10.7 Measuring Systematic Risk
Use the following information to answer the question(s) below.
Suppose that the market portfolio is equally likely to increase by 24% or decrease by 8%. Security “X”
goes up on average by 29% when the market goes up and goes down by 11% when the market goes
down. Security “Y” goes down on average by 16% when the market goes up and goes up by 16% when
the market goes down. Security “Z” goes up on average by 4% when the market goes up and goes up by
4% when the market goes down.
1) The beta for security “X” is closest to:
A) 0
B) 0.80
C) 1.00
D) 1.25
2) The beta for security “Y” is closest to:
A) -1.00
B) -0.25
C) 0.00
D) 0.25
3) The beta for security “Z” is closest to:
A) -1.00
B) -0.25
C) 0.00
D) 0.25
4) The risk-free rate is closest to:
A) 0%
B) 4%
C) 8%
D) 16%
5) The expected return on the market portfolio is closest to:
A) 0%
B) 4%
C) 8%
D) 16%
6) The expected return on security “Y” is closest to:
A) 0%
B) 4%
C) 10%
D) 15%
7) The expected return on security with a beta of 0.8 is closest to:
A) 0.0%
B) 3.2%
C) 6.4%
D) 7.2%
8) The expected return on security with a beta of 1.2 is closest to:
A) 4.8%
B) 8.0%
C) 8.8%
D) 9.6%
9) The expected return on security with a beta of 0 is closest to:
A) -4.0%
B) 0.0%
C) 3.2%
D) 4.0%
10) The expected return on security with a beta of 1 is closest to:
A) -4.0%
B) 3.2%
C) 4.0%
D) 8.0%
11) Which of the following statements is FALSE?
A) In exchange for bearing systematic risk, investors want to be compensated by earning a higher
return.
B) A key step to measuring systematic risk is finding a portfolio that contains only unsystematic risk.
C) When evaluating the risk of an investment, an investor will care about its systematic risk, which
cannot be eliminated through diversification.
D) To measure the systematic risk of a stock, we must determine how much of the variability of its
return is due to systematic, market-wide risks versus diversifiable, firm specific risks.
12) Which of the following statements is FALSE?
A) Beta differs from volatility.
B) The risk premium investors can earn by holding the market portfolio is the difference between the
market portfolio’s expected return and the risk-free interest rate.
C) Stocks in cyclical industries, in which revenues tend to vary greatly over the business cycle, are likely
to be more sensitive to systematic risk and have higher betas than stocks in less sensitive industries.
D) If we assume that the market portfolio (or the S&P 500) is efficient, then changes in the value of the
market portfolio represent unsystematic shocks to the economy.
13) Which of the following statements is FALSE?
A) Beta measures the sensitivity of a security to market wide risk factors.
B) Volatility measures total risk, while beta measures only systematic risk.
C) The beta is the expected percentage change in the excess return of the market portfolio for a 1%
change in the excess return of a security.
D) Utilities tend to be stable and highly regulated, and thus are insensitive to fluctuations in the overall
market.
14) Which of the following statements is FALSE?
A) Because diversification improves with the number of stocks held in a portfolio an efficient portfolio
should be a large portfolio containing many different stocks.
B) The beta of a security is the sensitivity of the security’s return to the return of the overall market.
C) An efficient portfolio cannot be diversified further, that is there is no way to reduce the risk of the
portfolio without lowering its expected return.
D) We call a portfolio that contains only unsystematic risk an efficient portfolio.
Use the information for the question(s) below.
Suppose the market portfolio’s excess return tends to increase by 30% when the economy is strong and
decline by 20% when the economy is weak. A type S firm has excess returns that increase by 45% when
the economy is strong and decrease by 30% when the economy is weak. A type I firm will also have
excess returns of either 45% or –30%, but the type I firm’s excess returns will depend only upon firm–
specific events and will be completely independent of the state of the economy.
15) What is the Beta for a type I firm?
A) 1.0
B) 0.75
C) 0.0
D) 1.5
16) What is the Beta for a type S firm?
A) 1.5
B) 0.0
C) 1.0
D) 0.75
10.8 Beta and the Cost of Capital
Use the following information to answer the question(s) below.
Company
Ticker
Beta
Ford Motor Company
F
2.77
International Business Machines
IBM
0.73
Merck
MRK
0.90
1) If the market risk premium is 6% and the risk-free rate is 4%, then the expected return of investing in
Ford Motor Company is closest to:
A) 10.0%
B) 16.2%
C) 17.1%
D) 20.6%
2) If the market risk premium is 6% and the risk-free rate is 4%, then the expected return of investing in
Merck is closest to:
A) 5.4%
B) 9.4%
C) 10.0%
D) 10.4%
3) If the expected return on the market is 11% and the risk-free rate is 4%, then the expected return of
investing in IBM is closest to:
A) 9.1%
B) 10.3%
C) 11.0%
D) 12.0%
4) If the expected return on the market is 11% and the expected return of investing in Merck is 10.35%,
then the risk-free rate must be:
A) 3.0%
B) 4.0%
C) 4.5%
D) 5.0%
5) If the risk-free rate is 5% and the expected return of investing in Merck is 11.3%, then the expected
return on the market must be:
A) 8.0%
B) 10.0%
C) 10.4%
D) 12.0%
6) Suppose that Luther’s beta is 0.9. If the market risk premium is 8% and the risk-free interest rate is
4%, then then expected return for Luther stock is?
A) 7.6%
B) 11.6%
C) 11.2%
D) 12.9%
7) Suppose that KAN’s beta is 1.5. If the market risk premium is 8% and the risk-free interest rate is 4%,
then then expected return for KAN stock is?
A) 8.0%
B) 16.0%
C) 13.5%
D) 10.0%
8) Suppose that Gold Digger’s beta is -0.8. If the market risk premium is 8% and the risk-free interest
rate is 4%, then the expected return for Gold Digger’s stock is?
A) -2.4%
B) 4.8%
C) 2.4%
D) 10.4%
9) Which of the following statements is FALSE?
A) The Capital Asset Pricing Model is the most important method for estimating the cost of capital that
is used in practice.
B) Because the risk that determines expected returns is unsystematic risk, which is measured by beta,
the cost of capital for an investment is the expected return available on securities with the same beta.
C) A common assumption is that the project has the same risk as the firm.
D) To determine a project’s cost of capital we need to estimate its beta.
Use the information for the question(s) below.
Suppose that in the coming year, you expect Exxon-Mobil stick to have a volatility of 42% and a beta of
0.9, and Merck’s stock to have a volatility of 24% and a beta of 1.1. The risk free interest rate is 4% and
the market’s expected return is 12%.
10) Which stock has the highest total risk?
A) Merck since it has a lower volatility
B) Merck since it has a higher Beta
C) Exxon-Mobil since it has a higher volatility
D) Exxon-Mobil since it has a lower beta
11) Which stock has the highest systematic risk?
A) Merck since it has a higher Beta
B) Exxon-Mobil since it has a lower beta
C) Exxon-Mobil since it has a higher volatility
D) Merck since it has a lower volatility
12) The cost of capital for a project with the same beta as Exxon Mobil’s stock is closest to:
A) 11.6%
B) 11.2%
C) 12.8%
D) 7.6%
13) The cost of capital for a project with the same beta as Merck’s stock is closest to:
A) 11.2%
B) 12.8%
C) 12.4%
D) 11.6%
14) Which of the following is consistent with the CAPM and efficient capital markets?
A) A security with a beta of 1 has a return last year of 8% when the market has a return of 12%.
B) Small stocks with a beta of 1.5 tend to have higher returns on average than large stocks with a beta of
1.5.
C) A security with only diversifiable risk has an expected return that exceeds the risk-free interest rate.
D) A security with only systematic risk has an expected return that exceeds the risk-free interest rate.
15) Which of the following statements is FALSE?
A) If the market portfolio were not efficient, investors could find strategies that would “beat the market”
with higher average returns and lower risk.
B) The CAPM states that the cost of capital depends only on systematic risk.
C) Efficient capital markets is a much stronger hypothesis than the CAPM.
D) The market portfolio is an efficient portfolio.
16) What is the market portfolio?