CHAPTER 08—RISK AND RATES OF RETURN
c
1
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Beta coefficient
Bloom’s: Analysis
Multiple Choice: Conceptual
59. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar
information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?
Years
Market
Stock A
Stock B
1
0.03
0.16
0.05
2
−0.05
0.20
0.05
3
0.01
0.18
0.05
4
−0.10
0.25
0.05
5
0.06
0.14
0.05
bA > 0; bB = 1.
bA > +1; bB = 0.
bA = 0; bB = −1.
bA < 0; bB = 0.
bA < −1; bB = 1.
d
1
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Beta coefficient
Bloom’s: Analysis
Multiple Choice: Conceptual
60. Which of the following statements is CORRECT?
An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio
of stocks.
The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that
CHAPTER 08—RISK AND RATES OF RETURN
includes the stock.
Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.
An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified
portfolio of stocks.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk
Bloom’s: Comprehension
Multiple Choice: Conceptual
61. Which of the following statements is CORRECT?
If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk
from the portfolio.
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.
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.
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.
A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless
rate.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and beta
Bloom’s: Comprehension
Multiple Choice: Conceptual
62. Inflation, recession, and high interest rates are economic events that are best characterized as being
systematic risk factors that can be diversified away.
company-specific risk factors that can be diversified away.
among the factors that are responsible for market risk.
risks that are beyond the control of investors and thus should not be considered by security analysts or
CHAPTER 08—RISK AND RATES OF RETURN
portfolio managers.
irrelevant except to governmental authorities like the Federal Reserve.
c
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Market risk
Bloom’s: Comprehension
Multiple Choice: Conceptual
63. Which of the following statements is CORRECT?
A stock’s beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an
investor who holds only that one stock.
If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk
inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially
riskless.
The required return on a firm’s common stock is, in theory, determined solely by its market risk. If the market
risk is known, and if that risk is expected to remain constant, then no other information is required to specify
the firm’s required return.
Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each
individual stock held in a portfolio.
A security’s beta measures its non-diversifiable, or market, risk relative to that of an average stock.
e
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Risk and port. divers.
Bloom’s: Comprehension
Multiple Choice: Conceptual
64. Which of the following statements is CORRECT?
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.
Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios
are subject to market (or systematic) risk.
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.
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.
CHAPTER 08—RISK AND RATES OF RETURN
If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk
from the portfolio.
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Risk and port. divers.
Bloom’s: Comprehension
Multiple Choice: Conceptual
65. Which of the following statements is CORRECT?
A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.
A portfolio that consists of 40 stocks that are not highly correlated with “the market” will probably be less
risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the
same standard deviations.
A two-stock portfolio will always have a lower beta than a one-stock portfolio.
If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than
a one-stock portfolio.
A stock with an above-average standard deviation must also have an above-average beta.
MODERATE
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Port. risk, return, and beta
Bloom’s: Comprehension
Multiple Choice: Conceptual
66. Consider the following information for three stocks, A, B, and C. The stocks’ returns are positively but not perfectly
positively correlated with one another, i.e., the correlations are all between 0 and 1.
Expected
Standard
Stock
Return
Deviation
Beta
A
10%
20%
1.0
B
10%
10%
1.0
C
12%
12%
1.4
Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds
invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal
expected returns. Which of the following statements is CORRECT?
Portfolio AB has a standard deviation of 20%.
Portfolio AB’s coefficient of variation is greater than 2.0.
CHAPTER 08—RISK AND RATES OF RETURN
Portfolio AB’s required return is greater than the required return on Stock A.
Portfolio ABC’s expected return is 10.66667%.
Portfolio ABC has a standard deviation of 20%.
d
1
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
67. Which of the following statements is CORRECT?
If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and
these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a
standard deviation that is less than that of the individual stocks.
A portfolio with a large number of randomly selected stocks would have more market risk than a single stock
that has a beta of 0.5, assuming that the stock’s beta was correctly calculated and is stable.
If a stock has a negative beta, its expected return must be negative.
A portfolio with a large number of randomly selected stocks would have less market risk than a single stock
that has a beta of 0.5.
According to the CAPM, stocks with higher standard deviations of returns must also have higher expected
returns.
b
1
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Port. return, CAPM, and beta
Bloom’s: Comprehension
Multiple Choice: Conceptual
68. For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?
The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.
The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
The beta of the portfolio is less than the weighted average of the betas of the individual stocks.
The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.
The beta of the portfolio is larger than the weighted average of the betas of the individual stocks.
d
1
CHAPTER 08—RISK AND RATES OF RETURN
69. Which of the following statements best describes what you should expect if you randomly select stocks and add them
to your portfolio?
Adding more such stocks will reduce the portfolio’s unsystematic, or diversifiable, risk.
Adding more such stocks will increase the portfolio’s expected rate of return.
Adding more such stocks will reduce the portfolio’s beta coefficient and thus its systematic risk.
Adding more such stocks will have no effect on the portfolio’s risk.
Adding more such stocks will reduce the portfolio’s market risk but not its unsystematic risk.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Comprehension
Multiple Choice: Conceptual
70. Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%.
Becky also has a $50,000 portfolio, but it has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is
also 25%. The correlation coefficient, r, between Bob’s and Becky’s portfolios is zero. If Bob and Becky marry and
combine their portfolios, which of the following best describes their combined $100,000 portfolio?
The combined portfolio’s expected return will be less than the simple weighted average of the expected returns
of the two individual portfolios, 10.0%.
The combined portfolio’s beta will be equal to a simple weighted average of the betas of the two individual
portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the
two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two
portfolios’ standard deviations, 25%.
The combined portfolio’s expected return will be greater than the simple weighted average of the expected
returns of the two individual portfolios, 10.0%.
The combined portfolio’s standard deviation will be greater than the simple average of the two portfolios’
standard deviations, 25%.
The combined portfolio’s standard deviation will be equal to a simple average of the two portfolios’ standard
deviations, 25%.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Comprehension
Multiple Choice: Conceptual
CHAPTER 08—RISK AND RATES OF RETURN
71. Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected
return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the
correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of
your 2-stock portfolio?
Your portfolio has a standard deviation of 30%, and its expected return is 15%.
Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.
Your portfolio has a beta equal to 1.6, and its expected return is 15%.
Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.
Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
72. 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?
The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
The expected return of your portfolio is likely to decline.
The diversifiable risk will remain the same, but the market risk will likely decline.
Both the diversifiable risk and the market risk of your portfolio are likely to decline.
The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio
should also decline.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
CHAPTER 08—RISK AND RATES OF RETURN
73. Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in
equilibrium, which of the following statements is CORRECT?
Jane’s portfolio will have less diversifiable risk and also less market risk than Dick’s portfolio.
The required return on Jane’s portfolio will be lower than that on Dick’s portfolio because Jane’s portfolio will
have less total risk.
Dick’s portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane’s
portfolio, but the required (and expected) returns will be the same on both portfolios.
If the two portfolios have the same beta, their required returns will be the same, but Jane’s portfolio will have
less market risk than Dick’s.
The expected return on Jane’s portfolio must be lower than the expected return on Dick’s portfolio because
Jane is more diversified.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
74. Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on
the two stocks have a correlation of +0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following
statements is CORRECT?
Portfolio P has a beta that is greater than 1.2.
Portfolio P has a standard deviation that is greater than 25%.
Portfolio P has an expected return that is less than 12%.
Portfolio P has a standard deviation that is less than 25%.
Portfolio P has a beta that is less than 1.2.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Analysis
75. Stocks A, B, and C all have an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns
Bloom’s: Comprehension
Multiple Choice: Conceptual
CHAPTER 08—RISK AND RATES OF RETURN
that are independent of one another, i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are
negatively correlated with one another, i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in
Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in
Stock C. Which of the following statements is CORRECT?
Portfolio AC has an expected return that is less than 10%.
Portfolio AC has an expected return that is greater than 25%.
Portfolio AB has a standard deviation that is greater than 25%.
Portfolio AB has a standard deviation that is equal to 25%.
Portfolio AC has a standard deviation that is less than 25%.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
76. Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on
the two stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% A and 50% B. Which of
the following statements is CORRECT?
The portfolio’s beta is less than 1.2.
The portfolio’s expected return is 15%.
The portfolio’s standard deviation is greater than 20%.
The portfolio’s beta is greater than 1.2.
The portfolio’s standard deviation is 20%.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
77. 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?
Portfolio P’s expected return is greater than the expected return on Stock B.
Portfolio P’s expected return is equal to the expected return on Stock A.
CHAPTER 08—RISK AND RATES OF RETURN
Portfolio P’s expected return is less than the expected return on Stock B.
Portfolio P’s expected return is equal to the expected return on Stock B.
Portfolio P’s expected return is greater than the expected return on Stock C.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
78. In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement is
false?
The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.
The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
The beta of the portfolio is lower than the lowest of the three betas.
The beta of the portfolio is higher than the highest of the three betas.
The beta of the portfolio is calculated as a weighted average of the individual stocks’ betas.
8-3 Risk in a Portfolio Context: The CAPM
FOFM.BRIG.16.08.03 – Risk in a Portfolio Context: The CAPM
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Portfolio risk and return
Bloom’s: Comprehension
Multiple Choice: Conceptual
79. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?
Stock B’s required return is double that of Stock A’s.
If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than
the required return on Stock A.
An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2.
If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than
the required return on Stock B.
If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A
will increase by more than that on Stock B.
CHAPTER 08—RISK AND RATES OF RETURN
80. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2,
but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $900,000 invested in Stock A and
$300,000 invested in Stock B. The correlation between the two stocks’ returns is zero (that is, rA,B = 0). Which of the
following statements is CORRECT?
Portfolio AB’s standard deviation is 17.5%.
The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued.
Portfolio AB’s expected return is 11.0%.
Portfolio AB’s beta is less than 1.2.
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Port. risk and ret. relationships
Bloom’s: Analysis
Multiple Choice: Conceptual
81. Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock’s returns is 20%. The
stocks’ returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists
of 50% X and 50% Y. Given this information, which of the following statements is CORRECT?
Portfolio P has a standard deviation of 20%.
The required return on Portfolio P is equal to the market risk premium (rM − rRF).
Portfolio P has a beta of 0.7.
Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
Portfolio P has the same required return as the market (rM).
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Port. risk and ret. relationships
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Port. risk and ret. relationships
Bloom’s: Analysis
Multiple Choice: Conceptual
CHAPTER 08—RISK AND RATES OF RETURN
82. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta
greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.
The effect of a change in the market risk premium depends on the slope of the yield curve.
If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a
beta of 1.0.
The effect of a change in the market risk premium depends on the level of the risk-free rate.
d
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Market risk premium
Bloom’s: Comprehension
Multiple Choice: Conceptual
83. Over the past 88 years, we have observed that investments with the highest average annual returns also tend to have
the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation
between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and
return), where the security with the highest risk is shown first, the one with the lowest risk last?
Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S.
Treasury bills.
Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term
government bonds.
Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S.
Treasury bills.
U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-
company stocks.
Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S.
Treasury bills.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Risk and ret. relationships
Bloom’s: Evaluation
Bloom’s: Analysis
Multiple Choice: Conceptual
CHAPTER 08—RISK AND RATES OF RETURN
84. During the coming year, the market risk premium (rM − rRF), is expected to fall, while the risk-free rate, rRF, is
expected to remain the same. Given this forecast, which of the following statements is CORRECT?
The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta
greater than 1.0.
The required return on all stocks will remain unchanged.
The required return will fall for all stocks, but it will fall more for stocks with higher betas.
The required return for all stocks will fall by the same amount.
The required return will fall for all stocks, but it will fall less for stocks with higher betas.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Required return
Bloom’s: Comprehension
Multiple Choice: Conceptual
85. 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?
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.
Stock B’s required rate of return is twice that of Stock A.
If Stock A’s required return is 11%, then the market risk premium is 5%.
If Stock B’s required return is 11%, then the market risk premium is 5%.
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.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
86. Assume that in recent years both expected inflation and the market risk premium (rM − rRF) have declined. Assume
also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these
changes?
The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.
Multiple Choice: Conceptual
CHAPTER 08—RISK AND RATES OF RETURN
The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.
The average required return on the market, rM, has remained constant, but the required returns have fallen for
stocks that have betas greater than 1.0.
Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas
less than 1.0.
The required returns on all stocks have fallen by the same amount.
b
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
CAPM and required return
Bloom’s: Comprehension
Multiple Choice: Conceptual
87. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
If a stock has a negative beta, its required return under the CAPM would be less than 5%.
If a stock’s beta doubled, its required return under the CAPM would also double.
If a stock’s beta doubled, its required return under the CAPM would more than double.
If a stock’s beta were 1.0, its required return under the CAPM would be 5%.
If a stock’s beta were less than 1.0, its required return under the CAPM would be less than 5%.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
CAPM and required return
Bloom’s: Analysis
Multiple Choice: Conceptual
88. Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns
equaling expected returns. Which of the following statements is CORRECT?
If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of
Stock LB will decline but the required return of Stock HB will increase.
If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB
will increase by more than that on Stock LB.
If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks
will increase by the same amount.
Since the market is in equilibrium, the required returns of the two stocks should be the same.
If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of
CHAPTER 08—RISK AND RATES OF RETURN
Stock HB will decline but the required return of Stock LB will increase.
b
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
CAPM and required return
Bloom’s: Analysis
Multiple Choice: Conceptual
89. 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 equal amounts
invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks
are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the
market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT?
The required return of all stocks will remain unchanged since there was no change in their betas.
The required return on Stock A will increase by less than the increase in the market risk premium, while the
required return on Stock C will increase by more than the increase in the market risk premium.
The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as
Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease.
The required returns on all three stocks will increase by the amount of the increase in the market risk premium.
The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as
Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.
b
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
CAPM and required return
Bloom’s: Analysis
Multiple Choice: Conceptual
90. Which of the following statements is CORRECT?
If a company’s beta doubles, then its required rate of return will also double.
Other things held constant, if investors suddenly become convinced that there will be deflation in the
economy, then the required returns on all stocks should increase.
If a company’s beta were cut in half, then its required rate of return would also be halved.
If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required
rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will
increase.
If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required
rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than
1.0 will rise.
CHAPTER 08—RISK AND RATES OF RETURN
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
CAPM and required return
Bloom’s: Comprehension
Multiple Choice: Conceptual
91. Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the
following statements is CORRECT?
An index fund with beta = 1.0 should have a required return of 11%.
If a stock has a negative beta, its required return must also be negative.
An index fund with beta = 1.0 should have a required return less than 11%.
If a stock’s beta doubles, its required return must also double.
An index fund with beta = 1.0 should have a required return greater than 11%.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
CAPM, beta, and req. return
Bloom’s: Analysis
Multiple Choice: Conceptual
92. Which of the following statements is CORRECT?
The slope of the security market line is equal to the market risk premium.
Lower beta stocks have higher required returns.
A stock’s beta indicates its diversifiable risk.
Diversifiable risk cannot be completely diversified away.
Two securities with the same stand-alone risk must have the same betas.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Comprehension
CHAPTER 08—RISK AND RATES OF RETURN
93. Which of the following statements is CORRECT?
Beta is measured by the slope of the security market line.
If the risk-free rate rises, then the market risk premium must also rise.
If a company’s beta is halved, then its required return will also be halved.
If a company’s beta doubles, then its required return will also double.
The slope of the security market line is equal to the market risk premium, (rM − rRF).
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Comprehension
Multiple Choice: Conceptual
94. 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.)
Stock A’s returns are less highly correlated with the returns on most other stocks than are B’s returns.
Stock B has a higher required rate of return than Stock A.
Portfolio P has a standard deviation of 22.5%.
More information is needed to determine the portfolio’s beta.
Portfolio P has a beta of 1.0.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
95. 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?
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.
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
Multiple Choice: Conceptual
CHAPTER 08—RISK AND RATES OF RETURN
than 1.0.
Since Nile’s beta is twice that of Elba’s, its required rate of return will also be twice that of Elba’s.
If the risk-free rate increases while the market risk premium remains constant, then the required return on an
average stock will increase.
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.
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
96. 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 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.
Stock Y must have a higher expected return and a higher standard deviation than Stock X.
If expected inflation increases but the market risk premium is unchanged, then the required return on both
stocks will fall by the same amount.
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.
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.
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
97. 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?
The required return would increase for both stocks but the increase would be greater for Stock B than for
Stock A.
The required return would decrease by the same amount for both Stock A and Stock B.
CHAPTER 08—RISK AND RATES OF RETURN
The required return would increase for Stock A but decrease for Stock B.
The required return on Portfolio P would remain unchanged.
The required return would increase for Stock B but decrease for Stock A.
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
98. 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?
The required return on Portfolio P would increase by 1%.
The required return on both stocks would increase by 1%.
The required return on Portfolio P would remain unchanged.
The required return on Stock A would increase by more than 1%, while the return on Stock B would increase
by less than 1%.
The required return for Stock A would fall, but the required return for Stock B would increase.
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Analysis
Multiple Choice: Conceptual
99. Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most
likely to occur?
The required return on a stock with beta = 1.0 will not change.
The required return on a stock with beta > 1.0 will increase.
The return on “the market” will remain constant.
The return on “the market” will increase.
The required return on a stock with a positive beta < 1.0 will decline.
8-4 The Relationship Between Risk and Rates of Return
CHAPTER 08—RISK AND RATES OF RETURN
100. Which of the following statements is CORRECT?
The slope of the SML is determined by the value of beta.
The SML shows the relationship between companies’ required returns and their diversifiable risks. The slope
and intercept of this line cannot be influenced by a firm’s managers, but the position of the company on the
line can be influenced by its managers.
Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of
the regression line was negative. The CAPM would indicate that the required rate of return on the stock should
be less than the risk-free rate for a well-diversified investor, assuming investors expect the observed
relationship to continue on into the future.
If investors become less risk averse, the slope of the Security Market Line will increase.
If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a
higher required return on the stock.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Comprehension
Multiple Choice: Conceptual
101. Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the
Security Market Line would be affected as follows:
The y-axis intercept would decline, and the slope would increase.
The x-axis intercept would decline, and the slope would increase.
The y-axis intercept would increase, and the slope would decline.
The SML would be affected only if betas changed.
Both the y-axis intercept and the slope would increase, leading to higher required returns.
1
8-4 The Relationship Between Risk and Rates of Return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
FOFM.BRIG.16.08.04 – The Relationship Between Risk and Rates of Return
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.07 – Risk and return
Bloom’s: Comprehension
Multiple Choice: Conceptual