.

**Chapter 11**

**Return and Risk: The Capital Asset Pricing Model**

**Multiple Choice Questions**

1. A portfolio is:

A. a group of assets, such as stocks and bonds, held as a collective unit by an investor.

B. the expected return on a risky asset.

C. the expected return on a collection of risky assets.

D. the variance of returns for a risky asset.

E. the standard deviation of returns for a collection of risky assets.

2. The percentage of a portfolio’s total value invested in a particular asset is called that asset’s:

A. portfolio return.

B. portfolio weight.

C. portfolio risk.

D. rate of return.

E. investment value.

3. Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk.

A. idiosyncratic

B. diversifiable

C. systematic

D. asset-specific

E. total

4. Risk that affects at most a small number of assets is called _____ risk.

A. portfolio

B. undiversifiable

C. market

D. unsystematic

E. total

5. The principle of diversification tells us that:

A. concentrating an investment in two or three large stocks will eliminate all of your risk.

B. concentrating an investment in three companies all within the same industry will greatly reduce your overall risk.

C. spreading an investment across five diverse companies will not lower your overall risk at all.

D. spreading an investment across many diverse assets will eliminate all of the risk.

E. spreading an investment across many diverse assets will eliminate some of the risk.

6. The _____ tells us that the expected return on a risky asset depends only on that asset’s nondiversifiable risk.

A. Efficient Markets Hypothesis (EMH)

B. systematic risk principle

C. Open Markets Theorem

D. Law of One Price

E. principle of diversification

7. The amount of systematic risk present in a particular risky asset, relative to the systematic risk present in an average risky asset, is called the particular asset’s:

A. beta coefficient.

B. reward-to-risk ratio.

C. total risk.

D. diversifiable risk.

E. Treynor index.

8. The linear relation between an asset’s expected return and its beta coefficient is the:

A. reward-to-risk ratio.

B. portfolio weight.

C. portfolio risk.

D. security market line.

E. market risk premium.

9. The slope of an asset’s security market line is the:

A. reward-to-risk ratio.

B. portfolio weight.

C. beta coefficient.

D. risk-free interest rate.

E. market risk premium.

10. You are considering purchasing stock S. This stock has an expected return of 8% if the economy booms and 3% if the economy goes into a recessionary period. The overall expected rate of return on this stock will:

A. be equal to one-half of 8% if there is a 50% chance of an economic boom.

B. vary inversely with the growth of the economy.

C. increase as the probability of a recession increases.

D. be equal to 75% of 8% if there is a 75% chance of a boom economy.

E. increase as the probability of a boom economy increases.

11. Which one of the following statements is correct concerning the expected rate of return on an individual stock given various states of the economy?

A. The expected return is a geometric average where the probabilities of the economic states are used as the exponential powers.

B. The expected return is an arithmetic average of the individual returns for each state of the economy.

C. The expected return is a weighted average where the probabilities of the economic states are used as the weights.

D. The expected return is equal to the summation of the values computed by dividing the expected return for each economic state by the probability of the state.

E. As long as the total probabilities of the economic states equal 100%, then the expected return on the stock is a geometric average of the expected returns for each economic state.

12. The expected return on a stock that is computed using economic probabilities is:

A. guaranteed to equal the actual average return on the stock for the next five years.

B. guaranteed to be the minimal rate of return on the stock over the next two years.

C. guaranteed to equal the actual return for the immediate twelve month period.

D. a mathematical expectation based on a weighted average and not an actual anticipated outcome.

E. the actual return you will receive.

13. The characteristic line is graphically depicted as:

A. the plot of the relationship between beta and expected return.

B. the plot of the returns of the security against the beta.

C. the plot of the security returns against the market index returns.

D. the plot of the beta against the market index returns.

E. None of the above.

14. The beta of a security is calculated by:

A. dividing the covariance of the security with the market by the variance of the market.

B. dividing the correlation of the security with the market by the variance of the market.

C. dividing the variance of the market by the covariance of the security with the market.

D. dividing the variance of the market by the correlation of the security with the market.

E. None of the above.

15. If investors possess homogeneous expectations over all assets in the market portfolio, when riskless lending and borrowing is allowed, the market portfolio is defined to:

A. be the same portfolio of risky assets chosen by all investors.

B. have the securities weighted by their market value proportions.

C. be a diversified portfolio.

D. All of the above.

E. None of the above.

16. Which one of the following is an example of a nondiversifiable risk?

A. a well respected president of a firm suddenly resigns

B. a well respected chairman of the Federal Reserve suddenly resigns

C. a key employee suddenly resigns and accepts employment with a key competitor

D. a well managed firm reduces its work force and automates several jobs

E. a poorly managed firm suddenly goes out of business due to lack of sales

17. The risk premium for an individual security is computed by:

A. multiplying the security’s beta by the market risk premium.

B. multiplying the security’s beta by the risk-free rate of return.

C. adding the risk-free rate to the security’s expected return.

D. dividing the market risk premium by the quantity (1 – beta).

E. dividing the market risk premium by the beta of the security.

18. Standard deviation measures _____ risk.

A. total

B. nondiversifiable

C. unsystematic

D. systematic

E. economic

19. 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.

20. 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

A. I and III only

B. II and IV only

C. I, III, and IV ony

D. II, III, and IV only

E. I, II, III, and IV

21. 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.

22. If a stock portfolio is well diversified, then the portfolio variance:

A. will equal the variance of the most volatile stock in the portfolio.

B. may be less than the variance of the least risky stock in the portfolio.

C. must be equal to or greater than the variance of the least risky stock in the portfolio.

D. will be a weighted average of the variances of the individual securities in the portfolio.

E. will be an arithmetic average of the variances of the individual securities in the portfolio.

23. Which one of the following statements is correct concerning the standard deviation of a portfolio?

A. The greater the diversification of a portfolio, the greater the standard deviation of that portfolio.

B. The standard deviation of a portfolio can often be lowered by changing the weights of the securities in the portfolio.

C. Standard deviation is used to determine the amount of risk premium that should apply to a portfolio.

D. Standard deviation measures only the systematic risk of a portfolio.

E. The standard deviation of a portfolio is equal to a weighted average of the standard deviations of the individual securities held within the portfolio.

24. The standard deviation of a portfolio will tend to increase when:

A. a risky asset in the portfolio is replaced with U.S. Treasury bills.

B. one of two stocks related to the airline industry is replaced with a third stock that is unrelated to the airline industry.

C. the portfolio concentration in a single cyclical industry increases.

D. the weights of the various diverse securities become more evenly distributed.

E. short-term bonds are replaced with Treasury Bills.

25. Systematic risk is measured by:

A. the mean.

B. beta.

C. the geometric average.

D. the standard deviation.

E. the arithmetic average.

26. Which one of the following is an example of systematic risk?

A. the price of lumber declines sharply

B. airline pilots go on strike

C. the Federal Reserve increases interest rates

D. a hurricane hits a tourist destination

E. people become diet conscious and avoid fast food restaurants

27. The systematic risk of the market is measured by:

A. a beta of 1.0.

B. a beta of 0.0.

C. a standard deviation of 1.0.

D. a standard deviation of 0.0.

E. a variance of 1.0.

28. Unsystematic risk:

A. can be effectively eliminated through portfolio diversification.

B. is compensated for by the risk premium.

C. is measured by beta.

D. cannot be avoided if you wish to participate in the financial markets.

E. is related to the overall economy.

29. Which one of the following is an example of unsystematic risk?

A. the inflation rate increases unexpectedly

B. the federal government lowers income taxes

C. an oil tanker runs aground and spills its cargo

D. interest rates decline by one-half of one percent

E. the GDP rises by 2% more than anticipated

30. The primary purpose of portfolio diversification is to:

A. increase returns and risks.

B. eliminate all risks.

C. eliminate asset-specific risk.

D. eliminate systematic risk.

E. lower both returns and risks.

31. Which one of the following would indicate a portfolio is being effectively diversified?

A. an increase in the portfolio beta

B. a decrease in the portfolio beta

C. an increase in the portfolio rate of return

D. an increase in the portfolio standard deviation

E. a decrease in the portfolio standard deviation

32. The majority of the benefits from portfolio diversification can generally be achieved with just _____ diverse securities.

A. 3

B. 6

C. 30

D. 50

E. 75

33. Which one of the following measures is relevant to the systematic risk principle?

A. variance

B. alpha

C. standard deviation

D. theta

E. beta

34. A security that is fairly priced will have a return _____ the Security Market Line.

A. below

B. on or below

C. on

D. on or above

E. above

35. The intercept point of the security market line is the rate of return which corresponds to:

A. the risk-free rate of return.

B. the market rate of return.

C. a value of zero.

D. a value of 1.0.

E. the beta of the market.

36. A stock with an actual return that lies above the security market line:

A. has more systematic risk than the overall market.

B. has more risk than warranted based on the realized rate of return.

C. has yielded a higher return than expected for the level of risk assumed.

D. has less systematic risk than the overall market.

E. has yielded a return equivalent to the level of risk assumed.

37. 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 1.0.

38. The excess return earned by an asset that has a beta of 1.0 over that earned by a risk-free asset is referred to as the:

A. market rate of return.

B. market risk premium.

C. systematic return.

D. total return.

E. real rate of return.

39. The efficient set of portfolios:

A. contains the portfolio combinations with the highest return for a given level of risk.

B. contains the portfolio combinations with the lowest risk for a given level of return.

C. is the lowest overall risk portfolio.

D. Both A and B.

E. Both A and C.

40. Diversification can effectively reduce risk. Once a portfolio is diversified, the type of risk remaining is:

A. individual security risk.

B. riskless security risk.

C. risk related to the market portfolio.

D. total standard deviations.

E. None of the above.

41. A well-diversified portfolio has negligible:

A. expected return.

B. systematic risk.

C. unsystematic risk.

D. variance.

E. Both C and D.

42. The Capital Market Line is the pricing relationship between:

A. efficient portfolios and beta.

B. the risk-free asset and standard deviation of the portfolio return.

C. the optimal portfolio and the standard deviation of portfolio return.

D. beta and the standard deviation of portfolio return.

E. None of the above.

43. Total risk can be divided into:

A. standard deviation and variance.

B. standard deviation and covariance.

C. portfolio risk and beta.

D. systematic risk and unsystematic risk.

E. portfolio risk and covariance.

44. Beta measures:

A. the ability to diversify risk.

B. how an asset covaries with the market.

C. the actual return on an asset.

D. the standard deviation of the assets’ returns.

E. All of the above.

45. The dominant portfolio with the lowest possible risk is:

A. the efficient frontier.

B. the minimum variance portfolio.

C. the upper tail of the efficient set.

D. the tangency portfolio.

E. None of the above.

46. The measure of beta associates most closely with:

A. idiosyncratic risk.

B. risk-free return.

C. systematic risk.

D. unexpected risk.

E. unsystematic risk.

47. An efficient set of portfolios is:

A. the complete opportunity set.

B. the portion of the opportunity set below the minimum variance portfolio.

C. only the minimum variance portfolio.

D. the dominant portion of the opportunity set.

E. only the maximum return portfolio.

48. A stock with a beta of zero would be expected to have a rate of return equal to:

A. the risk-free rate.

B. the market rate.

C. the prime rate.

D. the average AAA bond.

E. None of the above.

49. The combination of the efficient set of portfolios with a riskless lending and borrowing rate results in:

A. the capital market line which shows that all investors will only invest in the riskless asset.

B. the capital market line which shows that all investors will invest in a combination of the riskless asset and the tangency portfolio.

C. the security market line which shows that all investors will invest in the riskless asset only.

D. the security market line which shows that all investors will invest in a combination of the riskless asset and the tangency portfolio.

E. None of the above.

50. According to the Capital Asset Pricing Model:

A. the expected return on a security is negatively and non-linearly related to the security’s beta.

B. the expected return on a security is negatively and linearly related to the security’s beta.

C. the expected return on a security is positively and linearly related to the security’s variance.

D. the expected return on a security is positively and non-linearly related to the security’s beta.

E. the expected return on a security is positively and linearly related to the security’s beta.

51. The diversification effect of a portfolio of two stocks:

A. increases as the correlation between the stocks declines.

B. increases as the correlation between the stocks rises.

C. decreases as the correlation between the stocks rises.

D. Both A and C.

E. None of the above.

52. 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. choose an efficient portfolio based on individual risk tolerance or utility.

C. never choose to invest in the riskless asset because the expected return on the riskless asset is lower over time.

D. invest only in the riskless asset and tangency portfolio choosing the weights based on individual risk tolerance.

E. All of the above.

53. When a security is added to a portfolio the appropriate return and risk contributions are:

A. the expected return of the asset and its standard deviation.

B. the expected return and the variance.

C. the expected return and the beta.

D. the historical return and the beta.

E. these both can not be measured.

54. When stocks with the same expected return are combined into a portfolio:

A. the expected return of the portfolio is less than the weighted average expected return of the stocks.

B. the expected return of the portfolio is greater than the weighted average expected return of the stocks.

C. the expected return of the portfolio is equal to the weighted average expected return of the stocks.

D. there is no relationship between the expected return of the portfolio and the expected return of the stocks.

E. None of the above.

55. The correlation between stocks A and B is the:

A. covariance between A and B divided by the standard deviation of A times the standard deviation of B.

B. standard deviation A divided by the standard deviation of B.

C. standard deviation of B divided by the covariance between A and B.

D. variance of A plus the variance of B dividend by the covariance.

E. None of the above.

56. You have plotted the data for two securities over time on the same graph, i.e., the monthly return of each security for the last 5 years. If the pattern of the movements of each of the two securities rose and fell as the other did, these two securities would have:

A. no correlation at all.

B. a weak negative correlation.

C. a strong negative correlation.

D. a strong positive correlation.

E. one can not get any idea of the correlation from a graph.

57. If the covariance of stock 1 with stock 2 is – .0065, then what is the covariance of stock 2 with stock 1?

A. -.0065

B. +.0065

C. greater than +.0065

D. less than -.0065

E. Need additional information.

58. You have a portfolio of two risky stocks which turns out to have no diversification benefit. The reason you have no diversification is the returns:

A. are too small.

B. move perfectly opposite of one another.

C. are too large to offset.

D. move perfectly with one another.

E. are completely unrelated to one another.

59. A portfolio will usually contain:

A. one riskless asset.

B. one risky asset.

C. two or more assets.

D. no assets.

E. None of the above.

60. If the correlation between two stocks is +1, then a portfolio combining these two stocks will have a variance that is:

A. less than the weighted average of the two individual variances.

B. greater than the weighted average of the two individual variances.

C. equal to the weighted average of the two individual variances.

D. less than or equal to average variance of the two weighted variances, depending on other information.

E. None of the above.

61. The opportunity set of portfolios is:

A. all possible return combinations of those securities.

B. all possible risk combinations of those securities.

C. all possible risk-return combinations of those securities.

D. the best or highest risk-return combination.

E. the lowest risk-return combination.

62. The correlation between two stocks:

A. can take on positive values.

B. can take on negative values.

C. cannot be greater than 1.

D. cannot be less than -1.

E. All of the above.

63. If the correlation between two stocks is -1, the returns:

A. generally move in the same direction.

B. move perfectly opposite one another.

C. are unrelated to one another as it is < 0.

D. have standard deviations of equal size but opposite signs.

E. None of the above.

64. Diversification can effectively reduce risk. Once a portfolio is diversified the type of risk remaining is:

A. individual security risk.

B. riskless security risk.

C. risk related to the market portfolio.

D. total standard deviations.

E. None of the above.

65. For a highly diversified equally weighted portfolio with a large number of securities, the portfolio variance is:

A. the average covariance.

B. the average expected value.

C. the average variance.

D. the weighted average expected value.

E. the weighted average variance.

66. A well-diversified portfolio has eliminated most of the:

A. expected return.

B. unsystematic risk.

C. systematic risk.

D. variance.

E. Both C and D.

67. A typical investor is assumed to be:

A. a fair gambler.

B. a gambler.

C. a single security holder.

D. risk averse.

E. risk neutral.

68. The total number of variance and covariance terms in a portfolio is N

^{2}. How many of these would be (including non-unique) covariances?

A. N

B. N

^{2}

C. N

^{2}– N

D. N

^{2}– N/2

E. None of the above.

69. The relationship between the covariance of the security with the market to the variance is called the:

A. alpha.

B. beta.

C. total risk.

D. standard deviation.

E. expected return.

70. According to the CAPM:

A. the expected return on a security is negatively and non-linearly related to the security’s beta.

B. the expected return on a security is negatively and linearly related to the security’s beta.

C. the expected return on a security is positively and linearly related to the security’s variance.

D. the expected return on a security is positively and non-linearly related to the security’s beta.

E. the expected return on a security is positively related to the security’s beta.

71. The elements along the diagonal of the variance/covariance matrix are:

A. covariances.

B. security weights.

C. security selections.

D. variances.

E. None of the above.

72. The elements in the off-diagonal positions of the variance/covariance matrix are:

A. covariances.

B. security selections.

C. variances.

D. security weights.

E. None of the above.

73. The beta of an individual security is calculated by:

A. dividing the covariance of the security with the market by the variance of the market.

B. dividing the correlation of the security with the market by the variance of the market.

C. multiplying the variance of the market by the covariance of the security with the market.

D. multiplying the variance of the market by the correlation of the security with the market.

E. None of the above.

74. A risk that affects a large number of assets, each to a greater or lesser degree is called:

A. total risk.

B. systematic risk.

C. unsystematic risk.

D. economic risk.

E. standard error.

75. As we add more securities to a portfolio, the ____ will decrease:

A. total risk.

B. systematic risk.

C. unsystematic risk.

D. economic risk.

E. standard error.

76. Diversification will not lower the ____ risk:

A. total risk.

B. systematic risk.

C. unsystematic risk.

D. variance risk.

E. standard error.

77. You want your portfolio beta to be 1.20. Currently, your portfolio consists of $100 invested in stock A with a beta of 1.4 and $300 in stock B with a beta of .6. You have another $400 to invest and want to divide it between an asset with a beta of 1.6 and a risk-free asset. How much should you invest in the risk-free asset?

A. $0

B. $140

C. $200

D. $320

E. $400

78. You have a $1,000 portfolio which is invested in stocks A and B plus a risk-free asset.

$400 is invested in stock A. Stock A has a beta of 1.3 and stock B has a beta of .7.

How much needs to be invested in stock B if you want a portfolio beta of .90?

A. $0

B. $268

C. $482

D. $543

E. $600

79. You recently purchased a stock that is expected to earn 12% in a booming economy, 8% in a normal economy and lose 5% in a recessionary economy. There is a 15% probability of a boom, a 75% chance of a normal economy, and a 10% chance of a recession. What is your expected rate of return on this stock?

A. 5.00%

B. 6.45%

C. 7.30%

D. 7.65%

E. 8.30%

80. The Inferior Goods Co. stock is expected to earn 14% in a recession, 6% in a normal economy, and lose 4% in a booming economy. The probability of a boom is 20% while the probability of a normal economy is 55% and the chance of a recession is 25%. What is the expected rate of return on this stock?

A. 6.00%

B. 6.72%

C. 6.80%

D. 7.60%

E. 11.33%

81. You are comparing stock A to stock B. Given the following information, which one of these two stocks should you prefer and why?

A. Stock A; because it has an expected return of 7% and appears to be more risky.

B. Stock A; because it has a higher expected return and appears to be less risky than stock B.

C. Stock A; because it has a slightly lower expected return but appears to be significantly less risky than stock B.

D. Stock B; because it has a higher expected return and appears to be just slightly more risky than stock A.

E. Stock B; because it has a higher expected return and appears to be less risky than stock A.

82. Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5% and the market rate of return is 10%. What is the amount of the risk premium on Zelo stock?

A. 4.47%

B. 5.50%

C. 5.54%

D. 6.77%

E. 12.30%

83. If the economy booms, RTF, Inc. stock is expected to return 10%. If the economy goes into a recessionary period, then RTF is expected to only return 4%. The probability of a boom is 60% while the probability of a recession is 40%. What is the variance of the returns on RTF, Inc. stock?

A. .000200

B. .000760

C. .000864

D. .001594

E. .029394

84. The rate of return on the common stock of Flowers by Flo is expected to be 14% in a boom economy, 8% in a normal economy, and only 2% in a recessionary economy. The probabilities of these economic states are 20% for a boom, 70% for a normal economy, and 10% for a recession. What is the variance of the returns on the common stock of Flowers by Flo?

A. .001044

B. .001280

C. .001863

D. .002001

E. .002471

85. Kurt’s Adventures, Inc. stock is quite cyclical. In a boom economy, the stock is expected to return 30% in comparison to 12% in a normal economy and a negative 20% in a recessionary period. The probability of a recession is 15%. There is a 30% chance of a boom economy. The remainder of the time, the economy will be at normal levels. What is the standard deviation of the returns on Kurt’s Adventures, Inc. stock?

A. 10.05%

B. 12.60%

C. 15.83%

D. 17.46%

E. 25.04%

86. What is the standard deviation of the returns on a stock given the following information?

A. 5.80%

B. 7.34%

C. 8.38%

D. 9.15%

E. 9.87%

87. You have a portfolio consisting solely of stock A and stock B. The portfolio has an expected return of 10.2%. Stock A has an expected return of 12% while stock B is expected to return 7%. What is the portfolio weight of stock A?

A. 46%

B. 54%

C. 58%

D. 64%

E. 70%

88. You own the following portfolio of stocks. What is the portfolio weight of stock C?

A. 30.8%

B. 37.4%

C. 42.3%

D. 45.2%

E. 47.9%

89. You own a portfolio with the following expected returns given the various states of the economy. What is the overall portfolio expected return?

A. 6.3%

B. 6.8%

C. 7.6%

D. 10.0%

E. 10.8%

90. What is the expected return on a portfolio which is invested 20% in stock A, 50% in stock B, and 30% in stock C?

A. 7.40%

B. 8.25%

C. 8.33%

D. 9.45%

E. 9.50%

91. What is the expected return on this portfolio?

A. 9.50%

B. 9.67%

C. 9.78%

D. 10.59%

E. 10.87%

92. What is the expected return on a portfolio comprised of $3,000 in stock K and $5,000 in stock L if the economy is normal?

A. 3.75%

B. 5.25%

C. 5.63%

D. 5.88%

E. 6.80%

93. What is the expected return on a portfolio comprised of $4,000 in stock M and $6,000 in stock N if the economy enjoys a boom period?

A. 6.4%

B. 6.8%

C. 10.4%

D. 13.2%

E. 14.0%

94. What is the portfolio variance if 30% is invested in stock S and 70% is invested in stock T?

A. .002220

B. .004056

C. .006224

D. .008080

E. .098000

95. What is the variance of a portfolio consisting of $3,500 in stock G and $6,500 in stock H?

A. .000209

B. .000247

C. .002098

D. .037026

E. .073600

96. What is the standard deviation of a portfolio that is invested 40% in stock Q and 60% in stock R?

A. 0.7%

B. 1.4%

C. 2.6%

D. 6.8%

E. 8.1%

97. What is the standard deviation of a portfolio which is comprised of $4,500 invested in stock S and $3,000 in stock T?

A. 1.4%

B. 1.9%

C. 2.6%

D. 5.7%

E. 7.2%

98. What is the standard deviation of a portfolio which is invested 20% in stock A, 30% in stock B and 50% in stock C?

A. 0.6%

B. 0.9%

C. 1.8%

D. 2.2%

E. 4.9%

99. What is the beta of a portfolio comprised of the following securities?

A. 1.008

B. 1.014

C. 1.038

D. 1.067

E. 1.127

100. Your portfolio is comprised of 30% of stock X, 50% of stock Y, and 20% of stock Z. Stock X has a beta of .64, stock Y has a beta of 1.48, and stock Z has a beta of 1.04. What is the beta of your portfolio?

A. 1.01

B. 1.05

C. 1.09

D. 1.14

E. 1.18

101. Your portfolio has a beta of 1.18. The portfolio consists of 15% U.S. Treasury bills, 30% in stock A, and 55% in stock B. Stock A has a risk-level equivalent to that of the overall market. What is the beta of stock B?

A. .55

B. 1.10

C. 1.24

D. 1.40

E. 1.60

102. You would like to combine a risky stock with a beta of 1.5 with U.S. Treasury bills in such a way that the risk level of the portfolio is equivalent to the risk level of the overall market. What percentage of the portfolio should be invested in Treasury bills?

A. 25%

B. 33%

C. 50%

D. 67%

E. 75%

103. The market has an expected rate of return of 9.8%. The long-term government bond is expected to yield 4.5% and the U.S. Treasury bill is expected to yield 3.4%. The inflation rate is 3.1%. What is the market risk premium?

A. 2.2%

B. 3.3%

C. 5.3%

D. 6.4%

E. 6.7%

104. The risk-free rate of return is 4% and the market risk premium is 8%. What is the expected rate of return on a stock with a beta of 1.28?

A. 9.12%

B. 10.24%

C. 13.12%

D. 14.24%

E. 15.36%

105. The common stock of Flavorful Teas has an expected return of 14.4%. The return on the market is 10% and the risk-free rate of return is 3.5%. What is the beta of this stock?

A. .65

B. 1.09

C. 1.32

D. 1.44

E. 1.68

106. The stock of Big Joe’s has a beta of 1.14 and an expected return of 11.6%. The risk-free rate of return is 4%. What is the expected return on the market?

A. 7.60%

B. 8.04%

C. 9.33%

D. 10.67%

E. 12.16%

107. The expected return on HiLo stock is 13.69% while the expected return on the market is 11.5%. The beta of HiLo is 1.3. What is the risk-free rate of return?

A. 2.8%

B. 3.1%

C. 3.7%

D. 4.2%

E. 4.5%

108. The stock of Martin Industries has a beta of 1.43. The risk-free rate of return is 3.6% and the market risk premium is 9%. What is the expected rate of return on Martin Industries stock?

A. 11.3%

B. 14.1%

C. 16.5%

D. 17.4%

E. 18.0%

109. Which one of the following stocks is correctly priced if the risk-free rate of return is 2.5% and the market risk premium is 8%?

A. A

B. B

C. C

D. D

E. E

110. Which one of the following stocks is correctly priced if the risk-free rate of return is 3.6% and the market rate of return is 10.5%?

A. A

B. B

C. C

D. D

E. E

GenLabs has been a hot stock the last few years, but is risky. The expected returns for GenLabs are highly dependent on the state of the economy as follows:

111. The expected return on GenLabs is:

A. 3.3%

B. 8.5%

C. 12.5%

D. 20.5%

E. None of the above.

112. The variance of GenLabs returns is:

A. .0207

B. .0428

C. .0643

D. .0733

E. None of the above.

113. The standard deviation of GenLabs returns is

A. .0845

B. .2069

C. .3065

D. .3358

E. None of the above.

114. Stock A has an expected return of 20%, and stock B has an expected return of 4%. However, the risk of stock A as measured by its variance is 3 times that of stock B. If the two stocks are combined equally in a portfolio, what would be the portfolio’s expected return?

A. 4%

B. 12%

C. 20%

D. Greater than 20%

E. Need more information to answer.

115. A portfolio is entirely invested into Buzz’s Bauxite Boring equity, which is expected to return 16%, and Zum’s Inc. bonds, which are expected to return 8%. 60% of the funds are invested in Buzz’s and the rest in Zum’s. What is the expected return on the portfolio?

A. 6.4%

B. 9.6%

C. 12.8%

D. 24.2%

E. Need additional information.

116. The variance of Stock A is .004, the variance of the market is .007 and the covariance between the two is .0026. What is the correlation coefficient?

A. .9285

B. .8542

C. .5010

D. .4913

E. .3510

117. A portfolio has 50% of its funds invested in Security One and 50% of its funds invested in Security Two. Security One has a standard deviation of 6%. Security Two has a standard deviation of 12%. The securities have a coefficient of correlation of 0.5. Which of the following values is closest to portfolio variance?

A. .0027

B. .0063

C. .0095

D. .0104

E. One must have covariance to calculate expected value.

118. A portfolio has 25% of its funds invested in Security C and 75% of its funds invested in Security D. Security C has an expected return of 8% and a standard deviation of 6%. Security D has an expected return of 10% and a standard deviation of 10%. The securities have a coefficient of correlation of 0.6. Which of the following values is closest to portfolio return and variance?

A. .090; .0081

B. .095; .001675

C. .095; .0072

D. .100; .00849

E. Cannot calculate without the number of covariance terms.

119. A portfolio contains two assets. The first asset comprises 40% of the portfolio and has a beta of 1.2. The other asset has a beta of 1.5. The portfolio beta is:

A. 1.35

B. 1.38

C. 1.42

D. 1.50

E. 1.55

120. A portfolio contains four assets. Asset 1 has a beta of .8 and comprises 30% of the portfolio. Asset 2 has a beta of 1.1 and comprises 30% of the portfolio. Asset 3 has a beta of 1.5 and comprises 20% of the portfolio. Asset 4 has a beta of 1.6 and comprises the remaining 20% of the portfolio. If the riskless rate is expected to be 3% and the market risk premium is 6%, what is the beta of the portfolio?

A. 0.80

B. 1.10

C. 1.19

D. 1.25

E. 1.40

**Essay Questions**

121. According to the CAPM, the expected return on a risky asset depends on three components.

Describe each component, and explain its role in determining expected return.

122. Draw the SML and plot asset C such that it has less risk than the market but plots above the

SML, and asset D such that it has more risk than the market and plots below the SML. (Be sure to indicate where the market portfolio is on your graph.) Explain how assets like C or D can plot as they do and explain why such pricing cannot persist in a market that is in equilibrium.

123. Why are some risks diversifiable and some nondiversifiable? Give an example of each.

124. We routinely assume that investors are risk-averse return-seekers; i.e., they like returns and dislike risk. If so, why do we contend that only systematic risk and not total risk is important?

125. In the first chapter, it was stated that financial managers should act to maximize shareholder wealth. Why are the efficient markets hypothesis (EMH), the CAPM, and the SML so important in the accomplishment of this objective?

126. Explain in words what beta is and why it is important.

127. A portfolio is made up of 75% of stock 1, and 25% of stock 2. Stock 1 has a variance of .08, and stock 2 has a variance of .035. The covariance between the stocks is -.001. Calculate both the variance and the standard deviation of the portfolio.

128. The diagram below represents an opportunity set for a two asset combination. Indicate the correct efficient set with labels; explain why it is so.