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Exam 6: Risk and Return

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Question 41

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Stock A's beta is 1.7 and Stock B's beta is 0.7.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 A.
B) Stock A must be a more desirable addition to a portfolio than B.
C) The expected return on Stock A should be greater than that on B.
D) The expected return on Stock B should be greater than that on A.
E) When held in isolation, Stock A has more risk than Stock B.

F) None of the above
G) C) and D)

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Question 42

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Assume that the market is in equilibrium and that Portfolio AB has 50% invested in Stock A and 50% invested in Stock B.Stock A has an expected return of 10% and a standard deviation of 20%.Stock B has an expected return of 13% and a standard deviation of 30%.The risk-free rate is 5% and the market risk premium,r_M - r_RF,is 6%.The returns of Stock A and Stock B are independent of one another,i.e.,the correlation coefficient between them is zero.Which of the following statements is CORRECT?

A) Since the two stocks have zero correlation, Portfolio AB is riskless.
B) Stock B's beta is 1.0000.
C) Portfolio AB's required return is 11%.
D) Portfolio AB's standard deviation is 25%.
E) Stock A's beta is 0.8333.

F) B) and C)
G) A) and E)

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Question 43

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Fiske Roofing Supplies' stock has a beta of 1.23,its required return is 11.75%,and the risk-free rate is 4.30%.What is the required rate of return on the market? (Hint: First find the market risk premium.)

In portfolio analysis,we often use ex post (historical)returns and standard deviations,despite the fact that we are really interested in ex ante (future)data.

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 stock with the low standard deviation.

Portfolio A has but one security,while Portfolio B has 100 securities.Because of diversification effects,we would expect Portfolio B to have the lower risk.However,it is possible for Portfolio A to be less risky.

Jenna holds a diversified $100,000 portfolio consisting of 20 stocks with $5,000 invested in each.The portfolio's beta is 1.12.Jenna plans to sell a stock with b = 0.90 and use the proceeds to buy a new stock with b = 1.80.What will the portfolio's new beta be?

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?

Your friend is considering adding one additional stock to a 3-stock portfolio,to form a 4-stock portfolio.She is highly risk averse and has asked for your advice.The three stocks currently held all have b = 1.0,and they are perfectly positively correlated with the market.Potential new Stocks A and B both have expected returns of 15%,are in equilibrium,and are equally correlated with the market,with r = 0.75.However,Stock A's standard deviation of returns is 12% versus 8% for Stock B.Which stock should this investor add to his or her portfolio,or does the choice not matter?

If a stock's market price exceeds its intrinsic value as seen by the marginal investor,then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

For markets to be in equilibrium,that is,for there to be no strong pressure for prices to depart from their current levels,

The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return.The risk-free rate is 4.20%.Henry now receives another $5.00 million,which he invests in stocks with an average beta of 0.65.What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium,then find the new portfolio beta.)

We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

How would the Security Market Line be affected,other things held constant,if the expected inflation rate decreases and investors also become more risk averse?

Someone who is risk averse has a general dislike for risk and a preference for certainty.If risk aversion exists in the market,then investors in general are willing to accept somewhat lower returns on less risky securities.Different investors have different degrees of risk aversion,and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return)than investors who have more tolerance for risk.

You have a portfolio P that consists of 50% Stock X and 50% Stock Y.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.Given this information,which of the following statements is CORRECT?

According to the Capital Asset Pricing Model,investors are primarily concerned with portfolio risk,not the risks of individual stocks held in isolation.Thus,the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

Assume that the risk-free rate,r_RF,increases but the market risk premium, (r_M - r_RF) ,declines,with the net effect being that the overall required return on the market,r_M,remains constant.Which of the following statements is CORRECT?

If you plotted the returns on a given stock against those of the market,and if 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 greater than the risk-free rate for a well-diversified investor,assuming that the observed relationship is expected to continue into the future.

One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset,assuming that the asset is held in a well-diversified portfolio.The risk of the asset held in isolation is not relevant under the CAPM.