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Exam 2: Risk and Return-Part I

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Question 51

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Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?

A) if both expected inflation and the market risk premium (rm - rrf) increase, the required return on stock hb will increase by more than that on stock lb.
B) if both expected inflation and the market risk premium (rm - rrf) increase, the required returns of both stocks will increase by the same amount.
C) since the market is in equilibrium, the required returns of the two stocks should be the same.
D) if expected inflation remains constant but the market risk premium (rm- rrf) declines, the required return of stock hb will decline but the required return of stock lb will increase.
E) if expected inflation remains constant but the market risk premium (rm - rrf) declines, the required return of stock lb will decline but the required return of stock hb will increase.

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

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Question 52

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Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return.

A) True
B) False

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Question 53

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If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a -28% return. What is the firm's expected rate of return?

Which of the following statements is CORRECT?

Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.

Recession, inflation, and high interest rates are economic events that are best characterized as being

Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.)

Paul McLaren holds the following portfolio: $\begin{array}{crr}\text { Stock } & \text { Investment } &\text { Beta }\\\mathrm{A} & \$ 150,000&1.40 \\\mathrm{~B} & 50,000&0.80 \\\mathrm{C} & 100,000 &1.00\\\mathrm{D} & 75,000&1.20 \\\text { Total } & \$ 375,000\end{array}$ Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75. By how much will the portfolio beta change?

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.

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.

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?

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECTσ

The slope of the SML is determined by the value of beta.

Megan Ross holds the following portfolio: $\begin{array}{lrl}\text { Stock }&\text { Investment }&\text { Beta }\\\mathrm{A} & \$ 150,000 & 1.40 \\\mathrm{~B} & 50,000 & 0.80 \\\mathrm{C} & 100,000 & 1.00 \\\mathrm{D} & 75,000 & 1.20\\\text { Total }&\$375,000\end{array}$ What is the portfolio's beta?

Ivan Knobel holds a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. He is in the process of buying 1,000 shares of Syngine Corp at $10 a share and adding it to his portfolio. Syngine has an expected return of 13.0% and a beta of 1.50. The total value of Ivan's current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Syngine stock?

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 matterσ

The distributions of rates of return for Companies AA and BB are given below: $\begin{array} { l l l r } \text { State of the } &{ \text { Prabability of } } \\\text { Economy } & \text { This State Occurrine } & \mathrm { AA } & \underline { \mathrm { BB } } \\ \text { Bonm } & 0.2 & 30 \% &-10 \% \\\text { Narmal } & 0.6 & 10 \% & 5 \% \\\text { Recesfion } & 0.2 & - 5 \% & 50 \%\end{array}$ We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.

Assume that your cousin holds just one stock, Eastman Chemical Bonding (ECB) , which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for Wilder's Creations and Buildings (WCB) . Both companies have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) $\begin{array}{lrrr} & \underline{ Year }& \underline{\mathrm{ECB}} & \underline{\mathrm{WCB}}\\&2011&40.00 \%&40.00 \%\\& 2012 & -10.00 \% & 15.00 \% \\& 2013 & 35.00 \% & -5.00 \% \\& 2014 & -5.00 \% & -10.00 \% \\& 2015 & 15.00 \% & 35.00 \% \\& & & \\\text { Average return }= & 15.00 \%& & 15.00 \% \\\text { Standard deviation }=& 22.64 \% && 22.64 \%\end{array}$