market line (SML) graph to the left of the market portfolio?

The stock has a beta less than 1 and has less market risk than the market portfolio.

True or false: For firms to be able to sell shares of stock, their managers must understand the returns required by shareholders.

True Rationale: Shareholders will only buy shares when they expect to be adequately compensated. Managers try to ensure that happens.

Which of these terms best describes an expected return with multiple states?

Weighted average return

Which of these are correct versions of the Capital Asset Pricing Model (CAPM)? Select all that apply.

-E(R) = Rf + β(RM - Rf) -E(R) = Rf + β(Market risk premium)

Which one of these defines the efficient market hypothesis (EMH)?

A theory that describes what types of information are reflected in current market prices

For almost all points on the capital market line, compared to the efficient frontier, there is [BLANK 1] risk per unit of expected return.

Blank 1: less

Which one of these is an argument for market efficiency?

Investors constantly seek mispriced stocks and cause that mispricing to disappear by their trades

A stock just paid an annual dividend of $1.34 which increases by 2 percent per year. How do you compute the required return if the stock is selling for $43 a share?

i = [($1.34 × 1.02)/$43] + 0.02

Which of these are characteristics associated with overconfident investors? Select all that apply.

-Valuing a stock too high based on their knowledge of the firm -Frequently trading stocks because they believe they possess superior market timing skills -Underestimating the risks associated with a stock

A stock has these expected returns: Boom economy =16 percent; Normal economy = 12 percent; Recession = -6 percent, There is a 30 percent chance of a boom and a 20 percent chance of a recession. What is the expected return?

9.6 percent Rationale: E(R) = (0.30 × 0.16) + (0.50 × 0.12) + (0.20 × -0.06) = 0.096 = 9.6%

Which one of these is an indicator of an inefficient securities market?

A firm just announced the discovery of a new metal and the firm's stock price remained constant.

There is a 75 percent chance the economy will boom and 25 percent chance it will be normal. If it booms, a stock will return 23 percent but if it is normal, the stock will lose 15 percent. Illustrate the expected return calculation.

E(R) = (0.75 × 0.23) + (0.25 × -0.15)

A stock has a beta of 1.2, the market rate of return is 11.3 percent, and the risk-free rate is 4.2 percent. How is the expected return on the stock computed?

E(R) = 0.042 + 1.2(0.113 - 0.042)

True or false: The stock of a firm which sells goods that are price elastic tend to have lower betas.

False Rationale: Firms which sell goods that are price inelastic tend to have lower betas.

Which one of these is commonly used as a proxy for the market portfolio?

S&P 500 Index

Which of these illustrates the definition of a probability distribution?

There is a 60 percent chance of rain and a 40 percent chance of pure sunshine.

If a stock has more market risk than the market portfolio and is overpriced, where will it plot on a security market line graph?

To the right of the market portfolio and below the security market line

A stock sells for $18 a share, the next dividend will be $1.54 per share, and the dividend increases by 2.5 percent annually. What is the required return?

11.06 percent Rationale: i = ($1.54/$18) + 0.025 = 0.1106 = 11.06%

If you buy a stock with a beta of 1.43 when the risk-free rate is 2.4 percent and the market rate is 8.7 percent, what is your expected rate of return?

11.41 percent Rationale: E(R) = 0.024 + 1.43(0.087 - 0.024) = 0.1141 = 11.41%

Which one of these variables is used to measure compensable risk in the capital asset pricing model (CAPM)?

Beta, β Rationale: Beta, β, is used in CAPM to measure compensable, or market, risk.

A stock has these expected returns: Boom economy = 15 percent; Normal economy = 8 percent; Recession = -3 percent. The probabilities are: Boom = 10 percent; Normal = 85 percent; Recession = 5 percent. Illustrate the expected return calculation.

E(R) = (0.10 × 0.15) + (0.85 × 0.08) + (0.05 × -0.03)

Which one of these should be used to estimate future stock performance?

Expected return

In the CAPM formula, what does the symbol RM stand for?

Market rate of return

The security market line (SML) graphs required return against which risk measure?

Market risk Rationale: The SML graphs required return against market risk as measured by beta.

Which one of these can be used as a definition of an efficient market?

Securities market where prices accurately value the risk-return relationship of each security given all available information

Kate, a corporate controller, knows her firm's earnings are going to be less than the market expects. The firm's stock price includes all information except for this. What form of market efficiency exists?

Semi-strong form

Lucas was just charged with insider trading. What form of market efficiency cannot exist if this charge is true?

The strong form of efficiency cannot exist.

True or false: The expected return is a forward-looking return that includes risk measures.

True Rationale: The expected return is a forward-looking return that includes risk measures.

Overconfidence causes individuals to do which one of these?

Underestimate risks

A portfolio consists of $500 of stock A, $200 of stock B, and $600 of stock C. The stock betas are 1.3, 2.2, and 0.5 for stocks A, B, and C, respectively. How is the portfolio beta computed?

βP = ($500/$1,300)(1.3) + ($200/$1,300)(2.2) + ($600/$1,300)(0.5)

A stock is expected to return 15% in a normal economy, 30% in a boom, and lose 15% in a recession. There is a 25% chance the economy will boom and a 25% chance of a recession. What is the standard deviation of the expected returns?

11.73% Rationale: Average = (0.50 × 15%) + (0.25 × 20%) + (0.25 × -10%) = 10% σ = [0.5 × (15% - 10%)2 + 0.25 × (20% - 10%)2 + 0.25 × (-10% - 10%)2]1/2 = 11.73%

There is a 5 percent chance of a depression, 25 percent chance of a recession, and a 70 percent chance of a normal economy. A stock will return 45 percent in a depression, 36 percent in a recession and 5 percent in a normal economy. What is the expected return?

14.75 percent Rationale: E(R) = (0.05 × 0.45) + (0.25 × 0.36) + (0.70 × 0.05) = 0.1475 = 14.75%

Which of these is the study of the cognitive processes and biases associated with making financial and economic decisions?

Behavioral finance

Which of the following are means of executive compensation that are directly affected by the value of a firm's stock? Select all that apply.

Granting of executive stock options Granting of restricted stock

Why should investors prefer a portfolio lying on the capital market line to those found on the efficient frontier? (Exclude the tangency point in your answer selection.)

Higher rates of return for the same level of risk

The study of behavioral finance suggests that markets may not be priced efficiently for which one of these reasons?

Investors may make irrational decisions.

Trading based on which one of these is an argument against market efficiency?

Psychological bias Rationale: Trading based on emotion or psychological bias is an argument against market efficiency as trading may be irrational.

A special type of stock that is not transferable from the current holder to others until certain specific conditions are satisfied is called a [BLANK 1] stock.

Blank 1: restricted

The risk-free rate is 3.2 percent while the market risk premium is 8.9 percent. How is the expected return for a stock with a beta of 0.98 computed?

E(R) = 0.032 + 0.98(0.089)

Which of the following will decrease the risk level of a firm? Select all that apply.

-Accepting a low-risk project Rationale: This will lower the firm's risk level. -Acquiring a less risky firm Rationale: This will decrease the firm's risk level.

Which of the following help explain why beta values on the same stock can vary, if in fact they do vary? Select all that apply.

-A different index was used as the market portfolio, i.e., the Wilshire 5000 versus the S&P 500 -Returns for different reporting intervals were used, i.e., weekly versus monthly returns -A different time period was used, i.e., 1997-1999 versus 1998-2000

The market portfolio has which of these characteristics? Select all that apply.

-No firm-specific risk Rationale: The market portfolio has only market risk, lies on the capital market line, and is an efficient portfolio. -Lies on the capital market line Rationale: The market portfolio has only market risk, lies on the capital market line, and is an efficient portfolio. -Is part of the efficient frontier Rationale: The market portfolio has only market risk, lies on the capital market line, and is an efficient portfolio.

If you buy a stock with a beta of 1.5 when the risk-free rate is 2% and the market rate is 12%, what is your expected rate of return?

17% Rationale: E(R) = 0.02 + 1.5(0.12 - 0.02) = 0.17 = 17.00%

What is the definition of an efficient market?

Securities market in which prices fully reflect available information on each security

The required return on a security is equal to which of these? Select all that apply.

-Risk-free rate + Security's risk premium -Real interest rate + Expected inflation premium + Security's risk premium Rationale: The risk-free rate consists of the real interest rate plus an expected inflation premium.

The standard deviation of expected returns with multiple economic states considers which of the following? Select all that apply.

-The expected return for each economic state Rationale: The standard deviation considers the expected return for each economic state and each state's probability of occurrence. -Probability of occurrence for each state of the economy Rationale: The standard deviation considers the expected return for each economic state and each state's probability of occurrence.

Which of these are key factors to consider when using beta to compute a required return? Select all that apply.

-The future risks associated with a firm may vary from past risks. -A company can change its operations. -Beta values are estimates, not facts.

A stock is expected to return 11 percent in a normal economy, 16 percent in a boom, and lose 9 percent in a recession. There is a 20 percent chance the economy will boom and a 10 percent chance of a recession. What is the standard deviation of the expected returns?

6.63 percent Rationale: Average = (0.7 × 11%) + (0.2 × 16%) + (0.1 × -9%) = 10%; σ = [0.7 × (11% - 10%)2 + 0.2 × (16% - 10%)2 + 0.1 × (-9% - 10%)2]1/2 = 6.63%

What is the most common reporting period for historical returns that is used when computing beta?

Monthly

An investor wants to create a portfolio that has a beta close to that of the overall market. The investor wants to invest half of the portfolio in a risk-free asset and the other half in a single stock. Given the following stocks, which one should the investor purchase?

Stock K, β = 1.98 Rationale: The desired portfolio beta is 1, while the risk-free asset beta is zero. The stock's beta needs to be close to 2. βP = (0.5 × 0) + (0.5 × 2) = 1

Which of these are characteristics associated with a stock market bubble? Select all that apply.

-Investor enthusiasm -Inflated bull market

How is required return defined?

Total return investors demand as compensation for the risk taken

You have a portfolio invested 40 percent in a stock A with a beta of 1.6, 30 percent in stock B, and 30 percent in a risk-free asset. What is the beta of stock B if the portfolio beta is equal to the market portfolio beta?

1.2 Rationale: The market beta is 1 while the risk-free beta is zero. 1 = (0.4 × 1.6) + (0.3 × βB) + (0.3 × 0); βB = 1.2

You invest equal amounts of money in four stocks with betas of 1.4, 2.6, 0.3, and 0.7. What is the portfolio beta?

1.25 Rationale: βP = (1.4 + 2.6 + 0.3 + 0.7)/4 = 1.25; This can also be computed as a weighted average with each weight being 0.25. The arithmetic method works only because the weights are equal.

Which one of these is a factor that most affects the level of a firm's beta?

Firm's line of business

Which one of these is most apt to be the result of irrational investor behavior?

Overinflated market prices

How is market risk premium defined?

Return on the market portfolio - Risk-free rate

A portfolio of ten stocks has a beta 1.12. The desired portfolio should have 25 percent more market risk than the overall market. If one more security is to be added to this portfolio, which security should be selected?

Stock A with a beta of 1.42

How do you explain an expected return given multiple states of the economy?

Summation of each expected return multiplied by its probability of occurrence Rationale: The return can also be defined as a weighted average with the weights being the probabilities of occurrence.

Which of the following will increase the risk level of a firm? Select all that apply.

-Selling the lowest-risk division Rationale: This will increase the firm's risk level as will accepting riskier projects or acquiring a riskier firm. -Accepting riskier projects Rationale: This will increase the firm's risk level as will selling the lowest risk-division or acquiring a riskier firm. -Acquiring a riskier firm Rationale: This will increase the firm's risk level.

A stock sells for $18 a share, the next dividend will be $1.54 per share, and the dividend decreases by 2.5 percent annually. What is the required return?

6.05% Rationale: i = ($1.54/$18) - 0.025 = 6.05%

Which one of these best defines the graphical view of a capital market line?

The linear relationship between risk and return with a vertical intercept at the risk-free rate

Which of these statements related to the capital asset pricing theory (CAPM) is (are) correct? Select all that apply.

-The CAPM is derived from modern portfolio theory. -The key difference between CAPM returns and efficient frontier returns is the inclusion of a risk-free rate. -CAPM provides higher expected returns than those found on the efficient frontier.

True or false: Asset pricing can be defined as mathematically relating a security's required return to the security's level of risk.

True Rationale: Asset pricing is the process of directly specifying, via a formula, the relationship between required return and risk.