Question

Answer: True or False for each statement.

(1) For a discount bond, the coupon rate must be greater than the current rate.

(2) Under CAPM, idiosyncratic risk plays an important role in an asset's required rate of return.

(3) If CAPM does not hold, then the idiosyncratic risk plays a significant role in the total risk of a well-diversified portfolio.

(4) The realized return on an equity (i.e., stock) investment can never be negative.

(5) The beta on the market portfolio is always equal to one.

Answer 1

(1) For a discount bond, the coupon rate must be lower than the current rate. If the current rate will be higher then the cash flows will be discounted at a higher rate and thus the value of the bond will be discounted.

This is a FALSE statement.

(2) The asset's required return is :

Re = Rf + beta(Rm - Rf),

The only risk factor taken into consideration , while determining the required return of stock so systematic risk and not the idiosyncratic risk.

This is a FALSE statement.

(3) In a well-diversified portfolio, all the unsystematic/idiosyncratic risk is completely diversified away and plays no significant role in a diversified portfolio.

This is a FALSE statement.

(4) The realized return on a stock can be negative, when the stock price falls.

This is a FALSE statement.

(5) Beta of a market portfolio is always equal to 1. The market portfolio of all investable assets has a beta of exactly 1

This is a TRUE statement.