31
56) Discuss whether the standard deviation of a portfolio is, or is not, a weighted average of the standard
deviations of the assets in the portfolio. Fully explain your answer.
Keywords: Standard Deviation, Portfolio, Diversification
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
57) Define systematic and unsystematic risk. What method is used to measure a firm’s market risk?
Keywords: Risk, Total Project Risk, Systematic Risk, Contribution-to-firm Risk
Learning Obj.: L.O. 6.4
AACSB: Reflective Thinking
Learning Objective 6.5
1) The required rate of return for an asset is equal to the risk-free rate plus a risk premium.
Keywords: Required Rate of Return, Risk-free Rate, Risk Premium
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
2) The T-bill return is used in the CAPM model as the risk-free rate.
Keywords: CAPM, T-bill, Risk-free Rate
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
32
3) The CAPM designates the risk-return trade-off existing in the market, where risk is defined in terms of
beta.
Keywords: CAPM, Risk-Return Trade-off, Beta
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
4) The S&P 500 index must be used as the measure of market return in the CAPM or the results are not
theoretically accurate.
Keywords: CAPM, S&P 500
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
5) According to the CAPM, for each unit of beta, an asset’s required rate of return increases by the
market’s return.
Keywords: CAPM, Beta, Required Return, Market Return
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
6) According to the CAPM, for each unit of beta, an asset’s required rate of return increases by the
market’s risk premium.
Keywords: CAPM, Beta, Required Return, Market Risk Premium
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
7) Stocks that plot above the security market line are underpriced because their expected returns exceed
their risk-adjusted required returns.
Keywords: Security Market Line
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
8) An investor with a required return of 8% for stock A will purchase stock A if the expected return for
stock A is less than or equal to 8%.
Keywords: Required Return, Expected Return
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
33
9) In general, the required rate of return is a function of (1) the time value of money, (2) the risk of an
asset, and (3) the investor’s attitude toward risk.
Keywords: Required Rate of Return
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
10) As the required rate of return of an investment decreases, the market price of the investment
decreases.
Keywords: Required Rate of Return
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
11) In an efficient market, a stock with a standard deviation of returns of 12% could have a higher
expected return than a stock with a standard deviation of 10% because the beta for the higher standard
deviation stock could be lower than the beta for the lower standard deviation stock.
Keywords: Risk-Return Trade-off, Beta, Standard Deviation
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
12) The capital asset pricing model
A) provides a risk-return trade-off in which risk is measured in terms of the market volatility.
B) provides a risk-return trade-off in which risk is measured in terms of beta.
C) measures risk as the coefficient of variation between security and market rates of return.
D) depicts the total risk of a security.
Keywords: Capital Asset Pricing Model, Beta, Risk-Return Trade-off
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
13) A typical measure for the risk-free rate of return is the
A) U.S. Treasury bill rate.
B) prime lending rate.
C) money-market rate.
D) short-term AAA-rated bond rate.
Keywords: Risk-Free Rate of Return, U.S. T-bill
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
34
14) If the beta for stock A equals zero, then
A) stock A‘s required return is equal to the required return on the market portfolio.
B) stock A’s required return is equal to the risk-free rate of return.
C) stock A has a guaranteed return.
D) stock A‘s required return is greater than the required return on the market portfolio.
Keywords: Beta, Required Rate of Return, Security Market Line
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
15) The risk-free rate of interest is 4% and the market risk premium is 9%. Howard Corporation has a beta
of 2.0, and last year generated a return of 16% with a standard deviation of returns of 27%. The required
return on Howard Corporation stock is
A) 36%.
B) 34%.
C) 26%.
D) 22%.
Keywords: Required Return, Beta, Security Market Line
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
16) Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta of 1.8 and a
standard deviation of returns of 18%. If the market risk premium increases, then
A) the required return on stock B will increase more than the required return on stock A.
B) the required returns on stocks A and B will both increase by the same amount.
C) the required returns on stocks A and B will remain the same.
D) the required return on stock A will increase more than the required return on stock B.
Keywords: Beta, Security Market Line, Market Risk Premium
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
17) Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B has a beta of 1.8 and a
standard deviation of returns of 18%. If the risk-free rate of return increases and the market risk premium
remains constant, then
A) the required return on stock B will increase more than the required return on stock A.
B) the required returns on stocks A and B will both increase by the same amount.
C) the required returns on stocks A and B will not change.
D) the required return on stock A will increase more than the required return on stock B.
Keywords: Beta, Security Market Line, Market Risk Premium, Risk-free Rate of Return
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
35
18) An investor currently holds the following portfolio:
Amount
Invested
8,000 shares of Stock A
$16,000
Beta = 1.3
15,000 shares of Stock B
$48,000
Beta = 1.8
25,000 shares of Stock C
$96,000
Beta = 2.2
If the risk-free rate of return is 2% and the market risk premium is 7%, then the required return on the
portfolio is
A) 14.91%.
B) 15.93%.
C) 21.91%.
D) 23.93%.
Keywords: Beta, Security Market Line, Portfolio, Required Return
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
19) Wendy purchased 800 shares of Robotics stock at $3 per share on 1/1/09. Wendy sold the shares on
12/31/09 for $3.45. Robotics stock has a beta of 1.3, the risk-free rate of return is 3%, and the market risk
premium is 8%. The required return on Robotics stock is
A) 13.4%.
B) 16.5%.
C) 17.6%.
D) 21.1%.
Keywords: Required Return, Security Market Line, Beta, Market Risk Premium
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
20) Based on the security market line, Robo-Tech stock has a required return of 14% and Friendly
Insurance Company has a required return of 10%. Robo-Tech has a standard deviation of returns of 18%.
Therefore,
A) Friendly must have a standard deviation of returns of less than 18% because Friendly is less risky than
Robo-Tech.
B) all rational investors will prefer Friendly over Robo–Tech.
C) for a well-diversified investor, Friendly is less risky than Robo-Tech.
D) the beta for Friendly must be greater than the beta for Robo-Tech because Friendly is the better buy for
a risk-averse investor.
Keywords: Security Market Line, Well-diversified, Beta, Risk
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
36
21) Green Company stock has a beta of 2 and a required return of 23%, while Gold Company stock has a
beta of 1.0 and a required return of 14%. The standard deviation of returns for Green Company is 10%
more than the standard deviation for Gold Company. The expected return on the market portfolio
according to the CAPM is
A) 9%.
B) 10%.
C) 12%.
D) 14%.
Keywords: CAPM, Security Market Line, Beta, Required Return
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
22) White Company stock has a beta of 2 and a required return of 23%, while Black Company stock has a
beta of 1.0 and a required return of 14%. The standard deviation of returns for White Company is 10%
more than the standard deviation for Black Company. The risk-free rate of return according to the CAPM
is
A) 4%.
B) 5%.
C) 6%.
D) impossible to determine with the information given.
Keywords: CAPM, Security Market Line, Beta, Required Return
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
23) Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the
market risk premium is 7.5%, the risk-free rate of return is
A) 4.1%.
B) 3.4%.
C) 2.0%.
D) 1.5%.
Keywords: CAPM, Security Market Line, Risk-free Rate of Return
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
37
24) Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the
risk-free rate of return is 4.2%, the expected return on the market portfolio is
A) 21%.
B) 19.2%.
C) 13.4%.
D) 10.2%.
Keywords: CAPM, Security Market Line, Risk-free Rate of Return, Market Portfolio
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
25) You are going to add one of the following three projects to your already well-diversified portfolio.
PROJECT 1 PROJECT 2
Probability
Return
Standard
Deviation
Beta
Return
Standard
Deviation
Beta
50% Chance
22%
12%
1.1
36%
19.5%
0.8
50% Chance
-4%
10.5%
-20%
PROJECT 3
Probability
Return
Standard
Deviation
Beta
10% Chance
28%
12%
2.0
70% Chance
18%
20% Chance
-8%
Assume the risk-free rate of return is 2% and the market risk premium is 8%. If you are a risk averse
investor, which project should you choose?
A) Project 1
B) Project 2
C) Project 3
D) Either Project 2 or Project 3 because the higher expected return on project 3 offsets its higher risk
Keywords: Beta, Risk-Return Trade-off, Expected Return, Security Market Line, Required Return
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
38
26) The appropriate measure for risk according to the capital asset pricing model is
A) the standard deviation of a firm’s cash flows.
B) alpha.
C) the standard deviation of a firm’s stock returns.
D) beta.
Keywords: Beta, CAPM, Risk
Learning Obj.: L.O. 6.5
AACSB: Reflective Thinking
27) Anchor Incorporated has a beta of 1.0. If the expected return on the market is 15%, what is the
expected return on Anchor Incorporated’s stock?
A) 15%
B) 14%
C) 18%
D) cannot be determined without the risk-free rate
Keywords: Beta, Security Market Line
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
28) Decker Corp. common stock has a required return of 17.5% and a beta of 1.75. If the expected risk free
return is 3%, what is the expected return for the market based on the CAPM?
A) 11.29%
B) 14.29%
C) 13.35%
D) 15.27%
Keywords: Beta, Security Market Line, Expected Return for the Market Portfolio
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking
29) Wildings, Inc. common stock has a beta of 1.2. If the expected risk free return is 4% and the expected
market risk premium is 9%, what is the expected return on Wildings’ stock?
A) 10.0%
B) 12.0%
C) 13.8%
D) 14.8%
Keywords: Beta, Security Market Line, Market Risk Premium, Expected Return
Learning Obj.: L.O. 6.5
AACSB: Analytical Thinking