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45. According to the CAPM, the risk premium an investor expects to receive on any stock or
portfolio increases:
A. directly with alpha.
B. inversely with alpha.
Difficulty: Easy
46. What is the expected return of a zero-beta security?
A. The market rate of return.
B. Zero rate of return.
Difficulty: Moderate
47. Standard deviation and beta both measure risk, but they are different in that
A. beta measures both systematic and unsystematic risk.
Difficulty: Easy
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48. The expected return-beta relationship
A. is the most familiar expression of the CAPM to practitioners.
B. refers to the way in which the covariance between the returns on a stock and returns on the
Difficulty: Moderate
49. The security market line (SML)
A. can be portrayed graphically as the expected return-beta relationship.
B. can be portrayed graphically as the expected return-standard deviation of market returns
Difficulty: Moderate
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50. Research by Jeremy Stein of MIT resolves the dispute over whether beta is a sufficient
pricing factor by suggesting that managers should use beta to estimate
D. book-to-market ratios.
E. None of the above was suggested by Stein.
Difficulty: Difficult
51. Studies of liquidity spreads in security markets have shown that
A. liquid stocks earn higher returns than illiquid stocks.
Difficulty: Difficult
52. An underpriced security will plot
A. on the Security Market Line.
B. below the Security Market Line.
Difficulty: Easy
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53. An overpriced security will plot
A. on the Security Market Line.
Difficulty: Easy
54. The risk premium on the market portfolio will be proportional to
A. the average degree of risk aversion of the investor population.
B. the risk of the market portfolio as measured by its variance.
Difficulty: Moderate
55. In equilibrium, the marginal price of risk for a risky security must be
D. adjusted by its degree of nonsystematic risk.
E. none of the above are true.
Difficulty: Moderate
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56. The capital asset pricing model assumes
A. all investors are price takers.
B. all investors have the same holding period.
Difficulty: Easy
57. The capital asset pricing model assumes
A. all investors are price takers.
B. all investors have the same holding period.
Difficulty: Easy
58. The capital asset pricing model assumes
A. all investors are price takers.
B. all investors have the same holding period.
Difficulty: Easy
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59. The capital asset pricing model assumes
A. all investors are fully informed.
B. all investors are rational.
Difficulty: Easy
60. If investors do not know their investment horizons for certain
A. the CAPM is no longer valid.
B. the CAPM underlying assumptions are not violated.
Difficulty: Moderate
61. The value of the market portfolio equals
A. the sum of the values of all equity securities.
B. the sum of the values of all equity and fixed income securities.
Difficulty: Moderate
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62. The amount that an investor allocates to the market portfolio is negatively related to
I) the expected return on the market portfolio.
II) the investor’s risk aversion coefficient.
III) the risk-free rate of return.
IV) the variance of the market portfolio
A. I and II
B. II and III
Difficulty: Moderate
63. One of the assumptions of the CAPM is that investors exhibit myopic behavior. What
does this mean?
D. They have the same economic view of the world.
E. They pay no taxes or transactions costs.
Difficulty: Moderate
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64. The CAPM applies to
A. portfolios of securities only.
B. individual securities only.
Difficulty: Moderate
65. Which of the following statements about the mutual fund theorem is true?
I) It is similar to the separation property.
II) It implies that a passive investment strategy can be efficient.
III) It implies that efficient portfolios can be formed only through active strategies.
IV) It means that professional managers have superior security selection strategies.
A. I and IV
B. I, II, and IV
Difficulty: Moderate
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66. The expected return – beta relationship of the CAPM is graphically represented by
D. the efficient frontier with a risk-free asset.
E. the efficient frontier without a risk-free asset.
Difficulty: Easy
67. A “fairly priced” asset lies
A. above the security market line.
Difficulty: Easy
68. For the CAPM that examines illiquidity premiums, if there is correlation among assets due
to common systematic risk factors, the illiquidity premium on asset i is a function of
A. the market’s volatility.
B. asset is volatility.
Difficulty: Moderate
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69. Your opinion is that security A has an expected rate of return of 0.145. It has a beta of 1.5.
The risk-free rate is 0.04 and the market expected rate of return is 0.11. According to the
Capital Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
Difficulty: Moderate
70. Your opinion is that security C has an expected rate of return of 0.106. It has a beta of 1.1.
The risk-free rate is 0.04 and the market expected rate of return is 0.10. According to the
Capital Asset Pricing Model, this security is
D. cannot be determined from data provided.
E. none of the above.
Difficulty: Moderate
71. The risk-free rate is 4 percent. The expected market rate of return is 12 percent. If you
expect stock X with a beta of 1.0 to offer a rate of return of 10 percent, you should
A. buy stock X because it is overpriced.
Difficulty: Moderate
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72. The risk-free rate is 5 percent. The expected market rate of return is 11 percent. If you
expect stock X with a beta of 2.1 to offer a rate of return of 15 percent, you should
A. buy stock X because it is overpriced.
Difficulty: Moderate
73. You invest 50% of your money in security A with a beta of 1.6 and the rest of your money
in security B with a beta of 0.7. The beta of the resulting portfolio is
A. 1.40
Difficulty: Moderate
74. You invest $200 in security A with a beta of 1.4 and $800 in security B with a beta of 0.3.
The beta of the resulting portfolio is
A. 1.40
B. 1.00
Difficulty: Moderate
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75. Security A has an expected rate of return of 0.10 and a beta of 1.3. The market expected
rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is
A. 1.7%.
Difficulty: Moderate
76. A security has an expected rate of return of 0.15 and a beta of 1.25. The market expected
rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is
A. 1.7%.
B. -1.7%.
Difficulty: Moderate
77. A security has an expected rate of return of 0.13 and a beta of 2.1. The market expected
rate of return is 0.09 and the risk-free rate is 0.045. The alpha of the stock is
D. 5.5%.
E. none of the above.
Difficulty: Moderate
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78. Assume that a security is fairly priced and has an expected rate of return of 0.13. The
market expected rate of return is 0.13 and the risk-free rate is 0.04. The beta of the stock is
___?
A. 1.25
Difficulty: Moderate
79. Assume that a security is fairly priced and has an expected rate of return of 0.17. The
market expected rate of return is 0.11 and the risk-free rate is 0.04. The beta of the stock is
___?
A. 1.25
Difficulty: Moderate
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Short Answer Questions
80. Discuss the differences between the capital market line and the security market line.
The capital market line measures the excess return (return of the portfolio over the risk-free
return) per unit of total risk, as measured by standard deviation. The CML applies to efficient
portfolios only. The security market line measures the excess returns of a portfolio or a
Difficulty: Moderate
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81. Discuss the assumptions of the capital asset pricing model, and how these assumptions
relate to the “real world” investment decision process.
The assumptions are:
(a) The market is composed of many small investors, who are price-takers; i. e., perfect
competition. In reality this assumption was fairly realistic until recent years when institutional
(c) Investments are limited to those that are publicly traded. In addition, it is assumed that
investors may borrow or lend any amount at a fixed, risk-free rate. Obviously, investors may
(d) Investors pay no taxes on returns and incur no transaction costs. Obviously, investors do
pay taxes and do incur transaction costs. The tax differentials across different types of
investment income and across different income levels have been lessened as a result of the
income tax simplification of 1986. Obviously, investors should consider after-tax, not before-
tax, returns; however, the no-tax assumption of the model is not a serious departure from
(e) All investors are mean-variance efficient. This assumption implies that all investors make
(f) All investors have homogeneous expectations, meaning that given the same data all
investors would process the data in the same manner, resulting in the same risk/return
assessments for all investment alternatives. Obviously, we do not have homogenous
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Difficulty: Difficult
82. Discuss the mutual fund theorem.
The mutual fund theorem is based on the concept that investors may obtain an efficient
portfolio by holding the market (investing in an S&P 500 index fund, for example). The
investor may adjust his or her holdings to the appropriate risk level by combining this
Difficulty: Easy
83. Discuss how the CAPM might be used in capital budgeting decisions and utility rate
decisions.
The CAPM can be used to establish a hurdle rate for capital budgeting projects, based on the
projects’ beta coefficients. For utility rate cases, the CAPM can be used to determine the fair
Difficulty: Moderate
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84. List and discuss two of the assumptions of the CAPM.
Assumptions are 1) there are many investors, none of whom can have an impact on market
prices, 2) investors are single-period planners with myopic behavior, 3) investments are
limited to a universe of publicly traded financial assets and risk-free borrowing and lending,
4) there are no taxes or transactions costs, 5) all investors are rational mean-variance
Difficulty: Moderate