Question

1. The expected return on a corporate bond is less than the investor required return for that bond. Which of the following is the most likely market response to that relationship?

A. The price will rise and the expected return will rise as a result of market trading of this bond.
B. The price will rise and the expected return will fall as a result of market trading of this bond.
C. The price will fall and the expected return will rise as a result of market trading of this bond.
D. The price will fall and the expected return will fall as a result of market trading of this bond. 2. Which of the following statements is most true in regard to the efficient market hypothesis of security pricing? A. When the market is properly functioning, expected returns, required returns and actual returns are all equal. B. When new information becomes available to investors, the impact of that information is immediately understood and incorporated into the market price of all securities. C. Both a and b are true. D. Neither a nor b are true. 3. Based on the current market price, a bond's yield is less than the average yield on bonds having similar risks. Which of the following statements is most likely given this relationship? A. The bond's market price will rise and the yield will fall due to market trading of this bond. B. The bond's market price will fall and the yield will fall due to market trading of this bond. C. The bond's market price will rise and the yield will rise as a result of market trading of this bond. D. The bond's market price will fall and the yield will rise as a result of market trading of this bond. 4. Which of the following statements are true regarding the beta measurement for an equity investment? A. The beta measurement is based on the ratio of covariance between the stock and market and the market variance. B. The beta measures the relative degree of risk that cannot be eliminated by diversification into a portfolio of investments. C. The beta measurement can be positive, negative, or zero. D. All of the above are true. 5. The net present value of a project is positive. Which of the following statements are true? A. The internal rate of return exceeds the cost of capital. B. The internal rate of return is equal to the cost of capital. C. The internal rate of return is less than the cost of capital. D. It is impossible to make a statement about the internal rate of return unless we have more information.

Answer 1

1. C is correct because when expected return is less than required return, investors will sell bond which will lead to price fall. When prices will fall, the expected return will rise beacuse coupon has fixed interest rate and principal value on maturity but since the price is low, returns will be higher. Another way to understand is that since the required return is greater than expected return, investors are discounting the cash flows on bond at a higher rate which will decrease the price of the bond.

3. Yield = Coupon/Current price of bond. Since the yield is greater than average yield, this means that current price is greater than it should be as per risk profile of bond. This will lead to selling of bond which will trigger fall of price. Once price falls, the yield will increase since coupon rate is fixed but the price which is in denominator is falling.D is correct

4. D is correct

Beta = covariance between market and stock returns / Variance of market returns

Since, beta represents volatility of a stock with respect to market, it denotes market risk. If market changes by a x, how much stock changes with respect to it. So, even if investor buys other stocks market risk will always be there.

Beta can be postive negative or zero. Negative beta means if market rises, stock will fall and vice versa