Question

11.       Which of the following statements is CORRECT?

            a.         If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

            b.         If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.

            c.         If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.

            d.         Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless.

            e.         A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

12.       Inflation, recession, and high interest rates are economic events that are best characterized as being

            a.         systematic risk factors that can be diversified away.

            b.         company-specific risk factors that can be diversified away.

            c.         among the factors that are responsible for market risk.

            d.         risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.

            e.         irrelevant except to governmental authorities like the Federal Reserve.

13. Which of the following statements is CORRECT?

            a.         Beta is measured by the slope of the security market line.

            b.         If the risk-free rate rises, then the market risk premium must also rise.

            c.         If a company's beta is halved, then its required return will also be halved.

            d.         If a company's beta doubles, then its required return will also double.

            e.         The slope of the security market line is equal to the market risk premium, (rM – rRF).

14. 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.

15. Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM – rRF), equals 4%. Which of the following statements is CORRECT?

            a.         If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.

            b.         If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elba's required return will decline because it has a beta less than 1.0.

            c.         Since Nile's beta is twice that of Elba's, its required rate of return will also be twice that of Elba's.

            d.         If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.

            e.         If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elba's will also decrease, but by more than Nile's because it has a beta less than 1.0.

16. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?

            a.         A portfolio consisting of $50,000 invested in Stock X and $50,000 invested in Stock Y will have a required return that exceeds that of the overall market.

            b.         Stock Y must have a higher expected return and a higher standard deviation than Stock X.

            c.         If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount.

            d.         If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y.

            e.         If expected inflation declines but the market risk premium is unchanged, then the required return on both stocks will decrease but the decrease will be greater for Stock Y.

17. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM – rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?

            a.         The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.

            b.         The required return would decrease by the same amount for both Stock A and Stock B.

            c.         The required return would increase for Stock A but decrease for Stock B.

            d.         The required return on Portfolio P would remain unchanged.

            e.         The required return would increase for Stock B but decrease for Stock A.

18. Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?

            a.         The required return on Portfolio P would increase by 1%.

            b.         The required return on both stocks would increase by 1%.

            c.         The required return on Portfolio P would remain unchanged.

            d.         The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%.

            e.         The required return for Stock A would fall, but the required return for Stock B would increase.

19. Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?

            a.         The required return on a stock with beta = 1.0 will not change.

            b.         The required return on a stock with beta > 1.0 will increase.

            c.         The return on "the market" will remain constant.

            d.         The return on "the market" will increase.

            e.         The required return on a stock with a positive beta < 1.0 will decline.

20.       A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT?

            a.         The bond’s expected capital gains yield is zero.

            b.         The bond’s yield to maturity is above 9%.

            c.         The bond’s current yield is above 9%.

            d.         If the bond’s yield to maturity declines, the bond will sell at a discount.

            e.         The bond’s current yield is less than its expected capital gains yield.

Answer 1

11 a) If you add enough randomly selected stocks it will not eliminate market risk rather through diversification it will eliminate asystematic risk. This is incorrect.

b) To minimise the risk we need to invest in minimum variance portfolio which can have any proportion of weights for different stocks. It is not necessary that the minimum risk would require to have equal number of each stocks. This is incorrect

c) Since this portfolio has only those stocks which has a beta of less than 1, the portfolio beta will be less than 1 as well. Now in comparison with another portfolio which consist of all stocks in the market which has a beta of 1, this portfolio should have a lower beta. This option is correct.

d) This is incorrect because you cannot eliminate market risk if you have a single asset other than the risk-free asset.

e) This is incorrect. If you have a portfolio with all stocks in the world you would expect a market return and so a market risk premium over the risk-free rate.

12) a) Incorrect. Systematic risk cannot be diversified away.

b) Inflation, recession and high interest rate are not company specific factors. This is incorrect.

c) Inflation, recession and high interest rate are amongst the many factors that is responsible for market risk. This is correct.

d) Incorrect. These factors are beyond the control of investors but should not be ignored as it can help you time the market.

e) Incorrect. These factors are important to markets.

13) a) Incorrect. Beta is one of the axes in security market line.

b) Incorrect. If risk free rate rises, market risk premium can remain same, increase or even decrease.

c) Incorrect. If beta is halved the risk premium is halved and not the expected return.

d) Incorrect. If beta is doubled the risk premium is doubled and not the expected return.

e) Correct. SML is given by E(R) = R_f + Beta*(Rm-R_f ).

Beta and E(R) are the X & Y axes respectively and so market risk premium (Rm-R_f ) is the slope.

14) a) Incorrect. We cannot comment on the correlation with other stocks through beta or standard deviation alone.

b) Incorrect. Higher beta has a higher expected rate of return and so return for A should be more than B.

c) Incorrect.We cannot comment on the portfolio standard deviation without any information on the correlation between A and B.

d) Incorrect. Portfolio beta = Weight of stock A* Beta of A + Weight of stock B* Beta of B. We have all inforamtion.

e) Correct. Portfolio Beta = 0.5*1.2 + 0.5*0.8 = 1