Investments Chapter 9

You invest 55% of your money in security A with a beta of 1.4 and the rest of your money in security B with a beta of 0.9. The beta of the resulting portfolio is

E. 1.175 0.55(1.4) + 0.45(0.90) = 1.175.

The capital asset pricing model assumes A. all investors are fully informed. B. all investors are rational. C. all investors are mean-variance optimizers. D. taxes are an important consideration. E. A, B and C are all true.

E. A, B and C are all true. The CAPM assumes that investors are fully informed, rational, mean-variance optimizers.

The capital asset pricing model assumes A. all investors are price takers. B. all investors have the same holding period. C. investors have homogeneous expectations. D. both A and B are true. E. A, B and C are all true.

E. A, B and C are all true. The CAPM assumes that investors are price-takers with the same single holding period and that there are no taxes or transaction costs.

A security has an expected rate of return of 0.13 and a beta of 2.1. The market expected rate of return is 0.09 and the risk-free rate is 0.045. The alpha of the stock is

A. -0.95% 13% - [4.5% +2.1(9% - 4.5%)] = -0.95%.

The risk-free rate and the expected market rate of return are 0.056 and 0.125, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on a security with a beta of 1.25 is equal to

A. 0.1225. E(R) = 5.6% + 1.25(12.5 - 5.6) = 14.225%

A security has an expected rate of return of 0.10 and a beta of 1.1. The market expected rate of return is 0.08 and the risk-free rate is 0.05. The alpha of the stock is

A. 1.7%. 10% - [5% +1.1(8% - 5%)] = 1.7%

As a financial analyst, you are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company has a beta of 1.4 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be ______%.

A. 13.8 The hurdle rate should be the required return from CAPM or (R = 4% + 1.4(11% - 4%) = 11%.

One of the assumptions of the CAPM is that investors exhibit myopic behavior. What does this mean?

A. They plan for one identical holding period. Myopic behavior is shortsighted, with no concern for medium-term or long-term implications.

2 According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of

A. beta risk. With a diversified portfolio, the only risk remaining is market, beta, or systematic, risk. This is the only risk that influences return according to the CAPM.

In equilibrium, the marginal price of risk for a risky security must be

A. equal to the marginal price of risk for the market portfolio. In equilibrium, the marginal price of risk for a risky security must be equal to the marginal price of risk for the market. If not, investors will buy or sell the security until they are equal.

Research by Jeremy Stein of MIT resolves the dispute over whether beta is a sufficient pricing factor by suggesting that managers should use beta to estimate

A. long-term returns but not short-term returns. Stein's results suggest that managers should use beta to estimate long-term returns but not short-term returns.

1 According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of

A. market risk. With a diversified portfolio, the only risk remaining is market, or systematic, risk. This is the only risk that influences return according to the CAPM.

3 According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of

A. systematic risk. With a diversified portfolio, the only risk remaining is market, beta, or systematic, risk. This is the only risk that influences return according to the CAPM.

The expected return - beta relationship of the CAPM is graphically represented by

A. the security market line. The security market line shows expected return on the vertical axis and beta on the horizontal axis. It has an intercept of rf and a slope of E(RM) - rf.

Your opinion is that Boeing has an expected rate of return of 0.112. It has a beta of 0.92. The risk- free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is

A. underpriced. 11.2% - 4% + 0.92(10% - 4%) = 1.68%; therefore, the security is under priced.

Your opinion is that CSCO has an expected rate of return of 0.15. It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the Capital Asset Pricing Model, this security is

A. underpriced. 15% - 4% + 1.3(11.5% - 4%) = 1.25%; therefore, the security is under priced.

Your opinion is that security C has an expected rate of return of 0.106. It has a beta of 1.1. The risk- free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is

A. underpriced.***** 4% + 1.1(10% - 4%) = 10.6%; therefore, the security is fairly priced.

According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false? A.The expected rate of return on a security decreases in direct proportion to a decrease in the risk-free rate. B. The expected rate of return on a security increases as its beta increases. C. A fairly priced security has an alpha of zero. D. In equilibrium, all securities lie on the security market line.E. All of the above statements are true.

A.The expected rate of return on a security decreases in direct proportion to a decrease in the risk-free rate. Statements B, C, and D are true, but statement A is false.

The market risk, beta, of a security is equal to

A.the covariance between the security's return and the market return divided by the variance of the market's returns. Beta is a measure of how a security's return covaries with the market returns, normalized by the market variance.

Security A has an expected rate of return of 0.10 and a beta of 1.3. The market expected rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is

B. -1.8%. 10% - [4% +1.3(10% - 4%)] = -1.8%.

The market portfolio has a beta of

B. 1. By definition, the beta of the market portfolio is 1.

You invest 50% of your money in security A with a beta of 1.6 and the rest of your money in security B with a beta of 0.7. The beta of the resulting portfolio is

B. 1.15 0.5(1.6) + 0.5(0.70) = 1.15.

Assume that a security is fairly priced and has an expected rate of return of 0.17. The market expected rate of return is 0.11 and the risk-free rate is 0.04. The beta of the stock is ___?

B. 1.86 17% = [4% +β(11% - 4%)]; 13% = β(7%); β = 1.86

As a financial analyst, you are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company has a beta of 0.67 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be ______%.

B. 8.69 The hurdle rate should be the required return from CAPM or (R = 4% + 0.67(11% - 4%) = 8.69%.

As a financial analyst, you are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company has a beta of 0.75 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be ______%.

B. 9.25 The hurdle rate should be the required return from CAPM or (R = 4% + 0.75(11% - 4%) = 9.25%.

According to the Capital Asset Pricing Model (CAPM), the expected rate of return on any security is equal to

B. Rf + β [E(RM) - Rf]. The expected rate of return on any security is equal to the risk free rate plus the systematic risk of the security (beta) times the market risk premium, E(RM - Rf).

An overpriced security will plot

B. below the Security Market Line. An overpriced security will have a lower expected return than the SML would predict; therefore it will plot below the SML.

Standard deviation and beta both measure risk, but they are different in that

B. beta measures only systematic risk while standard deviation is a measure of total risk. B is the only true statement.

In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is

B. beta. Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta.

According to the Capital Asset Pricing Model (CAPM), fairly priced securities

B. have zero alphas. A zero alpha results when the security is in equilibrium (fairly priced for the level of risk).

Studies of liquidity spreads in security markets have shown that

B. illiquid stocks earn higher returns than liquid stocks. Studies of liquidity spreads in security markets have shown that illiquid stocks earn higher returns than liquid stocks.

In the context of the Capital Asset Pricing Model (CAPM) the relevant risk is

B. market risk. Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta.

A "fairly priced" asset lies

B. on the security market line. Securities that lie on the SML earn exactly the expected return generated by the CAPM. Their prices are proportional to their beta coefficients and they have alphas equal to zero

Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the Capital Asset Pricing Model, this security is

B. overpriced. 11.5% - 4% + 1.3(11.5% - 4%) = -2.25%; therefore, the security is overpriced.

The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If you expect CAT with a beta of 1.0 to offer a rate of return of 10 percent, you should

B. sell short stock X because it is overpriced. 10% < 4% + 1.0(11% - 4%) = 11.0%; therefore, stock is overpriced and should be shorted.

The risk-free rate is 4 percent. The expected market rate of return is 12 percent. If you expect stock X with a beta of 1.0 to offer a rate of return of 10 percent, you should

B. sell short stock X because it is overpriced. 10% < 4% + 1.0(12% - 4%) = 12.0%; therefore, stock is overpriced and should be shorted.

The risk-free rate is 5 percent. The expected market rate of return is 11 percent. If you expect stock X with a beta of 2.1 to offer a rate of return of 15 percent, you should

B. sell short stock X because it is overpriced. 15% < 5% + 2.1(11% - 5%) = 17.6%; therefore, stock is overpriced and should be shorted.

The risk-free rate is 7 percent. The expected market rate of return is 15 percent. If you expect a stock with a beta of 1.3 to offer a rate of return of 12 percent, you should

B. sell short the stock because it is overpriced. 12% < 7% + 1.3(15% - 7%) = 17.40%; therefore, stock is overpriced and should be shorted.

In the context of the Capital Asset Pricing Model (CAPM) the relevant risk is

B. systematic risk. Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta.

You invest $200 in security A with a beta of 1.4 and $800 in security B with a beta of 0.3. The beta of the resulting portfolio is

C. 0.52 0.2(1.4) + 0.8(0.3) = 0.52.

Assume that a security is fairly priced and has an expected rate of return of 0.13. The market expected rate of return is 0.13 and the risk-free rate is 0.04. The beta of the stock is ___?

C. 1 13% = [4% +β(13% - 4%)]; 9% = β(9%); β = 1.

As a financial analyst, you are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 5 percent and the expected market rate of return is 10 percent. Your company has a beta of 0.67 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be ______%.

C. 8.35 The hurdle rate should be the required return from CAPM or (R = 5% + 0.67(10% - 5%) = 8.35%.

Given the following two stocks A and B A: E(r) = 0.12, Beta = 1.2 B: E(r) = 0.14, Beta = 1.8 If the expected market rate of return is 0.09 and the risk-free rate is 0.05, which security would be considered the better buy and why?

C. A because it offers an expected excess return of 2.2%. A's excess return is expected to be 12% - [5% + 1.2(9% - 5%)] = 2.2%. B's excess return is expected to be 14% - [5% + 1.8(9% - 5%)] = 1.8%.

Which of the following statements about the mutual fund theorem is true? I) It is similar to the separation property. II) It implies that a passive investment strategy can be efficient. III) It implies that efficient portfolios can be formed only through active strategies. IV) It means that professional managers have superior security selection strategies.

C. I and II The mutual fund theorem is similar to the separation property. The technical task of creating mutual funds can be delegated to professional managers; then individuals combine the mutual funds with risk- free assets according to their preferences. The passive strategy of investing in a market index fund is efficient.

Which statement is not true regarding the Capital Market Line (CML)? A. The CML is the line from the risk-free rate through the market portfolio. B. The CML is the best attainable capital allocation line. C. The CML is also called the security market line. D. The CML always has a positive slope. E. The risk measure for the CML is standard deviation.

C. The CML is also called the security market line. Both the Capital Market Line and the Security Market Line depict risk/return relationships. However, the risk measure for the CML is standard deviation and the risk measure for the SML is beta (thus C is not true; the other statements are true).

An underpriced security will plot

C. above the Security Market Line. An underpriced security will have a higher expected return than the SML would predict; therefore it will plot above the SML.

According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio increases:

C. directly with beta. The market rewards systematic risk, which is measured by beta, and thus, the risk premium on a stock or portfolio varies directly with beta.

Your personal opinion is that a security has an expected rate of return of 0.11. It has a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to the Capital Asset Pricing Model, this security is

C. fairly priced. 11% = 5% + 1.5(9% - 5%) = 11.0%; therefore, the security is fairly priced.

Your opinion is that CSCO has an expected rate of return of 0.1375. It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the Capital Asset Pricing Model, this security is

C. fairly priced. 13.75% - 4% + 1.3(11.5% - 4%) = 0.0%; therefore, the security is fairly priced.

Your opinion is that security A has an expected rate of return of 0.145. It has a beta of 1.5. The risk- free rate is 0.04 and the market expected rate of return is 0.11. According to the Capital Asset Pricing Model, this security is

C. fairly priced. 14.5% = 4% + 1.5(11% - 4%) = 14.5%; therefore, the security is fairly priced.

Your opinion is that Boeing has an expected rate of return of 0.08. It has a beta of 0.92. The risk- free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is

C. fairly priced. 8.0% - 4% + 0.92(10% - 4%) = -1.52%; therefore, the security is overpriced.

Your opinion is that Boeing has an expected rate of return of 0.0952. It has a beta of 0.92. The risk- free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is

C. fairly priced. 9.52% - 4% + 0.92(10% - 4%) = 0.0%; therefore, the security is fairly priced.

According to the Capital Asset Pricing Model (CAPM), over priced securities

C. have negative betas. According to the Capital Asset Pricing Model (CAPM), over priced securities have negative alphas.

Capital Asset Pricing Theory asserts that portfolio returns are best explained by:

C. systematic risk. The risk remaining in diversified portfolios is systematic risk; thus, portfolio returns are commensurate with systematic risk.

If investors do not know their investment horizons for certain

C. the implications of the CAPM are not violated as long as investors' liquidity needs are not priced. This is discussed in the chapter's section about extensions to the CAPM. It examines what the consequences are when the assumptions are removed.

For the CAPM that examines illiquidity premiums, if there is correlation among assets due to common systematic risk factors, the illiquidity premium on asset i is a function of

C. the trading costs of security i. The formula for this extension to the CAPM relaxes the assumption that trading is costless.

In a well diversified portfolio

C. unsystematic risk is negligible. Market, or systematic, or nondiversifiable, risk is present in a diversified portfolio; the unsystematic risk has been eliminated.

The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on security X with a beta of 1.2 is equal to

D. 0.132. E(R) = 6% + 1.2(12 - 6) = 13.2%.

You invest $600 in a security with a beta of 1.2 and $400 in another security with a beta of 0.90. The beta of the resulting portfolio is

D. 1.08 0.6(1.2) + 0.4(0.90) = 1.08.

As a financial analyst, you are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company has a beta of 1.0 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be ______%.

D. 11 The hurdle rate should be the required return from CAPM or (R = 4% + 1.0(11% - 4%) = 11%.

A security has an expected rate of return of 0.15 and a beta of 1.25. The market expected rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is

D. 3.5%. 15% - [4% +1.25(10% - 4%)] = 3.5%

The security market line (SML) A. can be portrayed graphically as the expected return-beta relationship. B. can be portrayed graphically as the expected return-standard deviation of market returns relationship. C. provides a benchmark for evaluation of investment performance. D. A and C. E. B and C.

D. A and C. The SML is a measure of expected return-beta (the CML is a measure of expected return-standard deviation of market returns). The SML provides the expected return-beta relationship for "fairly priced" securities; thus if a portfolio manager selects securities that are underpriced and produces a portfolio with a positive alpha, this portfolio manager would receive a positive evaluation.

The amount that an investor allocates to the market portfolio is negatively related to I) the expected return on the market portfolio. II) the investor's risk aversion coefficient. III) the risk-free rate of return. IV) the variance of the market portfolio A. I and II B. II and III C. II and IV D. II, III, and IV E. I, III, and IV

D. II, III, and IV

Which statement is not true regarding the market portfolio? A. It includes all publicly traded financial assets. B. It lies on the efficient frontier. C. All securities in the market portfolio are held in proportion to their market values. D. It is the tangency point between the capital market line and the indifference curve. E. All of the above are true.

D. It is the tangency point between the capital market line and the indifference curve. The tangency point between the capital market line and the indifference curve is the optimal portfolio for a particular investor.

What is the expected return of a zero-beta security?

D. The risk-free rate. E(RS)=rf +0(RM -rf)=rf.

According to the Capital Asset Pricing Model (CAPM),

D. a security with a positive alpha is considered to be underpriced. A security with a positive alpha is one that is expected to yield an abnormal positive rate of return, based on the perceived risk of the security, and thus is underpriced.

The expected return-beta relationship A. is the most familiar expression of the CAPM to practitioners. B. refers to the way in which the covariance between the returns on a stock and returns on the market . measures the contribution of the stock to the variance of the market portfolio, which is beta. C. assumes that investors hold well-diversified portfolios. D. all of the above are true. E. none of the above are true.

D. all of the above are true. Statements A, B and C all describe the expected return-beta relationship.

Empirical results regarding betas estimated from historical data indicate that

D. betas appear to regress toward one over time. Betas vary over time, betas may be negative or less than one, betas are not always near zero; however, betas do appear to regress toward one over time.

The capital asset pricing model assumes A. all investors are price takers. B. all investors have the same holding period. C. investors pay taxes on capital gains. D. both A and B are true. E. A, B and C are all true.

D. both A and B are true. The CAPM assumes that investors are price-takers with the same single holding period and that there are no taxes or transaction costs.

The risk premium on the market portfolio will be proportional to A. the average degree of risk aversion of the investor population. B. the risk of the market portfolio as measured by its variance. C. the risk of the market portfolio as measured by its beta. D. both A and B are true. E. both A and C are true.

D. both A and B are true. The risk premium on the market portfolio is proportional to the average degree of risk aversion of the investor population and the risk of the market portfolio measured by its variance.

The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If you expect CAT with a beta of 1.0 to offer a rate of return of 13 percent, you should

D. buy stock X because it is underpriced. 13% > 4% + 1.0(11% - 4%) = 11.0%; therefore, stock is under priced.

According to the Capital Asset Pricing Model (CAPM), under priced securities

D. have positive alphas. According to the Capital Asset Pricing Model (CAPM), under priced securities have positive alphas.

The Security Market Line (SML) is

D. the line that represents the expected return-beta relationship. The SML is a measure of expected return per unit of risk, where risk is defined as beta (systematic risk).

Which statement is true regarding the market portfolio? A. It includes all publicly traded financial assets. B. It lies on the efficient frontier. C. All securities in the market portfolio are held in proportion to their market values. D. It is the tangency point between the capital market line and the indifference curve. E. A, B, and C are true.

E. A, B, and C are true. The tangency point between the capital market line and the indifference curve is the optimal portfolio for a particular investor.

Which statement is true regarding the Capital Market Line (CML)? A. The CML is the line from the risk-free rate through the market portfolio. B. The CML is the best attainable capital allocation line. C. The CML is also called the security market line. D. The CML always has a positive slope. E. A, B, and D are true.

E. A, B, and D are true. Both the Capital Market Line and the Security Market Line depict risk/return relationships. However, the risk measure for the CML is standard deviation and the risk measure for the SML is beta (thus C is not true; the other statements are true).

The CAPM applies to

E. all portfolios and individual securities. The CAPM is an equilibrium model for all assets. Each asset's risk premium is a function of its beta coefficient and the risk premium on the market portfolio.

The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If you expect CAT with a beta of 1.0 to offer a rate of return of 11 percent, you should

E. none of the above, as the stock is fairly priced. 11% = 4% + 1.0(11% - 4%) = 11.0%; therefore, stock is fairly priced.

The value of the market portfolio equals

E. the entire wealth of the economy. The market portfolio includes all assets in existence.