Chapter 25: Portfolio Theory and Asset Pricing Models
True / False
1. The slope of the SML is determined by the value of beta.
a. True
b. False
2. If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was
negative, the CAPM would indicate that the required rate of return on Selleck’s stock should be less than the risk-free rate
for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.
a. True
b. False
3. The SML relates required returns to firms’ systematic (or market) risk. The slope and intercept of this line can be
influenced by managerial actions.
a. True
b. False
Chapter 25: Portfolio Theory and Asset Pricing Models
4. The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b =
1) stock is zero.
a. True
b. False
5. If the returns of two firms are negatively correlated, then one of them must have a negative beta.
a. True
b. False
6. A stock with a beta equal to −1.0 has zero systematic (or market) risk.
a. True
b. False
Chapter 25: Portfolio Theory and Asset Pricing Models
7. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are
negative.
a. True
b. False
8. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are
interested in ex ante (future) data.
a. True
b. False
9. We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single
security.
a. True
b. False
Chapter 25: Portfolio Theory and Asset Pricing Models
10. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose
standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if
stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.
a. True
b. False
11. The CAPM is a multi-period model which takes account of differences in securities’ maturities, and it can be used to
determine the required rate of return for any given level of systematic risk.
a. True
b. False
12. Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are
specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.
Chapter 25: Portfolio Theory and Asset Pricing Models
a. True
b. False
Multiple Choice
13. Which of the following statements is CORRECT?
a. The slope of the CML is ( M − rRF)/bM.
b. All portfolios that lie on the CML to the right of σM are inefficient.
c. All portfolios that lie on the CML to the left of σM are inefficient.
d. The slope of the CML is ( M − rRF)/σM.
e. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.
14. You have the following data on three stocks:
Stock Standard Deviation Beta
A 0.15 0.79
B 0.25 0.61
C 0.20 1.29
As a risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part
of a well-diversified portfolio.
a. A; B.
b. B; C.
c. C; A.
Chapter 25: Portfolio Theory and Asset Pricing Models
d. C; B.
e. A; A.
15. Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a
diversified portfolio?
a. Standard deviation; correlation coefficient.
b. Beta; variance.
c. Coefficient of variation; beta.
d. Beta; beta.
e. Variance; correlation coefficient.
16. Which of the following is NOT a potential problem with beta and its estimation?
a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier
assets, the calculated beta will be drastically different than the “true” or “expected future” beta.
b. The beta of “the market,” can change over time, sometimes drastically.
c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because
conditions have changed.
d. There is a wide confidence interval around a typical stock’s estimated beta.
e. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.
Chapter 25: Portfolio Theory and Asset Pricing Models
17. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true about these securities?
(Assume market equilibrium.)
a. Stock B must be a more desirable addition to a portfolio than Stock A.
b. Stock A must be a more desirable addition to a portfolio than Stock B.
c. The expected return on Stock A should be greater than that on Stock B.
d. The expected return on Stock B should be greater than that on Stock A.
e. When held in isolation, Stock A has greater risk than Stock B.
18. In a portfolio of three different stocks, which of the following could NOT be true?
a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
b. The beta of the portfolio is less than the betas of each of the individual stocks.
c. The beta of the portfolio is greater than the beta of one or two of the individual stocks’ betas.
d. The beta of the portfolio cannot be equal to 1.
e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.
Chapter 25: Portfolio Theory and Asset Pricing Models
19. 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
a. bA > +1; bB = 0.
b. bA = 0; bB = −1.
c. bA < 0; bB = 0.
d. bA < −1; bB = 1.
e. bA > 0; bB = 1.
20. Which of the following statements is CORRECT?
a. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.
b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.
c. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.
d. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.
e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.
Chapter 25: Portfolio Theory and Asset Pricing Models
21. Which of the following statements is CORRECT?
a. The characteristic line is the regression line that results from plotting the returns on a particular stock versus the
returns on a stock from a different industry.
b. The slope of the characteristic line is the stock’s standard deviation.
c. The distance of the plot points from the characteristic line is a measure of the stock’s market risk.
d. The distance of the plot points from the characteristic line is a measure of the stock’s diversifiable risk.
e. “Characteristic line” is another name for the Security Market Line.
22. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to
1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a
mineral rights company stock (b = 2.00). What is the new beta of the portfolio?
a. 1.1139
b. 1.1700
c. 1.2311
d. 1.2927
e. 1.3573
Chapter 25: Portfolio Theory and Asset Pricing Models
23. Your mother’s well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of
buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0%
and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the
portfolio be after the purchase of the Safety stock?
rp bp
a. 11.69%; 1.22
b. 12.30%; 1.28
c. 12.92%; 1.34
d. 13.56%; 1.41
e. 14.24%; 1.48
24. Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the
market risk premium is 5.0%, (4) Talcott Inc.’s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the
last 5 years. Calculate the required rate of return for Talcot Inc.
a. 10.29%
b. 10.83%
c. 11.40%
d. 12.00%
e. 12.60%
Chapter 25: Portfolio Theory and Asset Pricing Models
25. A stock you are holding has a beta of 2.0 and the stock is currently in equilibrium. The required rate of return on the
stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases
by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the
required return on your stock increase as a result of this event?
a. 36.10%
b. 38.00%
c. 40.00%
d. 42.00%
e. 44.10%
Chapter 25: Portfolio Theory and Asset Pricing Models
26. Calculate the required rate of return for the Wagner Assets Management Group, which holds 4 stocks. The market’s
required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund’s assets are as follows:
Stock Investment Beta
A $ 200,000 1.50
B 300,000 −0.50
C 500,000 1.25
D 1,000,000 0.75
a. 10.67%
b. 11.23%
c. 11.82%
d. 12.45%
e. 13.10%
27. Consider the information below for Postman Builders Inc. Suppose that the expected inflation rate and thus the
inflation premium increase by 2.0 percentage points, and Postman acquires risky assets that increase its beta by the
indicated percentage. What is the firm’s new required rate of return?
Beta: 1.50
Required return (rs) 10.20%
RPM: 6.00%
Percentage increase in beta: 20%
a. 14.00%
b. 14.70%
c. 15.44%
d. 16.21%
e. 17.02%