Corporate Finance: Core Principles & Apps, 5e (Ross)
Chapter 11 Return and Risk: The Capital Asset Pricing Model (CAPM)
1) Which one of these measures the interrelationship between two securities?
A) Standard deviation
B) Variance
C) Beta
D) Covariance
E) Alpha
2) Angelo anticipates earning a rate of return of 11.4 percent on his portfolio next year. The 11.4
percent is referred to as the
A) expected return.
B) future return.
C) holding period return.
D) actual return.
E) average return.
3) Which one of these measures the squared deviations of actual returns from expected returns?
A) Variance
B) Covariance
C) Beta
D) Correlation
E) Alpha
4) A negative covariance between the returns of Stock A and Stock B indicates that
A) market prices of Stock A and Stock B move in tandem when their returns are declining.
B) the return on one stock will exceed that stock’s average return when the second stock has a
return that is less than its average.
C) a portfolio investing equally in Stocks A and B will have a negative expected rate of return.
D) both Stock A and Stock B have negative rates of return for the period.
E) one stock has a negative rate of return while the other stock has a positive rate of return for the
period.
5) The correlation between stocks A and B is equal to the
A) standard deviation of A divided by the standard deviation of B.
B) covarianceAB divided by the product of the standard deviations of A and B.
C) standard deviation of B divided by the covarianceAB.
D) sum of the variances of A and B divided by the covarianceAB.
E) product of the standard deviation of A multiplied by the standard deviation of B divided by
covarianceAB.
6) You plotted the monthly rate of return for two securities against time for the past 48 months. If
the pattern of the movements of these two sets of returns rose and fell together the majority, but not
all, of the time, then the securities have
A) no correlation at all.
B) a weak negative correlation.
C) a strong negative correlation.
D) a strong positive correlation.
E) a perfect positive correlation.
7) The market risk of a portfolio of two stocks will be reduced the most if the securities within that
portfolio have a correlation of
A) −1
B) −0.5
C) 0
D) 0.5
E) 1
8) If there is no diversification benefit derived from combining two risky stocks into one portfolio,
then the
A) returns on the two stocks must move perfectly in sync with one another.
B) returns on the two stocks must move perfectly opposite of one another.
C) stocks must have a zero correlation.
D) portfolio is equally weighted between the two stocks.
E) two stocks are completely unrelated to one another.
9) The expected return on a portfolio
A) can be greater than the expected return on the best performing security in the portfolio.
B) can be less than the expected return on the worst performing security in the portfolio.
C) is independent of the performance of the overall economy.
D) is limited by the returns on the individual securities within the portfolio.
E) is an arithmetic average of the returns of the individual securities when the weights of those
securities are unequal.
10) When computing the expected return on a portfolio of stocks the portfolio weights are based on
the
A) number of shares owned in each stock.
B) price per share of each stock.
C) market value of the total shares held in each stock.
D) original amount invested in each stock.
E) cost per share of each stock held.
11) The portfolio expected return considers which of the following factors?
I. The amount of money currently invested in each individual security
II. Various levels of economic activity
III. The performance of each stock given various economic scenarios
IV. The probability of various states of the economy occurring
A) I and III only
B) II and IV only
C) I, III, and IV only
D) II, III, and IV only
E) I, II, III, and IV only
12) If a stock portfolio is well diversified, then the portfolio variance
A) must be equal to or greater than the variance of the least risky stock in the portfolio.
B) will be a weighted average of the variances of the individual securities in the portfolio.
C) will equal the variance of the most volatile stock in the portfolio.
D) will be an arithmetic average of the variances of the individual securities in the portfolio.
E) may be less than the variance of the least risky stock in the portfolio.
13) The standard deviation of a portfolio will tend to increase when
A) the portfolio concentration in a single cyclical industry increases.
B) one of two stocks related to the airline industry is replaced with a third stock that is unrelated to
any other stock in the portfolio.
C) a risky asset in the portfolio is replaced with U.S. Treasury bills.
D) the weights of the various diverse securities become more evenly distributed.
E) short-term bonds are replaced with Treasury Bills.
14) Assume two securities are negatively correlated. If these two securities are combined into an
equally weighted portfolio, the portfolio standard deviation must be
A) equal to the standard deviation of the overall market.
B) equal to the arithmetic average of the standard deviations of the individual securities.
C) equal to zero.
D) less than the weighted average of the standard deviations of the individual securities.
E) equal to or greater than the lowest standard deviation of the two securities.
15) The covariance of two securities is
A) equal to the variance of one security divided by the variance of the second security.
B) zero when the securities are positively related.
C) expressed as a squared value.
D) limited to a range of 0 to +1.
E) unaffected by any changes in the probabilities of various states of the economy occurring.
16) The dominant portfolio with the lowest possible level of risk out of a set of portfolios
consisting of two securities is referred to as the
A) efficient frontier.
B) minimum variance portfolio.
C) upper tail of the efficient set.
D) tangency portfolio.
E) risk-free portfolio.
17) Which one of the following statements is correct concerning the standard deviation of a
portfolio?
A) Standard deviation is used to determine the amount of risk premium that should apply to a
portfolio.
B) The greater the diversification of a portfolio, the greater the standard deviation of that portfolio.
C) Standard deviation measures only the systematic risk of a portfolio.
D) The standard deviation of a portfolio can often be lowered by changing the weights of the
securities in the portfolio.
E) The standard deviation of a portfolio must equal the weighted average of the standard
deviations of the individual securities held within the portfolio.
18) Which one of these statements is correct regarding a portfolio of two risky securities?
A) Both the rate of return and the standard deviation of a portfolio can be changed by changing the
portfolio weights.
B) The opportunity set is represented by a forward bending curve when expected returns are
graphed against standard deviation.
C) Diversification occurs when the correlation between two securities is +1.
D) The standard deviation of a portfolio cannot be lower than the weighted average standard
deviation of the securities held within the portfolio.
E) The minimum variance portfolio of two stocks also represents the portfolio’s highest possible
rate of return.
19) Which statement correctly applies to the feasible set of returns for a portfolio consisting of
domestic stocks, A and B? Assume that the expected returns are plotted against standard
deviations.
A) Any combination of Stock A and Stock B that plot to the right of the minimum variance
portfolio is an efficient portfolio.
B) Given any specific level of risk, the maximum obtainable rate of return will plot on the efficient
frontier.
C) The minimum variance portfolio will move to the right on the risk-return graph if foreign
securities are added to the portfolio.
D) To obtain the highest possible return, the portfolio return and standard deviation should plot
above the feasible set.
E) The higher the correlation between Stocks A and B, the greater the bend in the curve of the
feasible set.
20) For an individual investor, the ideal portfolio could best be described as the portfolio that
A) has the lowest standard deviation given a specific expected rate of return.
B) lies above and to the left of the feasible set.
C) produces the highest rate of return.
D) qualifies as the minimum variance portfolio.
E) lies within the feasible set.
21) The standard deviation of a risk-free asset is
A) 0.
B) −1.
C) +1.
D) between 0 and −1.
E) between 0 and +1.
22) The combination of the efficient set of portfolios with a riskless lending and borrowing rate
results in the
A) capital market line that shows that investors will only invest in the riskless asset.
B) capital market line that shows that investors will invest in a combination of the riskless asset
and the tangency portfolio.
C) security market line that shows that all investors will invest in the riskless asset only.
D) security market line that shows that all investors will invest in a combination of the riskless
asset and the tangency portfolio.
E) capital market line that shows that investors will invest at the vertical intercept point of that line.
23) The separation principle states that an investor will
A) choose any efficient portfolio and invest some amount in the riskless asset to generate the
expected return.
B) never choose to invest in the riskless asset because the expected return on the riskless asset is
lower over time.
C) invest only in the riskless asset and tangency portfolio, choosing the weights of each based on
his/her individual risk tolerance.
D) randomly select any efficient portfolio.
E) select a portfolio based solely on his/her desired rate of return while ignoring the associated
risks of their selection.
24) What is the first step an investor takes when making an investment decision according to the
separation principle?
A) Determine the mix of risky and risk-free assets he/she will hold
B) Quantify the amount of risk he/she is willing to accept
C) Estimate future inflation and risk-free rates
D) Determine the portfolio of risky assets that he/she will hold
E) Specify a desired rate of return
25) The capital market line
A) assumes investors can borrow, but not lend, at the risk-free rate.
B) depicts the highest rate of return for every level of risk given only a single portfolio of risky
assets.
C) intersects its graph at the origin and is linear in nature.
D) intersects the vertical axis at the risk-free rate.
E) intersects the risky portfolio at that portfolio’s lowest risk point.
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26) Mr. Rhoades is the CEO of Daily News. The majority of stockholders do not approve of the
decisions made by Mr. Rhoades and have repeatedly requested that he be ousted. Over the last
couple of months, it has become apparent that the CEO is going to be replaced by a member of the
board, Mr. Bentley, who is highly respected. This morning, the official announcement was made
that Mr. Rhoades has stepped down and will be replaced immediately by Mr. Bentley. How is the
stock price of the Daily News most apt to react to this announcement?
A) Highly positive and immediate reaction
B) A slow but positive reaction
C) An immediate negative reaction
D) Middling reaction over multiple days
E) No reaction
27) The market price of ABC stock is most apt to be affected by which one of these events?
A) Twenty-five percent increase in interest rates, just as expected
B) The sudden passing of ABC’s CEO
C) An increase in ABC’s annual dividend by the same percentage as last year’s increase
D) The completion of ABC’s new distribution center, right on schedule
E) An increase in ABC’s payroll costs, in line with current inflation
28) Over time, the unexpected return on a company’s stock is expected to equal
A) zero.
B) the risk-free rate.
C) the company’s average rate of return.
D) the market risk premium.
E) the average return on the overall market.
29) Which one of the following is an example of systematic risk?
A) A poorly managed company suddenly goes out of business due to slow sales.
B) An efficient company reduces its work force and automates several jobs.
C) A key company employee suddenly resigns and accepts employment with a competitor.
D) A well respected chairman of the Federal Reserve suddenly resigns.
E) An unpopular president of a firm suddenly resigns.
30) Which one of the following is the best example of systematic risk?
A) The price of tomatoes declines sharply.
B) Inflation rises unexpectedly.
C) Commercial airline pilots go on strike.
D) A hurricane hits a tourist destination.
E) People become diet conscious and avoid fast food restaurants.
31) Well-diversified portfolios have negligible
A) systematic risks.
B) unsystematic risks.
C) expected returns.
D) variances.
E) market risks.
32) Unsystematic risk
A) can be effectively eliminated through portfolio diversification.
B) is measured by beta.
C) is compensated for by the risk premium.
D) is nondiversifiable.
E) is related to the overall economy.
33) The primary purpose of portfolio diversification is to
A) increase returns and risks.
B) eliminate all risks.
C) eliminate asset-specific risk.
D) lower both returns and risks.
E) eliminate systematic risk.
34) Which one of the following would tend to indicate that a portfolio is being effectively
diversified?
A) A decrease in the portfolio standard deviation
B) An increase in the portfolio rate of return
C) An increase in the portfolio beta
D) An increase in the portfolio standard deviation
E) A constant portfolio beta
35) The principle of diversification tells us that
A) concentrating a portfolio in three companies within the same industry will greatly reduce the
overall risk of a portfolio.
B) concentrating a portfolio in two or three large stocks will eliminate all of a portfolio’s risk.
C) spreading an investment across many diverse assets will eliminate all of a portfolio’s risk.
D) spreading an investment across many diverse assets will lower a portfolio’s level of risk.
E) spreading an investment across five diverse companies will not lower a portfolio’s level of risk.
36) Systematic risk is measured by
A) beta.
B) the arithmetic average.
C) the geometric average.
D) covariance.
E) standard deviation.
37) The beta of a security is calculated by dividing the
A) variance of the market by the covariance of the security with the market.
B) correlation of the security with the market by the variance of the security.
C) variance of the market by the correlation of the security with the market.
D) covariance of the security with the market by the variance of the market.
E) covariance of the security with the market by the variance of the security.
38) A portfolio consists of five securities that have individual betas of 1.38, 0.87, 1.02, 1.49, and
0.67. You do not know the portfolio weight of each security. What do you know with certainty?
A) The portfolio beta will not be affected by any change in the portfolio weights.
B) The portfolio beta will not change if an additional security with a beta of 1 is added to the
portfolio.
C) The portfolio beta will be greater than the market beta.
D) The portfolio beta will be less than 1.49 and greater than 0.67.
E) The optimal portfolio beta for any investor must be greater than 0 and less than 1.
39) The risk of an individual security that will be compensated by the market depends upon the
A) standard deviation of that security.
B) covariance of that security with the market.
C) expected rate of return on that security.
D) security’s historical variance.
E) industry most associated with that security.
40) The risk premium for an individual security is computed by
A) adding the risk-free rate to the security’s expected return.
B) multiplying the security’s beta by the market risk premium.
C) multiplying the security’s beta by the risk-free rate of return.
D) dividing the market risk premium by the beta of the security.
E) dividing the market risk premium by the quantity (1 − Beta).
41) The systematic risk of the market is assigned a
A) beta of 1.
B) beta of 0.
C) standard deviation of 1.
D) standard deviation of 0.
E) variance of 1.
42) A security that is fairly priced will have a return that lies ________ the security market line.
A) below
B) on or below
C) on
D) on or above
E) above
43) Assume the risk-free rate and the market risk premium are both positive. Trevor currently
owns a portfolio consisting of risky and risk-free securities. The portfolio has an expected return of
11.2 percent, a standard deviation of 16.2 percent, and a beta of 1.21. He has decided that he would
prefer a higher expected return. Which one of these actions should he take?
A) Replace a stock in his current portfolio with a beta of 1.34 with a stock that has a beta of 1.03
B) Sell a portion of the risky assets and use the proceeds to purchase risk-free securities
C) Lower both the portfolio standard deviation and beta
D) Increase the portfolio weight of the risky assets without affecting the total portfolio value
E) Increase the standard deviation of the portfolio without affecting the portfolio beta
44) The intercept point of the security market line is the rate of return that corresponds to
A) the market rate of return.
B) the beta of the market.
C) a value of one.
D) a value of zero.
E) the risk-free rate.
45) Amy has a portfolio with a beta of 1.26 but has decided to lower her investment risk. Adding
which one of the following securities to her portfolio is most assuredly going to lower the risk of
the portfolio?
A) A stock that has a covariance with the market of 0.89
B) A security that has a standard deviation of 11 percent
C) A security with a beta of 1.58
D) U.S. Treasury bills
E) A mix of small-company and large-company stocks
46) A stock with an actual return that lies above the security market line has
A) less systematic risk than the overall market.
B) more risk than warranted based on the realized rate of return.
C) yielded a return equivalent to the level of risk assumed.
D) more systematic risk than the overall market.
E) yielded a higher return than expected for the level of risk assumed.
47) The market risk premium is computed by
A) adding the risk-free rate of return to the inflation rate.
B) adding the risk-free rate of return to the market rate of return.
C) subtracting the risk-free rate of return from the inflation rate.
D) subtracting the risk-free rate of return from the market rate of return.
E) multiplying the risk-free rate of return by a beta of one.
48) The excess return earned by an asset that has a beta of one over that earned by a risk-free asset
is referred to as the
A) market rate of return.
B) systematic return.
C) real rate of return.
D) market risk premium.
E) total return.
49) Assume you are looking at a security market line graph. Where would an overpriced stock with
a beta of 0.98 plot on that graph?
A) To the right of the market and below the security market line
B) To the left of the market and below the security market line
C) To the right of the market and above the security market line
D) To the left of the market and above the security market line
E) To the right of the market on the security market line
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50) A stock with a beta of zero would be expected to have a rate of return equal to
A) the prime rate.
B) the average AAA bond.
C) the market rate.
D) the risk-free rate.
E) zero.
51) According to the capital asset pricing model, the expected return on a security is
A) negatively and linearly related to the security’s beta.
B) positively and linearly related to the security’s beta.
C) positively and nonlinearly related to the security’s beta.
D) positively and linearly related to the security’s variance.
E) negatively and nonlinearly related to the security’s beta.
52) You recently purchased a stock that is expected to earn 12 percent in a booming economy, 9
percent in a normal economy, and lose 15 percent in a recessionary economy. The probabilities of
a boom, a normal economy, and a recession are 18, 75, and 7 percent, respectively. What is your
expected rate of return on this stock?
A) 7.93%
B) 7.45%
C) 7.86%
D) 7.75%
E) 7.68%
53) The Inferior Goods Co. stock is expected to earn 18 percent in a recession, 10 percent in a
normal economy, and lose 21 percent in a booming economy. The probability of a boom is 22
percent while the probability of a normal economy is 75 percent. What is the expected rate of
return on this stock?
A) 3.42%
B) 3.15%
C) 3.67%
D) 10.83%
E) 10.41%
54) RTF stock is expected to return 11 percent in a normal economy and lose 15 percent in a
recession. The probability of a recession is 33 percent and the probability of a booming economy is
zero. What is the variance of the returns on RTF stock?
A) 0.019093
B) 0.013760
C) 0.017864
D) 0.014946
E) 0.019394