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Cooley 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 the firm's required rate of return?


A) 11.36%
B) 11.65%
C) 11.95%
D) 12.25%
E) 12.55%

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

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, which is the risk-free rate.

A) True
B) False

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The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.

A) True
B) False

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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) The required rate of return on a riskless bond will decline.

F) A) and B)
G) B) and E)

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Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio?


A) Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.
B) Adding more such stocks will increase the portfolio's expected rate of return.
C) Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk.
D) Adding more such stocks will have no effect on the portfolio's risk.
E) Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.

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

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Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?


A) Portfolio P's expected return is greater than the expected return on Stock B.
B) Portfolio P's expected return is equal to the expected return on Stock A.
C) Portfolio P's expected return is less than the expected return on Stock B.
D) Portfolio P's expected return is equal to the expected return on Stock B.
E) Portfolio P's expected return is greater than the expected return on Stock C.

F) A) and D)
G) A) and C)

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During the coming year, the market risk premium (rM − rRF) , is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT?


A) The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.
B) The required return on all stocks will remain unchanged.
C) The required return will fall for all stocks, but it will fall more for stocks with higher betas.
D) The required return for all stocks will fall by the same amount.
E) The required return will fall for all stocks, but it will fall less for stocks with higher betas.

F) A) and B)
G) C) and D)

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Which of the following statements is CORRECT?


A) 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.
B) The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
C) 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.
D) If investors become 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.
E) An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.

F) A) and B)
G) All of the above

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Which of the following statements is CORRECT?


A) When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.
B) Portfolio diversification reduces the variability of returns on an individual stock.
C) Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events.
D) The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs.
E) A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio.

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

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If the returns of two firms are negatively correlated, then one of them must have a negative beta.

A) True
B) False

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The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions.

A) True
B) False

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Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

A) True
B) False

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A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

A) True
B) False

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Stocks A, B, and C all have an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns that are independent of one another, i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are negatively correlated with one another, i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is CORRECT?


A) Portfolio AC has an expected return that is less than 10%.
B) Portfolio AC has an expected return that is greater than 25%.
C) Portfolio AB has a standard deviation that is greater than 25%.
D) Portfolio AB has a standard deviation that is equal to 25%.
E) Portfolio AC has a standard deviation that is less than 25%.

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

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Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.)


A) 8.76%
B) 8.98%
C) 9.21%
D) 9.44%
E) 9.68%

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

Correct Answer

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

A) True
B) False

Correct Answer

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Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio?


A) Your portfolio has a standard deviation of 30%, and its expected return is 15%.
B) Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.
C) Your portfolio has a beta equal to 1.6, and its expected return is 15%.
D) Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.
E) Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.

F) A) and E)
G) D) and E)

Correct Answer

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Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.)


A) Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns.
B) Stock B has a higher required rate of return than Stock A.
C) Portfolio P has a standard deviation of 22.5%.
D) More information is needed to determine the portfolio's beta.
E) Portfolio P has a beta of 1.0.

F) A) and D)
G) C) and D)

Correct Answer

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If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

A) True
B) False

Correct Answer

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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 be affected as follows:


A) The y-axis intercept would decline, and the slope would increase.
B) The x-axis intercept would decline, and the slope would increase.
C) The y-axis intercept would increase, and the slope would decline.
D) The SML would be affected only if betas changed.
E) Both the y-axis intercept and the slope would increase, leading to higher required returns.

F) B) and C)
G) D) and E)

Correct Answer

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