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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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Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will by definition be riskless.

A) True
B) False

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Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?


A) The fact that a security or project may not have a past history that can be used as the basis for calculating beta.
B) Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta.
C) The beta of an "average stock," or "the market," can change over time, sometimes drastically.
D) Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
E) All of the statements above are true.

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

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The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT?


A) If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.
B) Stock B's required rate of return is twice that of Stock A.
C) If Stock A's required return is 11%, then the market risk premium is 5%.
D) If Stock B's required return is 11%, then the market risk premium is 5%.
E) If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.

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

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The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

A) True
B) False

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A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

A) True
B) False

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When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

A) True
B) False

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A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?


A) Either A or B, i.e., the investor should be indifferent between the two.
B) Stock A.
C) Stock B.
D) Neither A nor B, as neither has a return sufficient to compensate for risk.
E) Add A, since its beta must be lower.

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

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Calculate the required rate of return for Climax Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years.


A) 10.29%
B) 10.83%
C) 11.40%
D) 12.00%
E) 12.60%

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

Correct Answer

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Linke Motors has a beta of 1.30, the T-bill rate is 3.00%, and the T- bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%. Based on the SML, what is the firm's required return?


A) 13.51%
B) 13.86%
C) 14.21%
D) 14.58%
E) 14.95%

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

Correct Answer

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Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed's actions would lead to a recession, and that led to an increase in the market risk premium, (rM - rRF) . Under these conditions, with other things held constant, which of the following statements is most correct?


A) The required return on all stocks would increase by the same amount.
B) The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0.
C) Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices.
D) The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
E) The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.

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

Correct Answer

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

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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 less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected.
B) Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.
C) A large portfolio of randomly selected stocks will 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.
D) 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.
E) If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

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

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Jim Angel holds a $200,000 portfolio consisting of the following stocks: Jim Angel holds a $200,000 portfolio consisting of the following stocks: What is the portfolio's beta? A) 0.938 B) 0.988 C) 1.037 D) 1.089 E) 1.143 What is the portfolio's beta?


A) 0.938
B) 0.988
C) 1.037
D) 1.089
E) 1.143

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

Correct Answer

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If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM − rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.

A) True
B) False

Correct Answer

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Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?


A) The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
B) The expected return of your portfolio is likely to decline.
C) The diversifiable risk will remain the same, but the market risk will likely decline.
D) Both the diversifiable risk and the market risk of your portfolio are likely to decline.
E) The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.

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

Correct Answer

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Assume that your uncle holds just one stock, East Coast Bank (ECB) , which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for West Coast Bank (WCB) . Both banks have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your uncle's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) Assume that your uncle holds just one stock, East Coast Bank (ECB) , which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for West Coast Bank (WCB) . Both banks have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your uncle's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) A) 3.29% B) 3.46% C) 3.65% D) 3.84% E) 4.03%


A) 3.29%
B) 3.46%
C) 3.65%
D) 3.84%
E) 4.03%

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

Correct Answer

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An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

A) True
B) False

Correct Answer

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The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

A) True
B) False

Correct Answer

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Assume that you are the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 5.00%. What rate of return should investors expect (and require) on this fund? Assume that you are the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 5.00%. What rate of return should investors expect (and require) on this fund? A) 10.56% B) 10.83% C) 11.11% D) 11.38% E) 11.67%


A) 10.56%
B) 10.83%
C) 11.11%
D) 11.38%
E) 11.67%

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

Correct Answer

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