Business Finance ch 10

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 Reason: 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

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 Reason: You need to add the constant growth rate to the dividend yield. 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 Reason: E(R) = 0.024 + 1.43(0.087 - 0.024) = 0.1141 = 11.41%

A stock is expected to return 15% in a normal economy, 20% in a boom, and lose 10% 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 Reason: 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 Reason: E(R) = (0.05 × 0.45) + (0.25 × 0.36) + (0.70 × 0.05) = 0.1475 = 14.75%

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

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

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

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%

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 Reason: 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%

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

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 time period was used, i.e., 1997-1999 versus 1998-2000 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

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.

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

A risk-free security

What does a beta of 1.2 indicate?

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

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

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

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

Accepting riskier projects Acquiring a riskier firm Selling the lowest-risk division

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

Acquiring a less risky firm Accepting a low-risk project

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

Behavioral finance

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

Beta, β

The capital allocation line provided by one-month T-bills and a broad index of common stocks is called the .

Blank 1: capital Blank 2: market Blank 3: line

For almost all points on the capital market line, compared to the efficient frontier, there is (more/less) risk per unit of expected return.

Blank 1: less

The CML represents a strategy that generates an investment opportunity.

Blank 1: passive

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

Blank 1: restricted

Beta measures which of these?

Comovement between a stock and the market portfolio

What type of relationship exists between risk and risk premiums?

Direct

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)

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)

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)

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)

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

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

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

Expected return

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

Firm's line of business

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

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

Free and readily available information to all market participants

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 restricted stock Granting of executive stock options

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

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

Historical returns for both Stock A and the market portfolio

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

Investor enthusiasm Inflated bull market

Which one of these is an argument for market efficiency?

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

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

Investors may make irrational decisions.

The market portfolio has which of these characteristics?

Is part of the efficient frontier Lies on the capital market line No firm-specific risk

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

It will increase Firm A's beta so it lies somewhere between Firm A's original beta and Firm B's beta.

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

Managers must ensure firms adequately reward their investors. 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.

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

Market rate of return

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

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

Market risk

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

Monthly

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

Overinflated market prices

How is a stock market bubble defined?

Period of overinflated prices followed by a dramatic collapse in prices

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

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

Psychological bias

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

Real interest rate + Expected inflation premium + Security's risk premium Risk-free rate + Security's 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

How is risk premium defined?

Required return - risk free rate

How is market risk premium defined?

Return on the market portfolio - Risk-free rate

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

S&P 500 Index

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

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

Security prices fully reflect 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

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

Semi-strong form: Prices reflect all historical and public 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

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

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

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

Summation of each expected return multiplied by its probability of occurrence

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 Probability of occurrence for each state of the economy

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.

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

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

How is the range of beta values defined for a portfolio of risky assets?

The lowest possible portfolio beta is defined as the lowest beta of any security held in the portfolio. The highest possible portfolio beta is defined as the highest beta of any security held in the portfolio.

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.

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.

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.

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

Three to five years

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

How is required return defined?

Total return investors demand as compensation for the risk taken

Overconfidence causes individuals to do which one of these?

Underestimate risks

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

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

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

Upward-sloping function Passes through the market rate of return

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 these terms best describes an expected return with multiple states?

Weighted average return

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

Yahoo! Finance Zacks Value Line Investment Survey

What is the definition of an efficient market?

a securities market in which prices fully reflect available information on each security

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

false

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

i = (D1/P0) + g

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

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

technical analysis

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

true

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

true

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

true

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)

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)