Finman Chap5

(Difficulty: E = Easy, M = Medium, and T = Tough)
Multiple Choice: Conceptual

Easy:
Risk concepts Answer: e Diff: E
1
. Which of the following statements is most correct?
a. Risk refers to the chance that some unfavorable event will occur, and
a probability distribution is completely described by a listing of
the likelihood of unfavorable events.
b. Portfolio diversification reduces the variability of returns on an
individual stock.
c. When company-specific risk has been diversified the inherent risk
that remains is market risk, which is constant for all securities in
the market.
d. stock with a beta of -1.! has "ero market risk.
e. #he $%& relates re'uired returns to firms( market risk. #he slope
and intercept of this line cannot be controlled by the financial
manager.
Risk measures Answer: a Diff: E
)
. *ou observe the following information regarding +ompany , and +ompany *-
+ompany , has a higher e.pected mean return than +ompany *.
+ompany , has a lower standard deviation than +ompany *.
+ompany , has a higher beta than +ompany *.
/iven this information, which of the following statements is most correct?
a. +ompany , has a lower coefficient of variation than +ompany *.
b. +ompany , has more company-specific risk than +ompany *.
c. +ompany , is a better stock to buy than +ompany *.
d. $tatements a and b are correct.
e. $tatements a, b, and c are correct.
Chapter 5 - Page 1
CHAPTE !
"#$ A%D ATE# &' ET(%
Market risk premium Answer: c Diff: E
0
. Which of the following statements is most correct? 1ssume that the
risk-free rate remains constant.2
a. 3f the market risk premium increases by 1 percentage point, then the
re'uired return on all stocks will rise by 1 percentage point.
b. 3f the market risk premium increases by 1 percentage point, then the
re'uired return will increase for stocks that have a beta greater
than 1.!, but it will decrease for stocks that have a beta less than
1.!.
c. 3f the market risk premium increases by 1 percentage point, then the
re'uired return will increase by 1 percentage point for a stock that
has a beta e'ual to 1.!.
d. $tatements a and c are correct.
e. 4one of the statements above is correct.
Standard deviation Answer: b Diff: E
5
. highly risk-averse investor is considering the addition of an asset to
a 1!-stock portfolio. #he two securities under consideration both have
an e.pected return,
k
, e'ual to 16 percent. 7owever, the distribution
of possible returns associated with sset has a standard deviation of
1) percent, while sset 8(s standard deviation is 9 percent. 8oth
assets are correlated with the market with r e'ual to !.:6. Which asset
should the risk-averse investor add to his;her portfolio?
a. sset .
b. sset 8.
c. 8oth and 8.
d. 4either nor 8.
e. +annot tell without more information.
Beta coefficient Answer: d Diff: E
6
. $tock has a beta of 1.6 and $tock 8 has a beta of !.6. Which of the
following statements must be true about these securities? 1ssume the
market is in e'uilibrium.2
a. When held in isolation, $tock has greater risk than $tock 8.
b. $tock 8 would be a more desirable addition to a portfolio than $tock .
c. $tock would be a more desirable addition to a portfolio than $tock 8.
d. #he e.pected return on $tock will be greater than that on $tock 8.
e. #he e.pected return on $tock 8 will be greater than that on $tock .
Chapter 5 - Page 2
Beta coefficient Answer: c Diff: E
<
. $tock , has a beta of !.6 and $tock * has a beta of 1.6. Which of the
following statements is most correct?
a. $tock *(s return this year will be higher than $tock ,(s return.
b. $tock *(s return has a higher standard deviation than $tock ,.
c. 3f e.pected inflation increases 1but the market risk premium is
unchanged2, the re'uired returns on the two stocks will increase by
the same amount.
d. 3f the market risk premium declines 1leaving the risk-free rate
unchanged2, $tock , will have a larger decline in its re'uired return
than will $tock *.
e. 3f you invest =6!,!!! in $tock , and =6!,!!! in $tock *, your
portfolio will have a beta less than 1.!, provided the stock returns
on the two stocks are not perfectly correlated.
Required return Answer: b Diff: E
:
. 3n the years ahead the market risk premium, 1k
%
- k
R>
2, is e.pected to
fall, while the risk-free rate, k
R>
, is e.pected to remain at current
levels. /iven this forecast, which of the following statements is most
correct?
a. #he re'uired return for all stocks will fall by the same amount.
b. #he re'uired return will fall for all stocks but will fall more for
stocks with higher betas.
c. #he re'uired return will fall for all stocks but will fall less for
stocks with higher betas.
d. #he re'uired return will increase for stocks with a beta less than
1.! and will decrease for stocks with a beta greater than 1.!.
e. #he re'uired return on all stocks will remain unchanged.
Risk and return Answer: a Diff: E N
9
. ?ver the past :6 years, we have observed that investments with higher
average annual returns also tend to have the highest standard deviations
in their annual returns. #his observation supports the notion that
there is a positive correlation between risk and return. Which of the
following lists correctly ranks investments from having the highest
returns and risk to those with the lowest returns and risk?
a. $mall-company stocks, large-company stocks, long-term corporate
bonds, long-term government bonds, @.$. #reasury bills.
b. $mall-company stocks, long-term corporate bonds, large-company
stocks, long-term government bonds, @.$. #reasury bills.
c. &arge-company stocks, small-company stocks, long-term corporate
bonds, @.$. #reasury bills, long-term government bonds.
d. @.$. #reasury bills, long-term government bonds, long-term corporate
bonds, small-company stocks, large-company stocks.
e. &arge-company stocks, small-company stocks, long-term corporate
bonds, long-term government bonds, @.$. #reasury bills.
Chapter 5 - Page 3
Portfolio risk Answer: b Diff: E
A
. $tock and $tock 8 both have an e.pected return of 1! percent and a
standard deviation of )6 percent. $tock has a beta of !.9 and $tock 8
has a beta of 1.). #he correlation coefficient, r, between the two
stocks is !.<. Portfolio P is a portfolio with 6! percent invested in
$tock and 6! percent invested in $tock 8. Which of the following
statements is most correct?
a. Portfolio P has a coefficient of variation e'ual to ).6.
b. Portfolio P has more market risk than $tock but less market risk
than $tock 8.
c. Portfolio P has a standard deviation of )6 percent and a beta of 1.!.
d. ll of the statements above are correct.
Portfolio risk return and beta Answer: e Diff: E
1!
a. two-stock portfolio will always have a lower standard deviation
than a one-stock portfolio.
b. two-stock portfolio will always have a lower beta than a one-stock
portfolio.
c. 3f portfolios are formed by randomly selecting stocks, a 1!-stock
portfolio will always have a lower beta than a one-stock portfolio.
Portfolio risk and return Answer: a Diff: E
11
. Which of the following statements best describes what would be e.pected
to happen as you randomly add stocks to your portfolio?
a. dding more stocks to your portfolio reduces the portfolio(s company-
specific risk.
b. dding more stocks to your portfolio reduces the beta of your
portfolio.
c. dding more stocks to your portfolio increases the portfolio(s
e.pected return.
e. ll of the statements above are correct.
Chapter 5 - Page 4
Portfolio risk and return Answer: e Diff: E
1)
. 8ob has a =6!,!!! stock portfolio with a beta of 1.), an e.pected return
of 1!.9 percent, and a standard deviation of )6 percent. 8ecky has a
=6!,!!! portfolio with a beta of !.9, an e.pected return of A.) percent,
and a standard deviation of )6 percent. #he correlation coefficient, r,
between 8ob(s and 8ecky(s portfolios is !. 8ob and 8ecky are engaged to
be married. Which of the following best describes their combined
=1!!,!!! portfolio?
a. #he combined portfolio(s e.pected return is a simple average of the
e.pected returns of the two individual portfolios 11!B2.
b. #he combined portfolio(s beta is a simple average of the betas of the
two individual portfolios 11.!2.
c. #he combined portfolio(s standard deviation is less than a simple
average of the two portfolios( standard deviations 1)6B2, even though
there is no correlation between the returns of the two portfolios.
10
. *our portfolio consists of =6!,!!! invested in $tock , and =6!,!!!
invested in $tock *. 8oth stocks have an e.pected return of 16 percent,
a beta of 1.<, and a standard deviation of 0! percent. #he returns of
the two stocks are independent--the correlation coefficient, r, is "ero.
Which of the following statements best describes the characteristics of
your portfolio?
a. *our portfolio has a beta e'ual to 1.< and its e.pected return is 16
percent.
b. *our portfolio has a standard deviation of 0! percent and its
e.pected return is 16 percent.
c. *our portfolio has a standard deviation less than 0! percent and its
beta is greater than 1.<.
d. *our portfolio has a standard deviation greater than 0! percent and a
beta e'ual to 1.<.
e. *our portfolio has a beta greater than 1.< and an e.pected return
greater than 16 percent.
Portfolio risk and return Answer: b Diff: E
15
. 3n general, which of the following will tend to occur if you randomly
add additional stocks to your portfolio, which currently consists of
only three stocks?
a. #he e.pected return of your portfolio will usually decline.
b. #he company-specific risk of your portfolio will usually decline, but
the market risk will tend to remain the same.
c. 8oth the company-specific risk and the market risk of your portfolio
will decline.
d. #he market risk and e.pected return of the portfolio will decline.
e. #he company-specific risk will remain the same, but the market risk
will tend to decline.
Chapter 5 - Page 5
Portfolio risk and return Answer: b Diff: E
16
. $tock , has a beta of !.: and $tock * has a beta of 1.0. #he standard
deviation of each stock(s returns is )! percent. #he returns are
independent of each other. 13n other words, the correlation
coefficient, r, between $tock , and $tock * is "ero.2 Portfolio P has
6! percent of its wealth invested in $tock , and the other 6! percent is
invested in $tock *. /iven this information, which of the following
a. Portfolio P has a standard deviation of )! percent.
b. #he re'uired return on Portfolio P is the same as the re'uired return
on the market 1k
%
2.
c. #he re'uired return on Portfolio P is e'ual to the market risk
premium 1k
%
C k
R>
2.
e. $tatements a and c are correct.
1<
. Dane has randomly selected a portfolio of )! stocks, and Eick has
randomly selected a portfolio of two stocks. Which of the following
a. #he re'uired return on Dane(s portfolio must be higher than the
re'uired return on Eick(s portfolio because Dane is more diversified.
b. 3f the two portfolios have the same beta, Dane(s portfolio will have
less market risk but the same amount of company-specific risk as
Eick(s portfolio.
c. 3f the two portfolios have the same beta, their re'uired returns will
be the same but Dane(s portfolio will have more company-specific risk
than Eick(s.
Portfolio risk and return Answer: d Diff: E
1:
. $tock and $tock 8 each have an e.pected return of 1) percent, a beta
of 1.), and a standard deviation of )6 percent. #he returns on the two
stocks have a correlation of !.<. Portfolio P has half of its money
invested in $tock and half in $tock 8. Which of the following
a. Portfolio P has an e.pected return of 1) percent.
b. Portfolio P has a standard deviation of )6 percent.
c. Portfolio P has a beta of 1.).
Chapter 5 - Page 6
19
. $tocks , 8, and + all have an e.pected return of 1! percent and a
standard deviation of )6 percent. $tocks and 8 have returns that are
independent of one another. 1#heir correlation coefficient, r, e'uals
"ero.2 $tocks and + have returns that are negatively correlated with
one another 1that is, r F !2. Portfolio 8 is a portfolio with half its
money invested in $tock and half invested in $tock 8. Portfolio + is
a portfolio with half its money invested in $tock and half invested in
$tock +. Which of the following statements is most correct?
a. Portfolio 8 has an e.pected return of 1! percent.
b. Portfolio 8 has a standard deviation of )6 percent.
c. Portfolio + has a standard deviation that is less than )6 percent.
1A
. $tock and $tock 8 each have an e.pected return of 16 percent, a
standard deviation of )! percent, and a beta of 1.). #he returns of the
two stocks are not perfectly correlatedG the correlation coefficient is
!.<. *ou have put together a portfolio that consists of 6! percent
$tock and 6! percent $tock 8. Which of the following statements is
most correct?
a. #he portfolio(s e.pected return is 16 percent.
b. #he portfolio(s beta is less than 1.).
c. #he portfolio(s standard deviation is )! percent.
Portfolio risk and return Answer: d Diff: E N
)!
. $tock has a beta of !.9, $tock 8 has a beta of 1.!, and $tock + has a
beta of 1.). Portfolio P has e'ual amounts invested in each of the three
stocks. Hach of the stocks has a standard deviation of )6 percent. #he
returns of the three stocks are independent of one another 1i.e., the
correlation coefficients all e'ual "ero2. Which of the following
a. Portfolio P(s e.pected return is less than the e.pected return of
$tock +.
b. Portfolio P(s standard deviation is less than )6 percent.
c. Portfolio P(s reali"ed return will always e.ceed the reali"ed return
of $tock .
e. $tatements b and c are correct.
Chapter 5 - Page 7
!APM Answer: b Diff: E
)1
. #he risk-free rate is < percent. $tock has a beta of 1.!, while $tock
8 has a beta of ).!. #he market risk premium 1k
%
C k
R>
2 is positive.
Which of the following statements is most correct?
a. $tock 8(s re'uired rate of return is twice that of $tock .
b. 3f $tock (s re'uired return is 11 percent, the market risk premium
is 6 percent.
c. 3f the risk-free rate increases 1but the market risk premium stays
unchanged2, $tock 8(s re'uired return will increase by more than
$tock (s.
d. $tatements b and c are correct.
!APM and required return Answer: c Diff: E
))
. 3n recent years, both e.pected inflation and the market risk premium
1k
%
C k
R>
2 have declined. ssume that all stocks have positive betas.
Which of the following is likely to have occurred as a result of these
changes?
a. #he average re'uired return on the market, k
%
, has remained constant,
but the re'uired returns have fallen for stocks that have betas
greater than 1.!.
b. #he re'uired returns on all stocks have fallen by the same amount.
c. #he re'uired returns on all stocks have fallen, but the decline has
been greater for stocks with higher betas.
d. #he re'uired returns on all stocks have fallen, but the decline has
been greater for stocks with lower betas.
e. #he re'uired returns have increased for stocks with betas greater
than 1.! but have declined for stocks with betas less than 1.!.
!APM and required return Answer: c Diff: E N
)0
. ssume that the risk-free rate is 6 percent. Which of the following
a. 3f a stock(s beta doubles, the stock(s re'uired return will also
double.
b. 3f a stock(s beta is less than 1.!, the stock(s re'uired return is
less than 6 percent.
c. 3f a stock has a negative beta, the stock(s re'uired return is less
than 6 percent.
Chapter 5 - Page 8
!APM and required return Answer: e Diff: E N
)5
. $tock , has a beta of 1.6 and $tock * has a beta of !.6. #he market is
in e'uilibrium 1that is, re'uired returns e'ual e.pected returns2.
Which of the following statements is most correct?
a. $ince the market is in e'uilibrium, the re'uired returns of the two
stocks should be the same.
b. 3f both e.pected inflation and the market risk premium 1k
%
- k
R>
2
increase, the re'uired returns of both stocks will increase by the
same amount.
c. 3f e.pected inflation remains constant but the market risk premium
1k
%
- k
R>
2 declines, the re'uired return of $tock , will decline but
the re'uired return of $tock * will increase.
!APM and required return Answer: b Diff: E N
)6
. $tock has a beta of !.9, $tock 8 has a beta of 1.!, and $tock + has a
beta of 1.). Portfolio P has e'ual amounts invested in each of the three
stocks. Hach of the stocks has a standard deviation of )6 percent. #he
returns of the three stocks are independent of one another 1i.e., the
correlation coefficients all e'ual "ero2. ssume that there is an
increase in the market risk premium, but that the risk-free rate remains
unchanged. Which of the following statements is most correct?
a. #he re'uired return of all three stocks will increase by the amount
of the increase in the market risk premium.
b. #he re'uired return on $tock will increase by less than the increase
in the market risk premium, while the re'uired return on $tock + will
increase by more than the increase in the market risk premium.
c. #he re'uired return of all stocks will remain unchanged since there
was no change in their betas.
d. #he re'uired return of the average stock will remain unchanged, but
the returns of riskier stocks 1such as $tock +2 will decrease while
the returns of safer stocks 1such as $tock 2 will increase.
e. #he re'uired return of the average stock will remain unchanged, but
the returns of riskier stocks 1such as $tock +2 will increase while
the returns of safer stocks 1such as $tock 2 will decrease.
!APM beta and required return Answer: c Diff: E
)<
. +urrently, the risk-free rate is < percent and the market risk premium
is 6 percent. ?n the basis of this information, which of the following
a. 3f a stock has a negative beta, its re'uired return must also be
negative.
b. 3f a stock(s beta doubles, its re'uired return must also double.
c. n inde. fund with beta I 1.! has a re'uired return of 11 percent.
Chapter 5 - Page 9
SM" Answer: a Diff: E
):
. Which of the following statements is incorrect?
a. #he slope of the security market line is measured by beta.
b. #wo securities with the same stand-alone risk can have different betas.
c. +ompany-specific risk can be diversified away.
d. #he market risk premium is affected by attitudes about risk.
e. 7igher beta stocks have a higher re'uired return.
SM" Answer: b Diff: E
)9
a. #he slope of the security market line is beta.
b. #he slope of the security market line is the market risk premium,
1k
%
C k
R>
2.
c. 3f you double a company(s beta its re'uired return more than doubles.
SM" Answer: c Diff: E
)A
. $tock has a beta of 1.) and a standard deviation of )! percent. $tock
8 has a beta of !.9 and a standard deviation of )6 percent. Portfolio P
is a =)!!,!!! portfolio consisting of =1!!,!!! invested in $tock and
=1!!,!!! invested in $tock 8. Which of the following statements is most
correct? 1ssume that the re'uired return is determined by the $ecurity
%arket &ine.2
a. $tock 8 has a higher re'uired rate of return than $tock .
b. Portfolio P has a standard deviation of )).6 percent.
c. Portfolio P has a beta e'ual to 1.!.
SM" Answer: e Diff: E
0!
. 4ile >oods( stock has a beta of 1.5 and Hlbe Hateries( stock has a beta of
!.:. ssume that the risk-free rate, k
R>
, is 6.6 percent and the market
risk premium, 1k
%
C k
R>
2, e'uals 5 percent. Which of the following
a. $ince 4ile(s beta is twice that of Hlbe(s, its re'uired rate of return
will also be twice that of Hlbe(s.
b. 3f the risk-free rate increases but the market risk premium remains
unchanged, the re'uired return will increase for both stocks but the
increase will be larger for 4ile since it has a higher beta.
c. 3f the market risk premium increases but the risk-free rate remains
unchanged, 4ile(s re'uired return will increase 1since it has a beta
greater than 1.!2 but Hlbe(s will decline 1since it has a beta less
than 1.!2.
Chapter 5 - Page 10
SM" Answer: c Diff: E
01
. $tock , has a beta of !.<, while $tock * has a beta of 1.5. Which of the
a. $tock * must have a higher e.pected return and a higher standard
deviation than $tock ,.
b. portfolio consisting of =6!,!!! invested in $tock , and =6!,!!!
invested in $tock * will have a re'uired return that e.ceeds that of
the overall market.
c. 3f the market risk premium decreases 1but e.pected inflation is
unchanged2, the re'uired return on both stocks will decrease but the
decrease will be greater for $tock *.
d. 3f e.pected inflation increases 1but the market risk premium is
unchanged2, the re'uired return on both stocks will decrease by the
same amount.
e. 3f e.pected inflation decreases 1but the market risk premium is
unchanged2, the re'uired return on both stocks will decrease but the
decrease will be greater for $tock *.
SM" Answer: b Diff: E
0)
. $tock has a beta of !.9 and $tock 8 has a beta of 1.). 6! percent of
Portfolio P is invested in $tock and 6! percent is invested in $tock 8.
3f the market risk premium 1k
%
C k
R>
2 were to increase but the risk-free
rate 1k
R>
2 remained constant, which of the following would occur?
a. #he re'uired return will decrease by the same amount for both $tock
and $tock 8.
b. #he re'uired return will increase for both stocks but the increase will
be greater for $tock 8 than for $tock .
c. #he re'uired return will increase for $tock but will decrease for
$tock 8.
d. #he re'uired return will increase for $tock 8 but will decrease for
$tock .
e. #he re'uired return on Portfolio P will remain unchanged.
SM" Answer: e Diff: E
00
. $tock has a beta of !.:, whereas $tock 8 has a beta of 1.0. Portfolio
P has 6! percent invested in both $tocks and 8. Which of the
following would occur if the market risk premium increased by
1 percentage point? 1ssume that the risk-free rate remains constant.2
a. #he re'uired return for $tock would fall but the re'uired return
for $tock 8 would increase.
b. #he re'uired return for Portfolio P would remain unchanged.
c. #he re'uired return for both stocks would increase by 1 percentage
point.
d. #he re'uired return for $tock would increase by more than
1 percentage point, while the return for $tock 8 would increase by
Chapter 5 - Page 11
less than 1 percentage point.
e. #he re'uired return for Portfolio P would increase by 1 percentage
point.
SM" Answer: b Diff: E N
05
. ssume that the risk-free rate remains constant, but that the market
risk premium declines. Which of the following is likely to occur?
a. #he re'uired return on a stock with a beta I 1.! will remain the
same.
b. #he re'uired return on a stock with a beta F 1.! will decline.
c. #he re'uired return on a stock with a beta J 1.! will increase.
SM" !APM and beta Answer: e Diff: E
06
a. #he slope of the security market line is beta.
b. stock with a negative beta must have a negative re'uired rate of
return.
c. 3f a stock(s beta doubles its re'uired rate of return must double.
d. 3f a stock has a beta e'ual to 1.!, its re'uired rate of return will
be unaffected by changes in the market risk premium.
Risk anal#sis and portfolio diversification Answer: d Diff: E
0<
a. Portfolio diversification reduces the variability of the returns on
the individual stocks held in the portfolio.
b. 3f an investor buys enough stocks, he or she can, through
diversification, eliminate virtually all of the nonmarket 1or
company-specific2 risk inherent in owning stocks. 3ndeed, if the
portfolio contained all publicly traded stocks, it would be riskless.
c. #he re'uired return on a firm(s common stock is determined by its
systematic 1or market2 risk. 3f the systematic risk is known, and if
that risk is e.pected to remain constant, then no other information
is re'uired to specify the firm(s re'uired return.
d. security(s beta measures its nondiversifiable 1systematic, or
market2 risk relative to that of an average stock.
e. stock(s beta is less relevant as a measure of risk to an investor
with a well-diversified portfolio than to an investor who holds only
that one stock.
Chapter 5 - Page 12
Miscellaneous risk concepts Answer: c Diff: E N
0:
. +onsider the following information for three stocks, $tock , $tock 8,
and $tock +. #he returns on each of the three stocks are positively
correlated, but they are not perfectly correlated. 1#hat is, all of the
correlation coefficients are between ! and 1.2
H.pected $tandard
$tock Return Eeviation 8eta
$tock 1!B )!B 1.!
$tock 8 1! )! 1.!
$tock + 1) )! 1.5
Portfolio P has half of its funds invested in $tock and half invested
in $tock 8. Portfolio K has one third of its funds invested in each of
the three stocks. #he risk-free rate is 6 percent, and the market is in
e'uilibrium. 1#hat is, re'uired returns e'ual e.pected returns.2 Which
of the following statements is most correct?
a. Portfolio P has a standard deviation of )! percent.
b. Portfolio P(s coefficient of variation is greater than ).!.
c. Portfolio K(s e.pected return is 1!.<: percent.
d. Portfolio K has a standard deviation of )! percent.
e. Portfolio P(s re'uired return is greater than the re'uired return on
$tock .
Medium:
Risk aversion Answer: b Diff: M
09
. *ou have developed the following data on three stocks-
$tock $tandard Eeviation 8eta
!.16 !.:A
8 !.)6 !.<1
+ !.)! 1.)A
3f you are a risk minimi"er, you should choose $tock if it is to be
held in isolation and $tock if it is to be held as part of a well-
diversified portfolio.
a. G
b. G 8
c. 8G
d. +G
e. +G 8
Chapter 5 - Page 13
SM" and risk aversion Answer: e Diff: M
0A
. ssume that investors become increasingly risk averse, so that the
market risk premium increases. lso, assume that the risk-free rate and
e.pected inflation remain the same. Which of the following is most
likely to occur?
a. #he re'uired rate of return will decline for stocks that have betas
less than 1.!.
b. #he re'uired rate of return on the market, k
%
, will remain the same.
c. #he re'uired rate of return for each stock in the market will
increase by an amount e'ual to the increase in the market risk
premium.
Portfolio risk and return Answer: c Diff: M
5!
. 3n a portfolio of three different stocks, which of the following could
not be true?
a. #he riskiness of the portfolio is less than the riskiness of each of
the stocks if each were held in isolation.
b. #he riskiness of the portfolio is greater than the riskiness of one
or two of the stocks.
c. #he beta of the portfolio is less than the beta of each of the
individual stocks.
d. #he beta of the portfolio is greater than the beta of one or two of
the individual stocks( betas.
e. 4one of the above 1that is, they all could be true, but not
necessarily at the same time2.
Portfolio risk and return Answer: d Diff: M N
51
. $tock has an e.pected return of 1! percent and a standard deviation of
)! percent. $tock 8 has an e.pected return of 1) percent and a standard
deviation of 0! percent. #he risk-free rate is 6 percent and the market
risk premium, k
%
- k
R>
, is < percent. ssume that the market is in
e'uilibrium. Portfolio P has 6! percent invested in $tock and 6!
percent invested in $tock 8. #he returns of $tock and $tock 8 are
independent of one another. 1#hat is, their correlation coefficient
e'uals "ero.2 Which of the following statements is most correct?
a. Portfolio P(s e.pected return is 11 percent.
b. Portfolio P(s standard deviation is less than )6 percent.
c. $tock 8(s beta is 1.)6.
Chapter 5 - Page 14
Portfolio risk and return Answer: d Diff: M N
5)
. $tock has a beta of 1.) and a standard deviation of )6 percent. $tock 8
has a beta of 1.5 and a standard deviation of )! percent. Portfolio P was
created by investing in a combination of $tocks and 8. Portfolio P has
a beta of 1.)6 and a standard deviation of 19 percent. Which of the
a. Portfolio P has the same amount of money invested in each of the two
stocks.
b. #he returns of the two stocks are perfectly positively correlated 1r I
1.!2.
c. $tock has more market risk than $tock 8 but less stand-alone risk.
d. Portfolio P(s re'uired return is greater than $tock (s re'uired return.
e. $tock has more market risk than Portfolio P.
Portfolio risk Answer: e Diff: M
50
a. %arket participants are able to eliminate virtually all market risk
if they hold a large diversified portfolio of stocks.
b. %arket participants are able to eliminate virtually all company-
specific risk if they hold a large diversified portfolio of stocks.
c. 3t is possible to have a situation where the market risk of a single
stock is less than that of a well diversified portfolio.
Portfolio risk and beta Answer: c Diff: M
55
. $tock has a beta I !.9, while $tock 8 has a beta I 1.<. Which of the
a. $tock 8(s re'uired return is double that of $tock (s.
b. n e'ually weighted portfolio of $tock and $tock 8 will have a beta
less than 1.).
c. 3f market participants become more risk averse, the re'uired return
on $tock 8 will increase more than the re'uired return for $tock .
Chapter 5 - Page 15
Portfolio risk and beta Answer: e Diff: M
56
a. 3f you add enough randomly selected stocks to a portfolio, you can
completely eliminate all the market risk from the portfolio.
b. 3f you formed a portfolio that included a large number of low-beta
stocks 1stocks with betas less than 1.! but greater than -1.!2, the
portfolio would itself have a beta coefficient that is e'ual to the
weighted average beta of the stocks in the portfolio, so the
portfolio would have a relatively low degree of risk.
c. 3f you were restricted to investing in publicly traded common stocks,
yet you wanted to minimi"e the riskiness of your portfolio as
measured by its beta, then according to the +P% theory you should
invest some of your money in each stock in the market. #hat is, if
there were 1!,!!! traded stocks in the world, the least risky
portfolio would include some shares in each of them.
d. Eiversifiable risk can be eliminated by forming a large portfolio, but
normally even highly-diversified portfolios are subLect to market risk.
e. $tatements b and d are correct.
Market risk Answer: b Diff: M
5<
. 3nflation, recession, and high interest rates are economic events that
are characteri"ed as
a. +ompany-specific risk that can be diversified away.
b. %arket risk.
c. $ystematic risk that can be diversified away.
d. Eiversifiable risk.
e. @nsystematic risk that can be diversified away.
Beta coefficient Answer: a Diff: M
5:
a. #he beta coefficient of a stock is normally found by running a
regression of past returns on the stock against past returns on a
stock market inde.. ?ne could also construct a scatter diagram of
returns on the stock versus those on the market, estimate the slope
of the line of best fit, and use it as beta.
b. 3t is theoretically possible for a stock to have a beta of 1.!. 3f a
stock did have a beta of 1.!, then, at least in theory, its re'uired
rate of return would be e'ual to the risk-free 1default-free2 rate of
return, k
R>
.
c. 3f you found a stock with a "ero beta and held it as the only stock
in your portfolio, you would by definition have a riskless portfolio.
*our 1-stock portfolio would be even less risky if the stock had a
negative beta.
d. #he beta of a portfolio of stocks is always larger than the betas of
any of the individual stocks.
Chapter 5 - Page 16
Beta coefficient Answer: d Diff: M
59
. *ou have developed data that give 112 the average annual returns on the
market for the past five years, and 1)2 similar information on $tocks
and 8. 3f these data are as follows, which of the possible answers best
describes the historical betas for and 8?
*ears %arket $tock $tock 8
1 !.!0 !.1< !.!6
) -!.!6 !.)! !.!6
0 !.!1 !.19 !.!6
5 -!.1! !.)6 !.!6
6 !.!< !.15 !.!6
a. b
J !G b
8
I 1
b. b
J M1G b
8
I !
c. b
I !G b
8
I -1
d. b
F !G b
8
I !
e. b
F -1G b
8
I 1
5A
a. $uppose the returns on two stocks are negatively correlated. ?ne has a
beta of 1.) as determined in a regression analysis, while the other has
a beta of -!.<. #he returns on the stock with the negative beta will
be negatively correlated with returns on most other stocks in the
market.
b. $uppose you are managing a stock portfolio, and you have information
that leads you to believe the stock market is likely to be very strong
in the immediate future. #hat is, you are confident the market is
about to rise sharply. *ou should sell your high-beta stocks and buy
low-beta stocks in order to take advantage of the e.pected market move.
c. +ollections 3nc. is in the business of collecting past-due accounts for
other companiesG that is, it is a collection agency. +ollections(
revenues, profits, and stock price tend to rise during recessions. #his
suggests that +ollections 3nc.(s beta should be 'uite high, say ).!,
because it does so much better than most other companies when the
economy is weak.
Chapter 5 - Page 17
Beta coefficient Answer: c Diff: M
6!
. Which of the following is not a difficulty concerning beta and its
estimation?
a. $ometimes a security or proLect does not have a past history that can
be used as a basis for calculating beta.
b. $ometimes, 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 NtrueO or Ne.pected futureO
beta.
c. #he beta of an Naverage stock,O or Nthe market,O can change over time,
sometimes drastically.
d. $ometimes the past data used to calculate beta do not reflect the
likely risk of the firm for the future because conditions have
changed.
Beta coefficient Answer: d Diff: M N
61
. +ertain firms and industries are characteri"ed by consistently low or
high betas, depending on the particular situation. ?n the basis of that
notion, which of the following companies seems out of place with its
stated beta? 1#hat is, one of the following companies definitely could
not have the indicated beta, while the other companies seem well matched
with their stated betas.2
a. $un %icrosystems, 8eta I 1.6A.
b. ma"on.com, 8eta I 1.:!.
c. >ord %otor +ompany, 8eta I !.A).
d. >lorida Power P &ight, 8eta I 1.6).
e. Wal-%art, 8eta I 1.16.
SM" Answer: e Diff: M
6)
a. #he $%& relates re'uired returns to firms( market risk. #he slope and
intercept of this line cannot be controlled by the financial manager.
b. #he slope of the $%& is determined by the value of beta.
c. 3f you plotted the returns of a given stock against those of the
market, and you found that the slope of the regression line was
negative, the +P% would indicate that the re'uired rate of return on
the stock should be less than the risk-free rate for a well-
diversified investor, assuming that the observed relationship is
e.pected to continue on into the future.
d. 3f investors become less risk averse, the slope of the $ecurity %arket
&ine will increase.
Chapter 5 - Page 18
SM" Answer: a Diff: M
60
. ?ther things held constant, 112 if the e.pected inflation rate decreases,
and 1)2 investors become more risk averse, the $ecurity %arket &ine would
shift
a. Eown and have a steeper slope.
b. @p and have a less steep slope.
c. @p and keep the same slope.
d. Eown and keep the same slope.
e. Eown and have a less steep slope.
SM" Answer: b Diff: M
65
. Which of the following statements is most correct about a stock that has a
beta I 1.)?
a. 3f the stock(s beta doubles its e.pected return will double.
b. 3f e.pected inflation increases 0 percent, the stock(s e.pected return
will increase by 0 percent.
c. 3f the market risk premium increases by 0 percent the stock(s e.pected
return will increase by less than 0 percent.
SM" Answer: b Diff: M N
66
. ssume that the risk-free rate, k
R>
, increases but the market risk
premium, 1k
%
C k
R>
2 declines. #he net effect is that the overall e.pected
return on the market, k
%
, remains constant. Which of the following
a. #he re'uired return will decline for stocks that have a beta less than
1.! but will increase for stocks that have a beta greater than 1.!.
b. #he re'uired return will increase for stocks that have a beta less than
1.! but will decline for stocks that have a beta greater than 1.!.
c. #he re'uired return of all stocks will fall by the amount of the
decline in the market risk premium.
d. #he re'uired return of all stocks will increase by the amount of the
increase in the risk-free rate.
e. $ince the overall return on the market stays constant, the re'uired
return on all stocks will remain the same.
Chapter 5 - Page 19
SM" !APM and portfolio risk Answer: a Diff: M
6<
a. n increase in e.pected inflation could be e.pected to increase the
re'uired return on a riskless asset and on an average stock by the
same amount, other things held constant.
b. graph of the $%& would show re'uired rates of return on the vertical
a.is and standard deviations of returns on the hori"ontal a.is.
c. 3f two NnormalO or NtypicalO stocks were combined to form a )-stock
portfolio, the portfolio(s e.pected return would be a weighted average
of the stocks( e.pected returns, but the portfolio(s standard
deviation would probably be greater than the average of the stocks(
standard deviations.
d. 3f investors became more risk averse, then 112 the slope of the $%&
would increase and 1)2 the re'uired rate of return on low-beta stocks
would increase by more than the re'uired return on high-beta stocks.
e. #he +P% has been thoroughly tested, and the theory has been confirmed
beyond any reasonable doubt.
Portfolio return !APM and beta Answer: e Diff: M
6:
a. 3f the returns from two stocks are perfectly positively correlated
1that is, the correlation coefficient is M12 and the two stocks have
e'ual variance, an e'ually weighted portfolio of the two stocks will
have a variance that is less than that of the individual stocks.
b. 3f a stock has a negative beta, its e.pected return must be negative.
c. ccording to the +P%, stocks with higher standard deviations of
returns will have higher e.pected returns.
d. portfolio with a large number of randomly selected stocks will have
less market risk than a single stock that has a beta e'ual to !.6.
!APM and required return Answer: d Diff: M
69
a. We would observe a downward shift in the re'uired returns of all
stocks if investors believed that there would be deflation in the
economy.
b. 3f investors became more risk averse, then the new security market
line would have a steeper slope.
c. 3f the beta of a company doubles, then the re'uired rate of return
will also double.
Chapter 5 - Page 20
Risk anal#sis and portfolio diversification Answer: e Diff: M
6A
a. 3f you add enough randomly selected stocks to a portfolio, you can
completely eliminate all the market risk from the portfolio.
b. 3f you form a large portfolio of stocks each with a beta greater than
1.!, this portfolio will have more market risk than a single stock
with a beta I !.9.
c. +ompany-specific 1or unsystematic2 risk can be reduced by forming a
large portfolio, but normally even highly-diversified portfolios are
subLect to market 1or systematic2 risk.
Portfolio diversification Answer: c Diff: M
<!
. Dane holds a large diversified portfolio of 1!! randomly selected stocks
and the portfolio(s beta I 1.). Hach of the individual stocks in her
portfolio has a standard deviation of )! percent. Dack has the same
amount of money invested in a single stock with a beta e'ual to 1.< and a
standard deviation of )! percent. Which of the following statements is
most correct?
a. Dane(s portfolio has a larger amount of company-specific risk since she
is holding more stocks in her portfolio.
b. Dane has a higher re'uired rate of return, since she is more
diversified.
c. Dane(s portfolio has less market risk since it has a lower beta.
Portfolio risk and SM" Answer: e Diff: M
<1
a. 3t is possible to have a situation in which the market risk of a
single stock is less than the market risk of a portfolio of stocks.
b. #he market risk premium will increase if, on average, market
participants become more risk averse.
c. 3f you selected a group of stocks whose returns are perfectly
positively correlated, then you could end up with a portfolio for
which none of the unsystematic risk is diversified away.
Chapter 5 - Page 21
Tough:
!APM Answer: c Diff: $
<)
a. ccording to +P% theory, the re'uired rate of return on a given stock
can be found by use of the $%& e'uation-
k
i
I k
R>
M 1k
%
- k
R>
2b
i
.
H.pectations for inflation are not reflected anywhere in this
e'uation, even indirectly, and because of that the te.t notes that the
+P% may not be strictly correct.
b. 3f the re'uired rate of return is given by the $%& e'uation as set
forth in $tatement a, there is nothing a financial manager can do to
change his or her company(s cost of capital, because each of the
elements in the e'uation is determined e.clusively by the market, not
by the type of actions a company(s management can take, even in the
long run.
c. ssume that the re'uired rate of return on the market is currently
k
%
I 16B, and that k
%
remains fi.ed at that level. 3f the yield curve
has a steep upward slope, the calculated market risk premium would be
larger if the 0!-day #-bill rate were used as the risk-free rate than
if the 0!-year #-bond rate were used as k
R>
.
SM" Answer: d Diff: $
<0
a. 3f investors become more risk averse but k
R>
remains constant, the
re'uired rate of return on high-beta stocks will rise, the re'uired
return on low-beta stocks will decline, but the re'uired return on
an average-risk stock will not change.
b. 3f %utual >und held e'ual amounts of 1!! stocks, each of which had
a beta of 1.!, and %utual >und 8 held e'ual amounts of 1! stocks with
betas of 1.!, then the two mutual funds would both have betas of 1.!.
#hus, they would be e'ually risky from an investor(s standpoint.
c. n investor who holds Lust one stock will be e.posed to more risk
than an investor who holds a portfolio of stocks, assuming the
stocks are all e'ually risky. $ince the holder of the 1-stock
portfolio is e.posed to more risk, he or she can e.pect to earn a
higher rate of return to compensate for the greater risk.
d. ssume that the re'uired rate of return on the market, k
%
, is given
and fi.ed. 3f the yield curve were upward-sloping, then the
$ecurity %arket &ine 1$%&2 would have a steeper slope if 1-year
#reasury securities were used as the risk-free rate than if 0!-year
#reasury bonds were used for k
R>
.
Chapter 5 - Page 22
Multiple Choice: P)o*lems
Easy:
Required return Answer: d Diff: E N
<5
. #he risk-free rate of interest, k
R>
, is < percent. #he overall stock
market has an e.pected return of 1) percent. 7a"lett, 3nc. has a beta of
1.). What is the re'uired return of 7a"lett, 3nc. stock?
a. 1).!B
b. 1).)B
c. 1).9B
d. 10.)B
e. 10.6B
Required return Answer: b Diff: E N
<6
. #he risk-free rate is 6 percent. $tock has a beta I 1.! and $tock 8
has a beta I 1.5. $tock has a re'uired return of 11 percent. What is
$tock 8(s re'uired return?
a. 1).5B
b. 10.5B
c. 15.5B
d. 16.5B
e. 1<.5B
!APM and required return Answer: d Diff: E
<<
. +alculate the re'uired rate of return for %ercury 3nc., assuming that
investors e.pect a 6 percent rate of inflation in the future. #he real
risk-free rate is e'ual to 0 percent and the market risk premium is
6 percent. %ercury has a beta of ).!, and its reali"ed rate of return
has averaged 16 percent over the last 6 years.
a. 16B
b. 1<B
c. 1:B
d. 19B
e. )!B
Chapter 5 - Page 23
!APM and market risk premium Answer: c Diff: E N
<:
. +onsider the following information for three stocks, $tock , $tock 8,
and $tock +. #he returns on each of the three stocks are positively
correlated, but they are not perfectly correlated. 1#hat is, all of the
correlation coefficients are between ! and 1.2
H.pected $tandard
$tock Return Eeviation 8eta
$tock 1!B )!B 1.!
$tock 8 1! )! 1.!
$tock + 1) )! 1.5
Portfolio P has half of its funds invested in $tock and half invested
in $tock 8. Portfolio K has one third of its funds invested in each of
the three stocks. #he risk-free rate is 6 percent, and the market is in
e'uilibrium. 1#hat is, re'uired returns e'ual e.pected returns.2 What
is the market risk premium 1k
%
- k
R>
2?
a. 5.!B
b. 5.6B
c. 6.!B
d. 6.6B
e. <.!B
Market risk premium Answer: d Diff: E
<9
. stock has an e.pected return of 1).)6 percent. #he beta of the stock
is 1.16 and the risk-free rate is 6 percent. What is the market risk
premium?
a. 1.0!B
b. <.6!B
c. 16.!!B
d. <.0!B
e. :.)6B
Beta coefficient Answer: b Diff: E
<A
. /iven the following information, determine which beta coefficient for
$tock is consistent with e'uilibrium-
k
Q
I 11.0BG k
R>
I 6BG k
%
I 1!B
a. !.9<
b. 1.)<
c. 1.1!
d. !.9!
e. 1.06
Chapter 5 - Page 24
Beta coefficient Answer: a Diff: E
:!
. ssume that the risk-free rate is 6 percent and that the market risk
premium is : percent. 3f a stock has a re'uired rate of return of 10.:6
percent, what is its beta?
a. 1.)6
b. 1.06
c. 1.0:
d. 1.<!
e. 1.A<
Portfolio beta Answer: b Diff: E
:1
. *ou hold a diversified portfolio consisting of a =1!,!!! investment in
each of )! different common stocks 1that is, your total investment is
=)!!,!!!2. #he portfolio beta is e'ual to 1.). *ou have decided to
sell one of your stocks that has a beta e'ual to !.: for =1!,!!!. *ou
plan to use the proceeds to purchase another stock that has a beta e'ual
to 1.5. What will be the beta of the new portfolio?
a. 1.1<6
b. 1.)06
c. 1.)6!
d. 1.)95
e. 1.000
Portfolio return Answer: a Diff: E
:)
. n investor is forming a portfolio by investing =6!,!!! in stock that
has a beta of 1.6!, and =)6,!!! in stock 8 that has a beta of !.A!. #he
return on the market is e'ual to < percent and #reasury bonds have a
yield of 5 percent. What is the re'uired rate of return on the
investor(s portfolio?
a. <.<B
b. <.9B
c. 6.9B
d. :.!B
e. :.6B
Portfolio return Answer: b Diff: E
:0
. *ou are an investor in common stocks, and you currently hold a well-
diversified portfolio that has an e.pected return of 1) percent, a beta
of 1.), and a total value of =A,!!!. *ou plan to increase your portfolio
by buying 1!! shares of #PH at =1! a share. #PH has an e.pected return
of )! percent with a beta of ).!. What will be the e.pected return and
the beta of your portfolio after you purchase the new stock?
a. p
k
Q
I )!.!BG b
p
I ).!!
b. p
k
Q
I 1).9BG b
p
I 1.)9
c. p
k
Q
I 1).!BG b
p
I 1.)!
d. p
k
Q
I 10.)BG b
p
I 1.5!
Chapter 5 - Page 25
e. p
k
Q
I 15.!BG b
p
I 1.0)
Portfolio risk and return Answer: a Diff: E N
:5
. $tock has an e.pected return of 1) percent, a beta of 1.), and a
standard deviation of )! percent. $tock 8 has an e.pected return of 1!
percent, a beta of 1.), and a standard deviation of 16 percent. Portfolio
P has =A!!,!!! invested in $tock and =0!!,!!! invested in $tock 8. #he
correlation between $tock (s returns and $tock 8(s returns is "ero 1that
is, r I !2. Which of the following statements is most correct?
a. Portfolio P(s e.pected return is 11.6 percent.
b. Portfolio P(s standard deviation is 19.:6 percent.
c. Portfolio P(s beta is less than 1.).
!oefficient of variation Answer: b Diff: E
:6
. 8elow are the stock returns for the past five years for gnew
3ndustries-
*ear $tock Return
)!!) ))B
)!!1 00
)!!! 1
1AAA -1)
1AA9 1!
What was the stock(s coefficient of variation during this 6-year period?
1@se the population standard deviation to calculate the coefficient of
variation.2
a. 1!.9!
b. 1.5<
c. 16.:)
d. !.<A
e. 5.))
Chapter 5 - Page 26
Medium:
E%pected return Answer: e Diff: M
:<
. ssume a new law is passed that restricts investors to holding only one
asset. risk-averse investor is considering two possible assets as the
asset to be held in isolation. #he assets( possible returns and related
probabilities 1that is, the probability distributions2 are as follows-
sset , sset *
P k P k
!.1! -0B !.!6 -0B
!.1! ) !.1! )
!.)6 6 !.0! 6
!.)6 9 !.0! 9
!.0! 1! !.)6 1!
Which asset should be preferred?
a. sset ,, since its e.pected return is higher.
b. sset *, since its beta is probably lower.
c. Hither one, since the e.pected returns are the same.
d. sset ,, since its standard deviation is lower.
e. sset *, since its coefficient of variation is lower and its
e.pected return is higher.
E%pected return Answer: c Diff: M
::
. /iven the following probability distribution, what are the e.pected
return and the standard deviation of returns for $ecurity D?
$tate

P
i
k
D
1 !.) 1!B
) !.< 16
0 !.) )!
a. 16BG <.6!B
b. 1)BG 6.19B
c. 16BG 0.1<B
d. 16BG 1!.!!B
e. )!BG 6.!!B
Required return Answer: c Diff: M
:9
. *ou are holding a stock that has a beta of ).! and is currently in
e'uilibrium. #he re'uired return on the stock is 16 percent, and the
return on an average stock is 1! percent. What would be the percentage
change in the return on the stock, if the return on an average stock
increased by 0! percent while the risk-free rate remained unchanged?
a. M)!B
b. M0!B
c. M5!B
d. M6!B
e. M<!B
Chapter 5 - Page 27
Required return Answer: c Diff: M
:A
. ?akdale >urniture 3nc. has a beta coefficient of !.: and a re'uired rate
of return of 16 percent. #he market risk premium is currently 6 percent.
3f the inflation premium increases by ) percentage points, and ?akdale
ac'uires new assets that increase its beta by 6! percent, what will be
?akdale(s new re'uired rate of return?
a. 10.6!B
b. )).9!B
c. 19.:6B
d. 16.)6B
e. 1:.!!B
Required return Answer: e Diff: M
9!
. Partridge Plastic(s stock has an estimated beta of 1.5, and its re'uired
rate of return is 10 percent. +leaver %otors( stock has a beta of !.9,
and the risk-free rate is < percent. What is the re'uired rate of
return on +leaver %otors( stock?
a. :.!B
b. 1!.5B
c. 1).!B
d. 11.!B
e. 1!.!B
E%pected and required returns Answer: c Diff: M
91
. #he reali"ed returns for the market and $tock D for the last four years
are given below-
*ear %arket $tock D
1 1!B 6B
) 16 !
0 -6 15
5 ! 1!
n average stock has an e.pected return of 1) percent and the market
risk premium is 5 percent. 3f $tock D(s e.pected rate of return as
viewed by a marginal investor is 9 percent, what is the difference
between D(s e.pected and re'uired rates of return?
a. !.<<B
b. 1.)6B
c. ).<5B
d. 0.:)B
e. 6.0<B
Chapter 5 - Page 28
E%pected and required returns Answer: b Diff: M
9)
. *ou have been scouring The Wall Street Journal looking for stocks that
are Ngood valuesO and have calculated e.pected returns for five stocks.
ssume the risk-free rate 1k
R>
2 is : percent and the market risk premium
1k
%
- k
R>
2 is ) percent. Which security would be the best investment?
1ssume you must choose Lust one.2
H.pected Return 8eta
a. A.!1B 1.:!
b. :.!<B !.!!
c. 6.!5B -!.<:
d. 9.:5B !.9:
e. 11.6!B ).6!
!APM and required return Answer: e Diff: M
90
. 7R +orporation has a beta of ).!, while &R +orporation(s beta is !.6.
#he risk-free rate is 1! percent, and the re'uired rate of return on an
average stock is 16 percent. 4ow the e.pected rate of inflation built
into k
R>
falls by 0 percentage points, the real risk-free rate remains
constant, the re'uired return on the market falls to 11 percent, and the
betas remain constant. When all of these changes are made, what will be
the difference in the re'uired returns on 7R(s and &R(s stocks?
a. 1.!B
b. ).6B
c. 5.6B
d. 6.5B
e. <.!B
!APM and required return Answer: a Diff: M N
95
. 8radley 7otels has a beta of 1.0, while Eouglas >arms has a beta of !.:.
#he re'uired return on an inde. fund that holds the entire stock market
is 1) percent. #he risk-free rate of interest is : percent. 8y how
much does 8radley(s re'uired return e.ceed Eouglas( re'uired return?
a. 0.!B
b. <.6B
c. 6.!B
d. <.!B
e. :.!B
Chapter 5 - Page 29
!APM and required return Answer: d Diff: M
96
. +ompany , has a beta of 1.<, while +ompany *(s beta is !.:. #he risk-
free rate is : percent, and the re'uired rate of return on an average
stock is 1) percent. 4ow the e.pected rate of inflation built into k
R>
rises by 1 percentage point, the real risk-free rate remains constant,
the re'uired return on the market rises to 15 percent, and betas remain
constant. fter all of these changes have been reflected in the data,
by how much will the re'uired return on $tock , e.ceed that on $tock *?
a. 0.:6B
b. 5.)!B
c. 5.9)B
d. 6.5!B
e. 6.:6B
!APM and required return Answer: e Diff: M
9<
. 7istorical rates of return for the market and for $tock are given
below-
*ear %arket $tock
1 <.!B 9.!B
) -9.! 0.!
0 -9.! -).!
5 19.! 1).!
3f the re'uired return on the market is 11 percent and the risk-free
rate is < percent, what is the re'uired return on $tock , according to
+P%;$%& theory?
a. <.!!B
b. <.6:B
c. :.)6B
d. :.:AB
e. 9.):B
Chapter 5 - Page 30
!APM and required return Answer: a Diff: M
9:
. $ome returns data for the market and for +ountercyclical +orp. are given
below-
*ear %arket +ountercyclical
1AAA -).!B 9.!B
)!!! 1).! 0.!
)!!1 -9.! 19.!
)!!) )1.! -:.!
#he re'uired return on the market is 15 percent and the risk-free rate
is 9 percent. What is the re'uired return on +ountercyclical +orp.
according to +P%;$%& theory?
a. 0.5)B
b. 5.69B
c. 9.!!B
d. 11.:<B
e. 15.!!B
Portfolio return Answer: c Diff: M
99
. $tock ,, $tock *, and the market have had the following returns over the
past four years.
*ear %arket , *
1AAA 11B 1!B 1)B
)!!! : 5 -0
)!!1 1: 1) )1
)!!) -0 -) -6
#he risk-free rate is : percent. #he market risk premium is 6 percent.
What is the re'uired rate of return for a portfolio that consists of
=15,!!! invested in $tock , and =<,!!! invested in $tock *?
a. A.A5B
b. 1!.<9B
c. 11.69B
d. 1).51B
e. 10.<:B
Chapter 5 - Page 31
Portfolio return Answer: b Diff: M
9A
. #he risk-free rate, k
R>
, is < percent and the market risk premium,
1k
%
C k
R>
2, is 6 percent. ssume that re'uired returns are based on the
+P%. *our =1 million portfolio consists of =:!!,!!! invested in a stock
that has a beta of 1.) and =0!!,!!! invested in a stock that has a beta of
!.9. Which of the following statements is most correct?
a. #he portfolio(s re'uired return is less than 11 percent.
b. 3f the risk-free rate remains unchanged but the market risk premium
increases by ) percentage points, the re'uired return on your portfolio
will increase by more than ) percentage points.
c. 3f the market risk premium remains unchanged but e.pected inflation
increases by ) percentage points, the re'uired return on your portfolio
will increase by more than ) percentage points.
d. 3f the stock market is efficient, your portfolio(s e.pected return
should e'ual the e.pected return on the market, which is 11 percent.
Portfolio return Answer: c Diff: M
A!
. portfolio manager is holding the following investments-
$tock mount 3nvested 8eta
, =1! million 1.5
* )! million 1.!
R 5! million !.9
#he manager plans to sell his holdings of $tock *. #he money from the
sale will be used to purchase another =16 million of $tock , and another
=6 million of $tock R. #he risk-free rate is 6 percent and the market
risk premium is 6.6 percent. 7ow many percentage points higher will the
re'uired return on the portfolio be after he completes this transaction?
a. !.!:B
b. !.19B
c. !.0AB
d. !.<:B
e. 1.05B
Portfolio return Answer: b Diff: M N
A1
. ssume that the risk-free rate is 6.6 percent and the market risk premium
is < percent. money manager has =1! million invested in a portfolio
that has a re'uired return of 1) percent. #he manager plans to sell =0
million of stock with a beta of 1.< that is part of the portfolio. $he
plans to reinvest this =0 million into another stock that has a beta of
!.:. 3f she goes ahead with this planned transaction, what will be the
re'uired return of her new portfolio?
a. 1!.6)B
b. 1!.09B
c. 11.01B
d. 1!.A!B
Chapter 5 - Page 32
e. 9.)9B
Chapter 5 - Page 33
Portfolio return Answer: a Diff: M N
A)
. #he current risk-free rate is < percent and the market risk premium is
6 percent. Hrika is preparing to invest =0!,!!! in the market and she
wants her portfolio to have an e.pected return of 1).6 percent. Hrika
is concerned about bearing too much stand-alone riskG therefore, she
will diversify her portfolio by investing in three different assets 1two
mutual funds and a risk-free security2. #he three assets she will be
investing in are an aggressive growth mutual fund that has a beta of
1.<, an $PP 6!! inde. fund with a beta of 1, and a risk-free security
that has a beta of !. $he has already decided that she will invest 1!
percent of her money in the risk-free asset. 3n order to achieve the
desired e.pected return of 1).6 percent, what proportion of Hrika(s
portfolio must be invested in the $PP 6!! inde. fund?
a. )0.00B
b. 00.00B
c. 60.00B
d. <<.<<B
e. :<.<<B
!APM and portfolio return Answer: d Diff: M
A0
. *our portfolio consists of =1!!,!!! invested in a stock that has a beta I
!.9, =16!,!!! invested in a stock that has a beta I 1.), and =6!,!!!
invested in a stock that has a beta I 1.9. #he risk-free rate is
: percent. &ast year this portfolio had a re'uired rate of return of 10
percent. #his year nothing has changed e.cept for the fact that the
market risk premium has increased by ) percent 1two percentage points2.
What is the portfolio(s current re'uired rate of return?
a. 6.15B
b. :.15B
c. 11.56B
d. 16.00B
e. 1<.)6B
!APM and portfolio return Answer: b Diff: M
A5
. +urrently, the risk-free rate is 6 percent and the market risk premium
is < percent. *ou have your money invested in three assets- an inde.
fund that has a beta of 1.!, a risk-free security that has a beta of !,
and an international fund that has a beta of 1.6. *ou want to have )!
percent of your portfolio invested in the risk-free asset, and you want
your overall portfolio to have an e.pected return of 11 percent. What
portion of your overall portfolio should you invest in the inter-
national fund?
a. !B
b. 5!B
c. 6!B
d. <!B
e. 9!B
Chapter 5 - Page 34
!APM and portfolio return Answer: c Diff: M
A6
. money manager is holding a =1! million portfolio that consists of the
following five stocks-
=5 million 1.)
8 ) million 1.1
+ ) million 1.!
E 1 million !.:
H 1 million !.6
#he portfolio has a re'uired return of 11 percent, and the market risk
premium, k
%
C k
R>
, is 6 percent. What is the re'uired return on $tock +?
a. :.)B
b. 1!.!B
c. 1!.AB
d. 11.!B
e. 11.6B
A<
. *ou have been managing a =1 million portfolio. #he portfolio has a beta
of 1.< and a re'uired rate of return of 15 percent. #he current risk-
free rate is < percent. ssume that you receive another =)!!,!!!. 3f
you invest the money in a stock that has a beta of !.<, what will be the
re'uired return on your =1.) million portfolio?
a. 1).!!B
b. 1).)6B
c. 10.1:B
d. 15.1)B
e. 10.<:B
A:
. +urrently, the risk-free rate, k
R>
, is 6 percent and the re'uired return
on the market, k
%
, is 11 percent. *our portfolio has a re'uired rate of
return of A percent. *our sister has a portfolio with a beta that is
twice the beta of your portfolio. What is the re'uired rate of return
on your sister(s portfolio?
a. 1).!B
b. 1).6B
c. 10.!B
d. 1:.!B
e. 19.!B
Chapter 5 - Page 35
!APM and portfolio return Answer: b Diff: M N
A9
. $tock has an e.pected return of 1! percent and a beta of 1.!. $tock 8
has a beta of ).!. Portfolio P is a two-stock portfolio, where part of
the portfolio is invested in $tock and the other part is invested in
$tock 8. ssume that the risk-free rate is 6 percent, that re'uired
returns are determined by the +P%, and that the market is in e'uilibrium
so that e.pected returns e'ual re'uired returns. Portfolio P has an
e.pected return of 1) percent. What proportion of Portfolio P consists
of $tock 8?
a. )!B
b. 5!B
c. 6!B
d. <!B
e. 9!B
Portfolio beta Answer: b Diff: M
AA
. *ou hold a diversified portfolio consisting of a =6,!!! investment in
each of )! different common stocks. #he portfolio beta is e'ual to
1.16. *ou have decided to sell one of your stocks, a lead mining stock
whose b is e'ual to 1.!, for =6,!!! net and to use the proceeds to buy
=6,!!! of stock in a steel company whose b is e'ual to ).!. What will
be the new beta of the portfolio?
a. 1.1)
b. 1.)!
c. 1.))
d. 1.1!
e. 1.16
Portfolio beta Answer: c Diff: M
1!!
. mutual fund manager has a =)!!,!!!,!!! portfolio with a beta I 1.).
ssume that the risk-free rate is < percent and that the market risk
premium is also < percent. #he manager e.pects to receive an additional
=6!,!!!,!!! in funds soon. $he wants to invest these funds in a variety
of stocks. fter making these additional investments she wants the
fund(s e.pected return to be 10.6 percent. What should be the average
beta of the new stocks added to the portfolio?
a. 1.1!
b. 1.00
c. 1.56
d. 1.<5
e. 1.9:
Chapter 5 - Page 36
Portfolio beta Answer: e Diff: M
1!1
. Walter Dasper currently manages a =6!!,!!! portfolio. 7e is e.pecting to
receive an additional =)6!,!!! from a new client. #he e.isting portfolio
has a re'uired return of 1!.:6 percent. #he risk-free rate is 5 percent
and the return on the market is A percent. 3f Walter wants the re'uired
return on the new portfolio to be 11.6 percent, what should be the average
beta for the new stocks added to the portfolio?
a. 1.6!
b. ).!!
c. 1.<:
d. 1.06
e. 1.9!
Portfolio return and beta Answer: a Diff: M
1!)
. portfolio manager is holding the following investments in her portfolio-
1 =0!! million !.:
) )!! million 1.!
0 6!! million 1.<
#he risk-free rate, k
R>
, is 6 percent and the portfolio has a re'uired
return of 11.<66 percent. #he manager is thinking about selling all of
her holdings of $tock 0, and instead investing the money in $tock 5, which
has a beta of !.A. 3f she were to do this, what would be the new
portfolio(s re'uired return?
a. A.:0B
b. 11.!AB
c. A.A1B
d. :.91B
e. 1!.)5B
Portfolio return and beta Answer: e Diff: M
1!0
. fund manager is holding the following stocks-
1 =0!! million 1.)
) 6<! million 1.5
0 0)! million !.:
5 )0! million 1.9
#he risk-free rate is 6 percent and the market risk premium is also
6 percent. 3f the manager sells half of her investment in $tock ) 1=)9!
million2 and puts the money in $tock 5, by how many percentage points will
her portfolio(s re'uired return increase?
a. !.0<B
b. !.))B
c. ).!!B
Chapter 5 - Page 37
d. !.)!B
e. !.5!B
Portfolio return and beta Answer: e Diff: M N
1!5
. portfolio manager is managing a =1! million portfolio. +urrently the
portfolio is invested in the following manner-
3nvestment Eollar mount 3nvested 8eta
$tock 1 =) million !.<
$tock ) 0 million !.9
$tock 0 0 million 1.)
$tock 5 ) million 1.5
+urrently, the risk-free rate is 6 percent and the portfolio has an
e.pected return of 1! percent. ssume that the market is in e'uilibrium
so that e.pected returns e'ual re'uired returns. #he manager is willing
to take on additional risk and wants to instead earn an e.pected return
of 1) percent on the portfolio. 7er plan is to sell $tock 1 and use the
proceeds to buy another stock. 3n order to reach her goal, what should
be the beta of the stock that the manager selects to replace $tock 1?
a. 1.5!
b. 1.:6
c. ).!6
d. ).5!
e. ).<!
Portfolio standard deviation Answer: a Diff: M
1!6
. 7ere are the e.pected returns on two stocks-
Returns
Probability , *
!.1 -)!B 1!B
!.9 )! 16
!.1 5! )!
3f you form a 6!-6! portfolio of the two stocks, what is the portfolio(s
standard deviation?
a. 9.1B
b. 1!.6B
c. 10.5B
d. 1<.6B
e. )!.!B
Chapter 5 - Page 38
!oefficient of variation Answer: e Diff: M N
1!<
. #he +>? of 8rady 8oots has estimated the rates of return to 8rady(s stock,
depending on the state of the economy. 7e has also compiled analysts(
e.pectations for the economy.
Hconomy Probability Return
Recession !.1 -)0B
8elow average !.1 -9
verage !.5 <
bove average !.) 1:
8oom !.) )5
/iven this data, what is the company(s coefficient of variation? 1@se the
population standard deviation, not the sample standard deviation when
calculating the coefficient of variation.2
a. 1.A5
b. )6.0A
c. ).)<
d. 6.01
e. 1.95
!oefficient of variation Answer: b Diff: M
1!:
. Ripken 3ron Works faces the following probability distribution-
$tock(s H.pected
$tate of Probability of Return if this
the Hconomy $tate ?ccurring $tate ?ccurs
8oom !.)6 )6B
4ormal !.6! 16
Recession !.)6 6
What is the coefficient of variation on the company(s stock?
a. !.!<
b. !.5:
c. !.65
d. !.<:
e. !.:1
Chapter 5 - Page 39
!oefficient of variation Answer: c Diff: M
1!9
. n analyst has estimated how a particular stock(s return will vary
depending on what will happen to the economy-
$tock(s H.pected
$tate of Probability of Return if this
the Hconomy $tate ?ccurring $tate ?ccurs
Recession !.1! -<!B
8elow verage !.)! -1!
verage !.5! 16
bove verage !.)! 5!
8oom !.1! A!
What is the coefficient of variation on the company(s stock?
a. ).1)1
b. ).)!1
c. ).5:)
d. 0.005
e. 0.:):
!oefficient of variation Answer: c Diff: M
1!A
. #he following probability distributions of returns for two stocks have
been estimated-
Returns
Probability $tock $tock 8
!.0 1)B 6B
!.5 9 5
!.0 < 0
What is the coefficient of variation for the stock that is less risky,
assuming you use the coefficient of variation to rank riskiness?
a. 0.<)
b. !.)9
c. !.1A
d. !.<<
e. 6.1<
Chapter 5 - Page 40
!oefficient of variation Answer: d Diff: M
11!
. financial analyst is forecasting the e.pected return for the stock of
7imalayan %otors. #he analyst estimates the following probability
distribution of returns-
Probability Return
)!B -6B
5! 1!
)! )!
1! )6
1! 6!
?n the basis of this analyst(s forecast, what is the stock(s coefficient
of variation?
a. !.9!
b. !.A1
c. !.A<
d. 1.!5
e. 1.1!
111
. stock market analyst estimates that there is a )6 percent chance the
economy will be weak, a 6! percent chance the economy will be average, and
a )6 percent chance the economy will be strong. #he analyst estimates
that 7artley 3ndustries( stock will have a 6 percent return if the economy
is weak, a 16 percent return if the economy is average, and a 0! percent
return if the economy is strong. ?n the basis of this estimate, what is
the coefficient of variation for 7artley 3ndustries( stock?
a. !.<1<55
b. !.65A05
c. !.:65A9
d. 0.<)0!<
e. !.<050)
11)
. n analyst has estimated Williamsport H'uipment(s returns under the
following economic states-
Hconomic $tate Probability H.pected Return
Recession !.)! -)5B
8elow average !.0! -0
bove average !.0! M16
8oom !.)! M6!
What is Williamsport(s estimated coefficient of variation?
a. !.0<
b. ).9!
c. ).9<
Chapter 5 - Page 41
d. ).A6
e. 0.0!
!oefficient of variation Answer: e Diff: M
110
. $tock R has had the following returns over the past five years-
*ear Return
1AA9 1!B
1AAA 1)
)!!! ):
)!!1 -16
)!!) 0!
What is the company(s coefficient of variation 1+S2? 1@se the
population standard deviation to calculate +S.2
a. AA.A1
b. 06.:<
c. A.99
d. ).:A
e. 1.)6
115
. n investor has =6,!!! invested in a stock that has an estimated beta of
1.), and another =16,!!! invested in the stock of the company for which
she works. #he risk-free rate is < percent and the market risk premium
is also < percent. #he investor calculates that the re'uired rate of
return on her total 1=)!,!!!2 portfolio is 16 percent. What is the beta
of the company for which she works?
a. 1.<
b. 1.:
c. 1.9
d. 1.A
e. ).!
Beta coefficient Answer: e Diff: M
116
. Portfolio P has 0! percent invested in $tock , and :! percent in $tock *.
#he risk-free rate of interest is < percent and the market risk premium
is 6 percent. Portfolio P has a re'uired return of 1) percent and
$tock , has a beta of !.:6. What is the beta of $tock *?
a. !.)1
b. 1.)!
c. !.A<
d. 1.<6
e. 1.0A
Chapter 5 - Page 42
!APM and beta coefficient Answer: d Diff: M
11<
. money manager is managing the account of a large investor. #he
investor holds the following stocks-
$tock mount 3nvested Hstimated 8eta
=),!!!,!!! !.9!
8 6,!!!,!!! 1.1!
+ 0,!!!,!!! 1.5!
E 6,!!!,!!! ????
#he portfolio(s re'uired rate of return is 1: percent. #he risk-free
rate, k
R>
, is : percent and the return on the market, k
%
, is 15 percent.
What is $tock E(s estimated beta?
a. 1.)6<
b. 1.09A
c. 1.5)A
d. ).!)<
e. ).165
Market return Answer: d Diff: M
11:
. #he returns of @nited Railroad 3nc. 1@R32 are listed below, along with
the returns on Nthe marketO-
*ear @R3 %arket
1 -15B -AB
) 1< 11
0 )) 16
5 : 6
6 -) -1
3f the risk-free rate is A percent and the re'uired return on @R3(s
stock is 16 percent, what is the re'uired return on the market? ssume
the market is in e'uilibrium. 17int- #hink rise over run.2
a. 5B
b. AB
c. 1!B
d. 10B
e. 1<B
Chapter 5 - Page 43
Tough:
Portfolio required return Answer: a Diff: $
119
. money manager is holding the following portfolio-
1 =0!!,!!! !.<
) 0!!,!!! 1.!
0 6!!,!!! 1.5
5 6!!,!!! 1.9
#he risk-free rate is < percent and the portfolio(s re'uired rate of
return is 1).6 percent. #he manager would like to sell all of her
holdings of $tock 1 and use the proceeds to purchase more shares of
$tock 5. What would be the portfolio(s re'uired rate of return
following this change?
a. 10.<0B
b. 1!.)AB
c. 11.!6B
d. 1).6)B
e. 15.00B
Multiple Part:
(The following information applies to the next two problems.)
portfolio manager has a =1! million portfolio, which consists of =1 million
invested in 1! separate stocks. #he portfolio beta is 1.). #he risk-free
rate is 6 percent and the market risk premium is < percent.
!APM and portfolio return Answer: d Diff: E N
11A
. What is the portfolio(s re'uired return?
a. <.)!B
b. A.96B
c. 1).!!B
d. 1).)!B
e. 1).06B
!APM and portfolio return Answer: c Diff: M N
1)!
. #he manager sells one of the stocks in her portfolio for =1 million. #he
stock she sold has a beta of !.A. $he takes the =1 million and uses the
money to purchase a new stock that has a beta of 1.<. What is the
re'uired return of her portfolio after purchasing this new stock?
a. 1!.:6B
b. 1).06B
c. 1).<)B
d. 10.06B
e. 15.<!B
Chapter 5 - Page 44
+e* Appendi, !A
Multiple Choice: Conceptual
Medium:
Beta calculation Answer: b Diff: M
6-
1)1
a. #he +P% is an e. ante model, which means that all of the variables
should be historical values that can reasonably be proLected into
the future.
b. #he beta coefficient used in the $%& e'uation should reflect the
e.pected volatility of a given stock(s return versus the return on
the market during some future period.
c. #he general e'uation- * I a M b, M e, is the standard form of a
simple linear regression where b I beta, and , e'uals the
independent return on an individual security being compared to *,
the return on the market, which is the dependent variable.
d. #he rise-over-run method is not a legitimate method of estimating
beta because it measures changes in an individual security(s return
regressed against time.
Multiple Choice: P)o*lems
Easy:
Beta calculation Answer: c Diff: E
6-
1))
. /iven the following returns on $tock D and Nthe marketO during the
last three years, what is the beta coefficient of $tock D? 17int-
#hink rise over run.2
*ear $tock D %arket
1 -10.96B -9.<0B
) )).A! 1).0:
0 06.16 1A.0:
a. !.A)
b. 1.1!
c. 1.:6
d. ).)5
e. 1.56
Chapter 5 - Page 45
Medium:
Beta and base #ear sensitivit# Answer: a Diff: M
6-
1)0
. /iven the following returns on $tock K and Nthe marketO during the
last three years, what is the difference in the calculated beta
coefficient of $tock K when *ear 1-*ear ) data are used as compared to
*ear )-*ear 0 data? 17int- #hink rise over run.2
*ear $tock K %arket
1 <.0!B <.1!B
) -0.:! 1).A!
0 )1.:1 1<.)!
a. A.1:
b. 1.!<
c. <.)0
d. !.91
e. !.6<
Beta calculation Answer: b Diff: M
6-
1)5
. $tock ,, and Nthe marketO have had the following rates of returns over
the past four years.
*ear $tock , %arket
1AAA 1)B 15B
)!!! 6 )
)!!1 11 15
)!!) -: -0
<! percent of your portfolio is invested in $tock ,, and the remaining
5! percent is invested in $tock *. #he risk-free rate is < percent
and the market risk premium is also < percent. *ou estimate that 15
percent is the re'uired rate of return on your portfolio. What is the
beta of $tock *?
a. 1.00
b. 1.A1
c. ).!!
d. ).16
e. ).00
Chapter 5 - Page 46
Beta calculation Answer: c Diff: E
6-
1)6
. 7anratty 3nc.(s stock and the stock market have generated the
following returns over the past five years-
*ear 7anratty %arket 1k
%
2
1 10B AB
) 19 16
0 -6 -)
5 )0 1A
6 < 1)
?n the basis of these historical returns, what is the estimated beta
of 7anratty 3nc.(s stock?
a. !.:90A
b. !.AA99
c. 1.):6:
d. 1.056)
e. 1.6!!!
Beta calculation Answer: a Diff: E
6-
1)<
. 8elow are the returns for the past five years for $tock $ and for the
overall market-
*ear $tock $ %arket 1k
%
2
1AA9 1)B 9B
1AAA 05 )9
)!!! -)A -)!
)!!1 -11 -5
)!!) 56 0!
What is $tock $(s estimated beta?
a. 1.50
b. !.<A
c. !.A1
d. 1.1!
e. 1.6!
Chapter 5 - Page 47
Multiple Part:
(The following information applies to the next two problems.)
*ou have been asked to use a +P% analysis to choose between $tocks R and $,
with your choice being the one whose e.pected rate of return e.ceeds its
re'uired rate of return by the widest margin. #he risk-free rate is < percent,
and the re'uired return on an average stock 1or Nthe marketO2 is 1! percent.
*our security analyst tells you that $tock $(s e.pected rate of return,
k
Q, is
e'ual to 11 percent, while $tock R(s e.pected rate of return,
k
Q, is e'ual to
1) percent. #he +P% is assumed to be a valid method for selecting stocks, but
the e.pected return for any given investor 1such as you2 can differ from the
re'uired rate of return for a given stock. #he following past rates of return
are to be used to calculate the two stocks( beta coefficients, which are then
to be used to determine the stocks( re'uired rates of return-
*ear $tock R $tock $ %arket
1 -16B !B -6B
) 6 6 6
0 )6 1! 16
Note: #he averages of the historical returns are not needed, and they are
generally not e'ual to the e.pected future returns.
Beta calculation Answer: c Diff: M
6-
1):.
+alculate both stocks( betas. What is the difference between the betas?
#hat is, what is the value of beta
R
- beta
$
? 17int- #he graphical method
of calculating the rise over run, or 1*
)
C *
1
2 divided by 1,
)
C ,
1
2 may aid
you.2
a. !.!
b. 1.!
c. 1.6
d. ).!
e. ).6
Required rate of return Answer: e Diff: M
6-
1)9
. $et up the $%& e'uation and use it to calculate both stocks( re'uired
rates of return, and compare those re'uired returns with the e.pected
returns given above. *ou should invest in the stock whose e.pected
return e.ceeds its re'uired return by the widest margin. What is the
widest margin, or greatest e.cess return 1
k
- k2?
a. !.!B
b. !.6B
c. 1.!B
d. ).!B
e. 0.!B
Chapter 5 - Page 48
CHAPTE !
A%#+E# A%D #&-(T"&%#
1& Risk concepts Answer: e Diff: E
)& Risk measures Answer: a Diff: E
$tatement a is correct, since the coefficient of variation is e'ual to the
standard deviation divided by the mean. #he remaining statements are false.
0& Market risk premium Answer: c Diff: E
+P% e'uation- k
s
I k
R>
M 1k
%
- k
R>
2b
3f the market risk premium 1measured by k
%
- k
R>
2 goes up by 1.!, then the
re'uired return for each stock will change by its beta times 1.!. #herefore,
a stock with a beta of !.6 will see its re'uired return go up by !.6
percentage point. #herefore, statement a is false. s Lust shown in
statement a, a stock with a beta of !.6 will see its re'uired return increase
by !.6 percentage point. ll stocks with positive betas will see their
re'uired returns increase. #herefore, statement b is false. 3f the market
risk premium increases by 1 percentage point, then the re'uired return
increases by 1.! times the stock(s beta. #herefore, the re'uired return of a
stock with a beta coefficient e'ual to 1.! will increase by 1 percentage
point, and statement c is correct.
5& Standard deviation Answer: b Diff: E
6& Beta coefficient Answer: d Diff: E
<& Beta coefficient Answer: c Diff: E
$tatement a is falseG * has a higher re'uired return because it is more risky,
but it may still end up actually earning a lower return than ,. $tatement b is
falseG beta tells us about the covariance of the stock with the market. 3t
tells us nothing about the stocks( individual standard deviations. $tatement c
is correct from the +P%- k
s
I k
R>
M 1k
%
C k
R>
2b. $tatement d is false from the
+P%. $tatement e is falseG the portfolio beta, b
p
, is calculated as 1!.6
!.62 M 1!.6 1.62 I 1.!.
:& Required return Answer: b Diff: E
#he easiest way to see this is to write out the +P%- k
s
I k
R>
M 1k
%
C k
R>
2b.
+learly, a change in the market risk premium is going to have the most effect on
firms with high betas. +onse'uently, statement b is the correct choice.
9& Risk and return Answer: a Diff: E N
#he correct answer is statement a. $tocks are riskier than bonds, with
stocks in small companies being riskier than stocks in larger companies. >rom
there, corporate bonds are riskier than government bonds, and longer-term
government bonds are riskier than shorter-term ones.
A& Portfolio risk Answer: b Diff: E
#he standard deviation of the portfolio will be less than the weighted
average of the two stocks( standard deviations because the correlation
coefficient is less than one. #herefore, although the e.pected return on the
portfolio will be the weighted average of the two returns 11! percent2, the
+S will not be e'ual to )6B;1!B. #herefore, statement a is false. Remember,
market risk is measured by beta. #he beta of the portfolio will be the
weighted average of the two betasG therefore, it will be less than the beta
of the high-beta stock 182, but more than the beta of the low-beta stock 12.
#herefore, the market risk of the portfolio will be higher than (s, but
lower than 8(s. #herefore, statement b is correct. 8ecause the correlation
between the two stocks is less than one, the portfolio(s standard deviation
will be less than )6 percent. #herefore, statement c is false.
1!& Portfolio risk return and beta Answer: e Diff: E
#he trick here is to notice the word always in each of the answers. 3f you
can find even one e.ception to the statement, then the statement will not
NalwaysO be true.
#he e.ception to statement a is if the correlation coefficient, r, I 1.!.
While this is unlikely to ever happen, theoretically it is still possible.
#herefore, there is an e.ception, so we cannot necessarily say always.
#herefore, statement a is false. 8eta has nothing to do with the number of
stocks in a portfolio. *ou can take a stock with a beta of !.5, and a stock
with a beta of 1.<, and combine them 1with e'ual weights2 in a portfolio. #he
portfolio beta will now be 1.!, which is higher than a portfolio of Lust the
first stock. #herefore, statement b is false. $tatement c is false for the
same reason that statement b is false. +onse'uently, the correct choice is
statement e.
11& Portfolio risk and return Answer: a Diff: E
$tatements b and c are false. Randomly adding more stocks will have no
effect on the portfolio(s beta or e.pected return.
1)& Portfolio risk and return Answer: e Diff: E
10& Portfolio risk and return Answer: a Diff: E
#he portfolio will have an e.pected return e'ual to the weighted average of the
individual stock returns. #he portfolio(s beta will also be e'ual to the
weighted average of the individual stock betas. #he standard deviation of the
portfolio will be less than 0! percent, because the stocks have a correlation
coefficient of less than one. #herefore, the portfolio(s beta will e'ual 1.<,
its standard deviation is less than 0! percent, and its e.pected return is 16
percent. #he correct answer must be statement a.
15& Portfolio risk and return Answer: b Diff: E
$ince we are randomly adding stocks, eventually your portfolio will have the
same e.pected return as the market, on average. #herefore, unless we are told
that the current e.pected return is higher than the market average, we have no
reason to believe that the e.pected return will decline. #herefore, statement
a is false. 3f we randomly add stocks to the portfolio, the company-specific
risk will decline because the standard deviation of the portfolio will be
declining. 7owever, the market risk 1as measured by beta2 will tend to remain
the same, for the same reason that in statement a the e.pected return was
unlikely to change. #herefore, statement b is correct. s in statement a, we
know there is no reason to believe that the market risk of the portfolio 1as
measured by beta2 will decline. #herefore, statement c is false. 4either the
market risk nor the e.pected return on the portfolio are e.pected to decline
1see above2, so statement d is false. #he company-specific risk 1as measured
by the standard deviation of the portfolio2 will decline and market risk is not
e.pected to change. #herefore, statement e is false.
16& Portfolio risk and return Answer: b Diff: E
$tatement a is false. $ince the correlation coefficient is less than one,
there is a benefit from diversification so the portfolio(s standard deviation
is less than )! percent. $tatement b is correct. #he beta of the portfolio is
the weighted average of the two betas. $o the portfolio(s beta is calculated
as- !.6 !.: M !.6 1.0 I 1.!. $ince the beta of the portfolio is e'ual to
1.! and the beta of the market is e'ual to 1.!, the portfolio must have the
same return as the market. $tatement c is false. #he re'uired return would be
e'ual to- k
p
I k
R>
M 1k
%
- k
R>
2b
p
.
1<& Portfolio risk and return Answer: e Diff: E
portfolio of randomly-selected stocks should, on average, have a beta of 1.!.
#herefore, both portfolios should have the same re'uired return. #herefore,
statement a is false. 8eta is the measure of market risk, while standard
deviation is the measure of diversifiable risk. $ince both portfolios have the
same beta, they will have the same market risk. $ince Dane has more stocks in
her portfolio, she is more diversified and will have less company-specific risk
than Eick. #herefore, statement b is false. Dane has more stocks in her
portfolio, so she is more diversified and will have less company-specific risk
than Eick. #herefore, statement c is false. $ince statements a, b, and c are
false, the correct choice is statement e.
1:& Portfolio risk and return Answer: d Diff: E
Remember, for portfolios you can take averages of betas and returns, but not
standard deviations. $o, the portfolio will have a return of 1) percent 1because
both stocks have returns of 1) percent2 and a beta of 1.) 1both stocks have betas
of 1.)2. 7owever, since the correlation coefficient is less than 1.!, the
portfolio(s standard deviation will be less than the average of the two stocks(
standard deviations. 1#hat is, the portfolio(s standard deviation will be less
than )6 percent.2 $o, statements a and c are correctG therefore, the correct
choice is statement d.
19& Portfolio risk and return Answer: e Diff: E
Remember, you can always find the portfolio re'uired return by finding the
weighted average return of the stocks in the portfolio. *ou can always find
the portfolio beta by finding the weighted average beta of the stocks in the
portfolio. *ou cannot find the standard deviation by finding the weighted
average standard deviation of the stocks in the portfolio, unless r I 1.!.
#he portfolio standard deviation is not a weighted average of the individual
stocks( standard deviations. 7ow-ever, since the ) correlation coefficients
are less than 1, we know the portfolio(s standard deviation will be less than
)6 percent. $ince statements a and c are correct, the correct choice is
statement e.
1A& Portfolio risk and return Answer: a Diff: E
$tatement a is trueG the others are false. $ince both stocks( betas are
e'ual to 1.), the portfolio beta will e'ual 1.). 8ecause the stocks(
correlation coefficient is less than one, the portfolio(s standard deviation
will be lower than )! percent.
)!& Portfolio risk and return Answer: d Diff: E N
#he correct answer is statement d. $tatement a is correctG $tock + has a
higher beta than Portfolio P. $tatement b is correctG the stocks are less
than perfectly correlated 1r 12, hence the portfolio standard deviation must
be less than )6B. $tatement c is incorrectG the e.pected returns of Portfolio
P are greater than the e.pected returns of $tock , but the reali"ed returns
cannot be known e. ante. #herefore statement d is the correct choice.
)1& !APM Answer: b Diff: E
#he +P% is written as- k
s
I k
R>
M 1k
%
C k
R>
2b. $tatement a is false based on
the +P% e'uation. $tatement b is correct on the basis of the +P% e'uation.
$tatement c is falseG the re'uired returns will increase by the same amount.
)) . !APM and required return
Answer: c Diff: E
*ou need to think about the +P% to answer this 'uestion- k
s
I k
R>
M 1k
%
C k
R>
2b.
>rom the statement in the 'uestion k
R>
and 1k
%
C k
R>
2 have both declined.
$tatement a is falseG the average re'uired return on the market must have
declined too. $tatement b is falseG the si"e of the decline depends on the beta
of the stock. $tatement c is correct. $tatement d is false. #his must be, if
statement c is correct. $tatement e is false because the re'uired returns will
have fallen for all stocks.
)0& !APM and required return Answer: c Diff: E N
#he correct answer is statement c. 7ere, the re'uired rate is k
s
I 6B M b RP
%
. 3f
a stock(s beta doubles, b becomes )b. $o, k
s
I 6B M )b RP
%
. 8ut doubling its
re'uired return would re'uire the e'uation to be )16B M b RP
%
2 I 1!B M )b
RP
%
. $o, statement a is incorrect. $tatement b would be correct only if the
beta coefficient were negative. #herefore, statement b is incorrect. $tatement c
is correct. 3f b F ! and RP
%
J !, then 1b RP
%
2 F !. $o, k
s
F 6B.
)5& !APM and required return Answer: e Diff: E N
#he correct answer is statement e. $ince $tock , is riskier, its re'uired
return should be higher, so statement a is incorrect. $ince the betas of
$tock and $tock 8 are different, statement b will be incorrect in most
circumstances. lthough some situations e.ist where this holds, in general,
it will not be true. $o, statement b is not always correct. $tatement c is
always incorrect. #he re'uired return for both stocks will decline. $o,
statement e is the correct choice.
)6& !APM and required return Answer: b Diff: E N
#he correct answer is statement b. Remember, the market risk premium is the
slope of the $ecurity %arket &ine. #his means high-beta stocks e.perience
greater increases in their re'uired returns, while low-beta stocks e.perience
smaller increases in their re'uired returns. $tatement a is incorrect.
$tatement b is correctG stocks with a beta less than 1 increase by less than
the increase in the market risk premium, and vice versa. $tatement c is
incorrectG since the market risk premium is changing, re'uired returns must
change too. $tatements d and e are incorrect for the same reason that
statement c is incorrect.
)< . !APM beta and required return
Answer: c Diff: E
k
R>
I <BG RP
%
I 6BG +P% e'uation- k
s
I k
R>
M 1k
%
- k
R>
2b.
$tatement a is false. Dust because a stock has a negative beta does not mean
its return is also negative. >or e.ample, if its beta were -!.6, its return
would be as follows-
k I k
R>
M RP
%
1b2
I 
will not double, so the overall return
will not double. $tatement c is correct. 3f b I 1.!, then-
k I k
R>
M RP
%
1b2
I 
, which depends on investor risk aversion.
)9& SM" Answer: b Diff: E
$tatement b is correct. $tatement a is false, since the slope of the $%& is
k
%
C k
R>
. $tatement c is false, since k
s
I k
R>
M 1k
%
C k
R>
2b. #he remaining
statements are false.
)A& SM" Answer: c Diff: E
$tatement c is correctG the others are false. $tock will have a higher
re'uired rate of return than 8 because has the higher beta.
#he standard deviation of a portfolio is not the average of the standard
deviations of the component stocks. #he portfolio beta is a weighted average
of the component stocks( betasG therefore, b
p
I 1.!.
0! & SM"
Answer: e Diff: E
#he +P% states k
s
I k
R>
M 1k
%
- k
R>
2b. Working through each statement, it is
apparent that none of the statements is consistent with the formula.
#herefore, statement e is the best choice.
01& SM" Answer: c Diff: E
$tock * will have a higher e.pected return than $tock , does 1because its beta
is higher2, but we are told nothing about its standard deviation. Remember,
beta has nothing to do with standard deviation. #herefore, statement a is
false. #he e.pected return of a portfolio of =6!,!!! in each stock will have a
re'uired return that is the weighted average of the returns on both stocks.
$ince each one has a weight of T, it will be a simple average. #he portfolio(s
beta will be the average of the two betas 11!.< M 1.52;) I 1.!2. #he portfolio
has the same beta that the market portfolio does and, therefore, the same
re'uired return that the market has. #herefore, statement b is false. 3f the
market risk premium decreases, the slope of the $%& will decrease. #herefore,
the re'uired returns of stocks with higher betas will decrease more.
#herefore, $tock *(s re'uired return will fall by more than $tock ,(s.
#herefore, statement c is correct. 3f the e.pected inflation increases, the
$%& will have a parallel shift up, and the re'uired returns on all stocks will
increase by the same amount, not decrease. #herefore, statement d is false.
3f e.pected inflation decreases, the $%& will have a parallel shift down, and
the re'uired returns on all stocks will decrease by the same amount. #herefore,
statement e is false.
0)& SM" Answer: b Diff: E
Remember, the market risk premium is the slope of the line in the $%& diagram.
#he line is anchored at the y-a.is, and when the market risk premium changes,
the line NrotatesO around that point. lso remember the $%& e'uation is k
s
I
k
R>
M 1k
%
- k
R>
2b. $tatement a is implying a Nparallel shiftO of the line, and
that is incorrect. review of the e'uation shows that, because beta is
multiplied by the market risk premium, changes in the market risk premium will
affect stocks with different betas differently. $tatement b is correct. #he
slope of the line will increase, so re'uired returns on stocks with betas
closer to ! will increase by less than returns on stocks with higher betas.
review of the e'uation shows that if the beta were higher, a change in the
market risk premium would have more effect on k
s
than if the beta were lower.
$tatement c is false because it is the reverse of statement b, which we have
already stated is true. $tatement d is false because an increase in the market
risk premium will increase the re'uired return on all stocks with positive
betas. $tatement e is false. #he portfolio beta is the weighted average of
the individual stocks( betas. 3n this case, the portfolio beta will be 1.!.
3t is clear from the $%& e'uation that a portfolio with a beta of 1.! will be
affected by changes in the market risk premium.
00& SM" Answer: e Diff: E
3f the market risk premium 1k
%
- k
R>
2 increases, the re'uired return on all
stocks with positive betas would increase. #herefore, statement a is false.
$ince the re'uired return for all positive beta stocks will increase, the
return for Portfolio P must increase as well. #herefore, statement b is
false. #he re'uired return on $tock will increase by !.: percent, and the
re'uired return on $tock 8 will increase by 1.0 percent. #herefore, statement
c is false. $tatement d is the opposite of what would actually happen, so
statement d is false. #he beta for Portfolio P is 1.!U16!B !.:2 M 16!B
1.02V. #herefore, the change in the portfolio(s re'uired return will be b
1k
%
- k
R>
2 I 1.! 1B I 1B. #herefore, statement e is correct.
05 & SM"
Answer: b Diff: E N
#he correct answer is statement b. 3f the risk premium declines, then the
slope of the $%& declines.
beta

k
8
1.!
t first, the line could be drawn at . #hen when the risk premium declines,
it will look more like 8. $tatements a and c are incorrect. #he re'uired
return on all stocks will fall. #herefore, statement b is correct.
06& SM" !APM and beta Answer: e Diff: E
$tatement e is correctG the others are false. #he market risk premium is the
slope of the $%&. 3f a stock has a negative beta, this does not mean its
re'uired return is negative. doubling of a stock(s beta doesn(t mean that
its re'uired return will double. #he re'uired return is a function of k
R>
,
k
%
, and beta. #he re'uired return is affected by the market risk premium.
0<& Risk anal#sis and portfolio diversification Answer: d Diff: E
security(s beta does indeed measure market risk relative to that of an
average stock. Eiversification reduces the variability of the port-folio(s
return. n investor, through diversification, can eliminate company-specific
riskG however, a portfolio containing all publicly-traded stocks would still
be e.posed to market risk. #he +P% specifies a stock(s re'uired return as-
k
s
I k
R>
M 1k
%
- k
R>
2b. #hus, the risk-free rate and the market risk premium
are needed along with a stock(s beta to determine its re'uired return.
stock(s beta is more relevant as a measure of risk to an investor with a
well-diversified portfolio than to an investor who holds only that one stock.
0:& Miscellaneous risk concepts Answer: c Diff: E N
#he correct answer is statement c. $tatement a is incorrect. $ince the
correlation is not 1.!!, the standard deviation of the portfolio is less than
)!B. >or the same reason, $tatement d is also incorrect. $ince Portfolio P(s
standard deviation is less than )!B, its +S 1; , 2 is less than ).!. $o,
statement b is incorrect. nd, statement e is incorrect since Portfolio P(s
re'uired return e'uals that of $tock . Portfolio K(s re'uired return I 11!B
M 1!B M 1)B2;0 I 1!.<:B. $o, statement c is the correct choice.
09& Risk aversion Answer: b Diff: M
0A& SM" and risk aversion Answer: e Diff: M
5!& Portfolio risk and return Answer: c Diff: M
51& Portfolio risk and return Answer: d Diff: M N
#he correct answer is statement d. $tatement a is correctG the e.pected return
of a portfolio is a weighted average of the returns of each of the component
stocks. 7ence, k
P
I w
M w
8
k
8
I !.611!B2 M !.611)B2 I 11B. $tatement b is
also correctG since the correlation coefficient is "ero, the standard deviation
of the portfolio must be less than the weighted average of the standard
deviations of each of the component stocks. $tatement c is incorrectG $tock
8(s beta can be calculated using- k
8
I k
R>
M 1k
%
C k
R>
2b. 1)B I 6B M 1<B2b.
#herefore, $tock 8(s beta is 1.1<. $o statement d is the correct choice.
5)& Portfolio risk and return Answer: d Diff: M N
#he correct answer is statement d. 3f the same amount were invested in $tocks
and 8, the portfolio beta would be 11;)2 1.) M 11;)2 1.5 I 1.0!. #his is not
the beta of the portfolio, so statement a is incorrect. $ince the standard
deviation of the portfolio is less than the standard deviation of both $tock
and $tock 8, they cannot be perfectly correlated. 3f they were, the standard
deviation of the portfolio would be between )!B and )6B, inclusive. $o,
statement b is incorrect. $ince the beta of $tock 8 is higher than that of $tock
, $tock 8 has more market riskG so, statement c is incorrect. $ince the beta of
the portfolio is higher than the beta of $tock , the portfolio has a higher
re'uired return than $tock G therefore, statement d is true. $tatement e is
incorrectG since the beta of $tock is less than the beta of the portfolio,
$tock has less market risk than the portfolio.
50& Portfolio risk Answer: e Diff: M
55& Portfolio risk and beta Answer: c Diff: M
56& Portfolio risk and beta Answer: e Diff: M
5<& Market risk Answer: b Diff: M
5:& Beta coefficient Answer: a Diff: M
59& Beta coefficient Answer: d Diff: M
5A& Beta coefficient Answer: a Diff: M
6!& Beta coefficient Answer: c Diff: M
61& Beta coefficient Answer: d Diff: M N
#he correct answer is statement d. H.cept for >lorida Power P &ight 1>PP&2,
the remaining four companies and betas are all in line with the nature of the
firms and their industries. 7owever, >PP& 1a utility company2 is out of place.
3ts indicated beta of 1.6) puts it in the same league as technology
frontrunners $un %icrosystems and ma"on.com. more reasonable beta estimate
for >PP& would be somewhere between !.6! and !.:!.
6)& SM" Answer: e Diff: M
60& SM" Answer: a Diff: M
65& SM" Answer: b Diff: M
66& SM" Answer: b Diff: M N
#he correct answer is statement b. simple e.ample helps here. ssume k
R>
is
originally 6B. nd the RP
%
is 0B. #hen, k
s
I 6B M 10B2b. Recall that the
market has a beta of 1.!. $o, the market re'uires a return of 9B. &et k
R>
now
be <B, and the RP
%
fall to )B. #he market still has a re'uired return of 9B.
$tatement a is incorrectG for any beta between "ero and one, you can see that
the new re'uired return is higher. >or e.ample, a stock with a beta of !.6
had an original re'uired return of <.6B, but now has a re'uired return of :B.
Dust the opposite happens for stocks with a beta greater than one. $tatement
b is correct, for Lust the opposite reason. >or e.ample, a stock with a beta
of ).! originally had a re'uired return I
6B M 10B2).! I 11B, but now has a re'uired return of rom the e.planations above, both statements c and d are clearly incorrect.
>or some stocks, the re'uired return will riseG for others, the re'uired
return will fall.
6<& SM" !APM and portfolio risk Answer: a Diff: M
n increase in e.pected inflation would lead to an increase in k
R>
, the
intercept of the $%&. 3f risk aversion were unchanged, then the slope of the
$%& would remain constant. #herefore, there would be a parallel upward shift
in the $%&, which would result in an increase in k
%
that is e'ual to the
e.pected increase in inflation.
6:& Portfolio return !APM and beta Answer: e Diff: M
$tatement e is correct because none of the statements are correct. $tatement a
is false because if the returns of ) stocks were perfectly positively
correlated the portfolio(s variance would e'ual the variance of each of the
stocks. $tatement b is false. stock can have a negative beta and still have
a positive return because k
s
I k
R>
M 1k
%
C k
R>
2b. $tatement c is false. ccording
to the +P%, stocks with higher betas have higher e.pected returns. 8etas are
a measure of market risk, while standard deviation is a measure of stand-alone
risk--but not a good measure. #he coefficient of variation is a better measure
of stand-alone risk. #he portfolio(s beta 1the measure of market risk2 will be
dependent on the beta of each of the randomly selected stocks in the portfolio.
7owever, the portfolio(s beta would probably approach b
%
I 1, which would
indicate higher market risk than a stock with a beta e'ual to !.6.
69& !APM and required return Answer: d Diff: M
6A& Risk anal#sis and portfolio diversification Answer: e Diff: M
<!& Portfolio diversification Answer: c Diff: M
$tatement c is correctG the others are false. 7olding a portfolio of stocks
reduces company-specific risk. Eiversification lowers riskG conse'uently, it
reduces the re'uired rate of return. 8eta measures market risk, the lower
the beta the lower the market risk.
<1& Portfolio risk and SM" Answer: e Diff: M
<)& !APM Answer: c Diff: $
<0& SM" Answer: d Diff: $
<5& Required return Answer: d Diff: E N
k
s
I k
R>
M 1k
%
- k
R>
2b

I 
M 1k
%
C k
R>
2b
11B I 6B M 1k
%
C k
R>
21.!

2.
$tep )- We can now find the re'uired return of $tock 8 using the +P%
e'uation with data inputs for $tock 8-
k
8
I k
R>
M 1k
%
C k
R>
2b
8
k
8
I 6B M 1<B21.5
k
8
I 10.5B.
<<& !APM and required return Answer: d Diff: E
k
R>
I kW M 3P I 0B M 6B I 9B.
k
s
I 9B M 16B2).! I 19B.
<:& !APM and market risk premium Answer: c Diff: E N
@sing $tock 1or any stock2,
1!B I k
R>
M 1k
%
C k
R>
2b
1!B I 6B M 1k
%
C k
R>
21.!
1k
%
C k
R>
2 I 6B.
<9& Market risk premium Answer: d Diff: E
1).)6B I 6B M 1RP
%
21.16
:.)6B I 1RP
%
21.16
RP
%
I <.0!50B <.0!B.
<A& Beta coefficient Answer: b Diff: E
3n e'uilibrium
k
k
I 11.0B.
k
I k
R>
M 1k
%
- k
R>
2b
11.0B I 6B M 11!B - 6B2b
b I 1.)<.
:!& Beta coefficient Answer: a Diff: E
10.:6B I 6B M 1:B2b
9.:6B I :Bb
b I 1.)6.
:1& Portfolio beta Answer: b Diff: E
1.) I 1;)!1!.:2 M 11A;)!2b
b is average beta for other 1A stocks.
1.1<6 I 11A;)!2b.
4ew 8eta I 1.1<6 M 1;)!11.52 I 1.)06.
:)& Portfolio return Answer: a Diff: E
#he portfolio(s beta is a weighted average of the individual security betas
as follows-
1=6!,!!!;=:6,!!!21.6 M 1=)6,!!!;=:6,!!!2!.A I 1.0. #he re'uired rate of
return is then simply- 5B M 1<B - 5B21.0 I <.<B.
:0& Portfolio return Answer: b Diff: E
p
k I !.A11)B2 M !.11)!B2 I 1).9B.

b
p
I !.A11.)2 M !.11).!2 I 1.)9.
:5 & Portfolio risk and return
Answer: a Diff: E N
#he correct answer is statement a. Remember, you can take the weighted
average of the beta, and the weighted average of the returns, but you can only
take the weighted average of the standard deviations if r I 1.!.
#he total portfolio value will be =A!!,!!! M =0!!,!!! I =1,)!!,!!!.
H.pected return-
!!! , )!! , 1 =
!!! , A!! =
1)B M
!!! , )!! , 1 =
!!! , 0!! =
1!B I 11.6B.
8eta-
!!! , )!! , 1 =
!!! , A!! =
1.) M
!!! , )!! , 1 =
!!! , 0!! =
1.) I 1.).
I U!.:611)B - 11.6B2
)
M !.)611!B - 11.6B2
)
V
T
I U!.19:6B M !.6<)6!BV
T
I U!.:6BV
T
I !.9<<!0B.
:6& !oefficient of variation Answer: b Diff: E
@sing your financial calculator you find the mean to be 1!.9B and the
population standard deviation to be 16.:16B. #he coefficient of variation is
Lust the standard deviation divided by the mean, or 16.:16B;1!.9B I 1.5661
1.5<.
:<& E%pected return Answer: e Diff: M
,
k
Q
I !.1!1-0B2 M !.1!1)B2 M !.)616B2 M !.)619B2 M !.0!11!B2 I <.16B.
*
k
Q
I !.!61-0B2 M !.1!1)B2 M !.0!16B2 M !.0!19B2 M !.)611!B2 I <.56B.
)
,
I !.1!1-0B - <.16B2
)
M !.1!1)B - <.16B2
)
M !.)616B - <.16B2
)
M !.)619B - <.16B2
)
M !.0!11!B - <.16B2
)
)
,
I 16.:0BG
,
I 0.A:B.
+S
,
I 0.A:B;<.16B I !.<56.
)
*
I !.!61-0B - <.56B2
)
M !.1!1)B - <.56B2
)
M !.0!16B - <.56B2
)
M !.0!19B - <.56B2
)
M !.)611!B - <.56B2
)
)
*
I 1!.A6BG
*
I 0.01B.
+S
*
I 0.01B;<.56B I !.610.
#herefore, sset * has a higher e.pected return and lower coefficient of
variation and hence it would be preferred.
::
& E%pected return Answer: c Diff: M
D
k
Q
I 1!.)21!.1!2 M 1!.<21!.162 M 1!.)21!.)!2 I !.16 I 16.!B.
H.pected return I 16.!B.
)
D
I 1!.)21!.1! - !.162
)
M !.<1!.16 - !.162
)
M 1!.)21!.)! - !.162
)
I !.!!1.
$tandard deviation I !.!!1 I !.!01
M 11!B - k
R>
2).!
16B I k
R>
M )!B - )k
R>

k
R>
I 6B.
$tep )- +alculate new market return
k
%
increases by 0!B, so k
%
I 1.011!B2 I 10B.
$tep 0- +alculate new re'uired return on stock
k
s
I 6B M 110B - 6B2) I )1B.
$tep 5- +alculate percentage change in return on stock
16B
16B - )1B
I 5!B.
:A& Required return Answer: c Diff: M
8efore- k
s
I 16B I k
R>
M 16B2!.:G k
R>
I 16B - 0.6BG k
R>
I 11.6B.
4ew k
R>
I 11.6B M ).!B I 10.6B.
4ew beta I !.: 1.6 I 1.!6.
fter- 4ew re'uired rate of return-
k
s
I 10.6B M 16B21.!6 I 19.:6B.
9!& Required return Answer: e Diff: M
$tep 1- +alculate the market risk premium 1k
%
- k
R>
2 using the information
for Partridge-
10BI 
21.5
k
%
- k
R>
I 6B.
$tep )- 4ow calculate the re'uired return for +leaver-
k
s
I ind
k
R>
. 4ote that RP
%
I k
%
- k
R>
, so
5B I 1)B - k
R>
k
R>
I 9B.
>ind k
D
I 9B M 5B1-!.<<2 I 6.0<B.
I 9.!!B - 6.0<B I ).<5B.
9)& E%pected and required returns Answer: b Diff: M
8y calculating the re'uired returns on each of the securities and comparing
re'uired and e.pected returns, we can identify which security is the best
investment alternativeG that is, the security for which the e.pected return
e.ceeds the re'uired return by the largest amount. #he e.pected and re'uired
returns and the differences between them are shown below-
$ecurity H.pected Return Re'uired Return H.pected-Re'uired
A.!1B :B M )B11.:2 I 1!.5!B -1.0AB
8 :.!<B :B M )B1!.!2 I :.!!B !.!<B
+ 6.!5B :B M )B1-!.<:2 I 6.<<B -!.<)B
E 9.:5B :B M )B1!.9:2 I 9.:5B !.!!B
H 11.6!B :B M )B1).6!2 I 1).!!B -!.6!B
+learly, security 8 is the best alternative.
90& !APM and required return Answer: e Diff: M
b
7R
I ).!G b
&R
I !.6. 4o changes occur.
k
R>
I 1!B. Eecreases by 0B to :B.
k
%
I 16B. >alls to 11B.
4ow $%&- k
i
I k
R>
M 1k
%
- k
R>
2b
i
.
k
7R
I :B M 111B - :B2) I :B M 5B1)2 I 16B
k
&R
I :B M 111B - :B2!.6 I :B M 5B1!.62 I A

Eifference <B
95& !APM and required return Answer: a Diff: M N
n inde. fund will have a beta of 1.!. 3f k
%
is 1) percent 1given in the
problem2 and the risk-free rate is : percent, you can calculate the market risk
premium 1RP
%
2.
k
s
I k
R>
M 1RP
%
2b
1)B I :B M 1RP
%
21.!
6B I RP
%
.
4ow, you can use the RP
%
, the k
R>
, and the two stock(s betas to calculate
their re'uired returns.
8radley-
k
s
I k
R>
M 1RP
%
2b
I :B M 16B21.0
I :B M <.6B
I 10.6B.
Eouglas-
k
s
I k
R>
M 1RP
%
2b
I :B M 16B2!.:
I :B M 0.6B
I 1!.6B.
#he difference in their re'uired returns is-
10.6B - 1!.6B I 0.!B.
96& !APM and required return Answer: d Diff: M
b
,
I 1.<G b
*
I !.:G k
R>
I :BG k
%
I 1)B.
3nflation increases by 1B, but kW remains constant. k
R>
increases by 1BG k
%
rises to 15B.
8efore inflation change-
k
,
I :B M 6B11.<2 I 16B.
k
*
I :B M 6B1!.:2 I 1!.6B.
fter inflation change-
k
,
I 9B M 115B - 9B21.< I 1:.<B.
k
*
I 9B M 115B - 9B2!.: I 1).)B.
k
,
- k
*
I 1:.<B - 1).)B I 6.5B.
9<& !APM and required return Answer: e Diff: M
k
I <B M 111B - <B2b
.
+alculate b
as follows using a financial calculator-

< 3nput 9 M
-9 3nput 0 M
-9 3nput -) M
19 3nput 1) M
! y ,m
swap b
I !.5605.
k
I <B M 6B1!.56052 I 9.)<<AB 9.):B

9:& !APM and required return Answer: a Diff: M
With your financial calculator input the following-
-) 3nput 9 M
1) 3nput 0 M
-9 3nput 19 M
)1 3nput -: M
! y,m
swap b
+
I -!.:<.
k
+
I 9B M 115B - 9B21-!.:<2 I 9B - 5.69B I 0.5)B.
99
& Portfolio return Answer: c Diff: M
+alculate
, b
and
* b
for the stocks using the regression function of a
calculator.
b
,
I !.:069G b
*
I 1.005A.
k
,
I :B M 6B1!.:0692 I 1!.<:AB.
k
*
I :B M 6B11.005A2 I 10.<:56B.
k
p
I 15;)!11!.<:AB2 M <;)!110.<:56B2 I 11.69B.
9A. Portfolio return Answer: b Diff: M
$tatement b is correctG all the other statements are false. 3f the market risk
premium increases by ) percent and k
R>
remains unchanged, then the portfolio(s
return will increase by )B11.!92 I ).1<B. $tatement a is false, since k
p
I 
increases
by ) percent, but RP
%
remains unchanged, the portfolio(s return will increase by
) percent. $tatement d is false. %arket efficiency states that the e.pected
return should e'ual the re'uired returnG therefore,
p
k
Q
I k
p
I 11.5B.
A!& Portfolio return Answer: c Diff: M
>ind the initial portfolio(s beta and its re'uired return. #hen, find the
new beta and new re'uired return. #hen subtract the two.
$tep 1- #he portfolio beta is the weighted average beta of the stocks in the
portfolio. #he total invested is =:! million 1=1! M =)! M =5!2.
b
?ld
I
,
_
:! =
1! =
11.52 M
,
_
:! =
)! =
11.!2 M
,
_
:! =
5! =
1!.92
b
?ld
I !.A5)A.
k
?ld
I k
R>
M 1k
%
C k
R>
2b
I 6B M 16.6B21!.A5)A2
I 1!.196:B.
$tep )- 4ow, change the weights. #he amount of , owned is now =)6 million
1=1! M =162, the amount of * owned is now =! million, and the amount
of R owned is =56 million 1=5! M =62.
b
4ew
I
,
_
:! =
)6 =
11.52 M
,
_
:! =
! =
11.!2 M
,
_
:! =
56 =
1!.92
b
4ew
I 1.!150.
k
4ew
I k
R>
M 1k
%
C k
R>
2b
I 6B M 16.6B211.!1502
I 1!.6:9<B.
$tep 0- 4ow subtract the two returns-
1!.6:9
I 6.6B +urrent portfolio I =1! million
RP
%
I 
M 1RP
%
2b
1)B I 6.6B M 1<B2b
1.!900 I b.
#he portfolio beta is the weighted average of the betas of the individual
stocks in the portfolio. 3f you sell =0 million of a stock that has a beta
of 1.<, what will be the beta of the remaining stocks?
$tep )- +alculate the beta of the remaining stocks in the portfolio.
1.!900 I 1=0;=1!211.<2 M 1=:;=1!2,
!.<!00 I 1=:;=1!2,
!.9<1A I ,.
!.9<1A is the beta of the =: million of stocks that remain. 4ow what happens
to the portfolio beta when the new stock is added?
$tep 0- +alculate the new portfolio(s beta.
b I 1=:;=1!21!.9<1A2 M 1=0;=1!21!.:2
I !.<!00 M !.)1
I !.9100.
$tep 5- +alculate the new portfolio(s re'uired return.
k
s
I k
R>
M 1RP
%
2b
I 6.6B M 1<B2!.9100
I 6.6B M 5.99B
I 1!.09B.
A) &Portfolio return Answer: a Diff: M N
#he aggressive growth mutual fund has an e.pected return of-
k
/%>
I <B M 16B21.< I 15B.
#he $PP 6!! inde. fund has an e.pected return of-
k
$P6!!
I <B M 1.!16B2 I 11B.
$o, to get the return she desires, Hrika must solve for ,, the percentage of
her portfolio invested in the $PP 6!! inde. fund-
1).6B I !.1!1<B2 M 1!.A! C ,2115B2 M ,111B2
11.AB I 1).<B - 15B, M 11B,
-!.:B I -0B,
!.)000 I ,.
$o invest )0.00B in the $PP 6!! inde. fund, invest <<.<:B in the aggressive
growth fund, and invest 1!.!!B in the risk-free asset. 14ote that the
percentage totals must add up so that 1!!B of the funds are invested.2
A0& !APM and portfolio return Answer: d Diff: M
b
p
I
=0!!,!!!
=1!!,!!!
1!.92 M
=0!!,!!!
=16!,!!!
11.)2 M
=0!!,!!!
=6!,!!!
11.92
b
p
I 1.1<<:.
&ast year- k I 10B
10B I :B M RP
%
11.1<<:2

I 6BG k
%
- k
R>
I <B.
k
R>
I 6B.
k
3nde.
I k
R>
M 1k
%
- k
R>
2b
I 6B M 1<B211.!2
I 11B.
k
3ntXl
I 6B M 1<B211.62
I 15B.
$tep )- &et , be the portion of the portfolio invested in the international
fund, and let 1!.9 C ,2 be the portion invested in the inde. fund-
11B I !.)1k
R>
2 M 1,21k
3ntXl
2 M 1!.9 - ,21k
3nde.
2
11B I !.)16B2 M 115B2, M 1!.92111B2 - 111B2,
11B I 1B M 15B, M 9.9B C 11B,
11B - 1B - 9.9B I 115B - 11B2,
1.)B I 0B,
, I !.5.
#herefore, 5! percent should be invested in the international fund.
A6& !APM and portfolio return Answer: c Diff: M
*ou are given the re'uired return on the portfolio, the RP
%
, and enough
information to calculate the beta of the original portfolio. With this
information you can find k
R>
. ?nce you have k
R>
, you can find the re'uired
return on $tock +.
$tep 1- >ind the portfolio beta-
#ake a weighted average of the individual stocks( betas to find the
portfolio beta. #he total amount invested in the portfolio is-
=5 million M =) million M =) million M =1 million M =1 million I =1!
million.
#he weighted average portfolio beta is-
. !) . 1 b
1!.62
=1!
=1
1!.:2
=1!
=1
11.!2
=1!
=)
11.12
=1!
=)
11.)2
=1!
=5
b
p

p
,
_
+
,
_
+
,
_
+
,
_
+
,
_
$tep )- @se the +P% and the portfolio(s re'uired return to calculate k
R>
,
the risk-free rate-

k
p
I k
R>
M RP
%
1b
p
2
11B I k
R>
M 6B11.!)2
6.AB I k
R>
.
$tep 0- @se the +P% to calculate the re'uired return on $tock +-
k
+
I k
R>
M RP
%
1b
+
2
k
+
I 6.AB M 6B11.!2
k
+
I 1!.AB.
A< . !APM and portfolio return
Answer: c Diff: M
$tep 1- Eetermine the market risk premium from the +P%-
!.15 I !.!< M 1k
%
- k
R>
21.<
1k
%
- k
R>
2 I !.!6.
$tep )- +alculate the beta of the new portfolio-
#he beta of the new portfolio is 1=)!!,!!!;=1,)!!,!!!21!.<2 M
1=1,!!!,!!!;=1,)!!,!!!211.<2 I 1.5000.
$tep 0- +alculate the re'uired return on the new portfolio-
#he re'uired return on the new portfolio is-
<B M 16B211.50002 I 10.1<<<:B 10.1:B.
A:
. !APM and portfolio return Answer: c Diff: M
$tep 1- Eetermine the beta of your portfolio-
AB I 6B M 111B - 6B2b
b I !.<<<<:.
$tep )- Eetermine the beta of your sister(s portfolio-
$ister(s beta I !.<<<<: ) I 1.0000.
$tep 0- Eetermine the re'uired return of your sister(s portfolio-
6B M 111B - 6B211.00002 I 10B.
A9 & !APM and portfolio return
Answer: b Diff: M N
k
I 1!BG b
I 1.!G b
8
I ).!G k
R>
I 6BG k
P
I 1)BG , I B of $tock 8 in portfolio.
$tep 1- Eetermine market risk premium, RP
%
.
k
I !.!6 M RP
%
11.!2
!.1! I !.!6 M RP
%
11.!2
RP
%
I !.!6.
$tep )- +alculate e.pected return of $tock 8.
k
8
I !.!6 M !.!61).!2 I !.16.
&et ,B of Portfolio P be in $tock 8, so 11 - ,2B is in $tock . #he e.pected
return of Portfolio P is the weighted average of the e.pected returns of the
two stocks.
!.1) I !.16, M 11 - ,21!.1!2.
!.1) I !.16, M !.1! C !.1!,
!.!) I !.!6,
, I !.5! I 5!B.
AA& Portfolio beta Answer: b Diff: M
8efore-

1.16 I !.A61b
R
2 M !.!611.!2
!.A61b
R
2 I 1.1!
b
R
I 1.16:A.
fter- b
p
I !.A61b
R
2 M !.!61).!2 I 1.1! M !.1! I 1.)!.
1!!& Portfolio beta Answer: c Diff: M
fter additional investments are made, for the entire fund to have an
e.pected return of 10.6B, the portfolio must have a beta of 1.)6 as shown by
10.6B I <B M 1<B2b. $ince the fund(s beta is a weighted average of the betas
of all the individual investments, we can calculate the re'uired beta on the
additional investment as follows-
1.)6 I
!! =)6!,!!!,!
1.)2 !!! 1=)!!,!!!,
M
!! =)6!,!!!,!
,2 !! 1=6!,!!!,!
1.)6 I !.A< M !.),
!.)A I !.),
, I 1.56.
1!1& Portfolio beta Answer: e Diff: M
>ind the beta of the original portfolio 1b
?ld
2 as 1!.:6B I 5B M 1AB - 5B2b
?ld
or
b
?ld
I 1.06. #o achieve an e.pected return of 11.6B, the new portfolio must have
a beta 1b
4ew
2 of 11.6B I 5B M 1AB - 5B2
4ew b
or
4ew b
I 1.6. #o construct a
portfolio with a b
4ew
I 1.6, the added stocks must have an average beta 1b
vg
2
such that-
1.6 I 1=)6!,!!!;=:6!,!!!2b
vg
M 1=6!!,!!!;=:6!,!!!21.06
1.6 I !.000b
vg
M !.A!
!.< I !.000b
vg
b
vg
I 1.9.
1!)& Portfolio return and beta Answer: a Diff: M
$tep 1- +alculate the beta of the original portfolio-
Right now, the total dollars invested in the portfolio is-
=0!! M =)!! M =6!! I =1,!!! million. #he portfolio(s beta is-
b I !.:1=0!!;=1,!!!2 M 1.!1=)!!;=1,!!!2 M 1.<1=6!!;=1,!!!2
I 1.)1.
$tep )- +alculate the market risk premium using the +P%, given the original
beta calculated in $tep 1-
k
p
I k
R>
M 1k
%
- k
R>
2b
11.<66B I 6B M 1k
%
- k
R>
21.)1
<.<66B I 1.)11k
%
- k
R>
2
6.6B I k
%
- k
R>
.
$tep 0- +alculate the new portfolio(s beta-
4ow, if she changes her portfolio and gets rid of $tock 0 1with a
beta of 1.<2 and replaces it with $tock 5 1with a beta of !.A2, the
new portfolio(s beta will be-
b I !.:1=0!!;=1,!!!2 M 1.!1=)!!;=1,!!!2 M !.A1=6!!;=1,!!!2
I !.9<.
$tep 5- +alculate the new portfolio(s re'uired return-
#he re'uired return will be-
k
p
I 6.!B M 6.6B1!.9<2
k
p
I A.:0B.
1!0& Portfolio return and beta Answer: e Diff: M
*ou need to find the beta of the portfolio now and after the change. #hen,
use the betas in the +P% to find the two different returns.
$tep 1- Eetermine the betas of the two portfolios-
#he total amount invested in the portfolios is- =0!! M =6<! M =0)! M
=)0! I =1,51! million. 14ote that the )nd portfolio changes only in
the composition of the stocks, not the amount invested.2
b
?ld
I 1=0!!;=1,51!21.) M 1=6<!;=1,51!21.5 M 1=0)!;=1,51!2!.: M
1=)0!;=1,51!21.9
I 1.)<09.
4ow, create the new portfolio by selling =)9! million of $tock ) and
reinvesting it in $tock 5. #he new portfolio(s beta will be-
b
4ew
I 1=0!!;=1,51!21.) M U1=6<! - =)9!2;=1,51!V1.5 M
1=0)!;=1,51!2!.: M U1=)0! M =)9!2;=1,51!V1.9
I 1.0500.
$tep )- Eetermine the returns of the two portfolios-
k
p?ld
I k
R>
M 1k
%
- k
R>
2b
I 6B M 16B21.)<09
I 11.01A!B.
k
p4ew
I k
R>
M 1k
%
- k
R>
2b
I 6B M 16B21.0500
I 11.:1<6B.
#he difference is- 11.:1<6B C 11.01A!B I !.0A:6B !.5!B.
1!5& Portfolio return and beta Answer: e Diff: M N
#he total portfolio is worth =1!,!!!,!!! so the beta of the portfolio is-
1);1!2 !.< M 10;1!2 !.9 M 10;1!2 1.) M 1);1!2 1.5 I 1.!.
k
p
I 1!BG b
p
I 1. With this, we can determine the market risk premium 1RP
%
2-
1!B I k
R>
M 1RP
%
2b
p
1!B I 6B M 1RP
%
21.!
6B I RP
%
.
#he manager wants an e.pected return k
p
I 1)B. $o, the manager needs a
portfolio with a beta of 1.5. #o check this-
k
p
I k
R>
M 1RP
%
2b
p

I 6B M 16B21.5 I 1)B.
#he manager has =),!!!,!!! to invest in a stock with a beta of ,. With this
stock, the new portfolio beta is-
1);1!2, M 10;1!2 !.9 M 10;1!2 1.) M 1);1!2 1.5 I 1.5.
!.), M !.)5 M !.0< M !.)9 I 1.5
!.), I !.6)
, I ).<!.
b
,
I ).<!.
1!6& Portfolio standard deviation Answer: a Diff: M
>ill in the columns for N,*O and Nproduct,O and then use the formula to
calculate the standard deviation. We did each 1k -
k
2
)
P calculation with a
calculator, stored the value, did the ne.t calculation and added it to the
first one, and so forth. When all three calculations had been done, we
recalled the stored memory value, took its s'uare root, and had
,*
I 9.1B.
Probability Portfolio ,* Product
!.1 -6.!B -!.6B
!.9 1:.6 15.!
!.1 0!.! 0.!

k
I 1<.6B
,*
I 11k -
k
2
)
P2
T
I 9.!:B 9.1B.
1!< & !oefficient of variation
Answer: e Diff: M N
k
QI 1!.121-)0B2 M 1!.121-9B2 M 1!.521<B2 M 1!.)211:B2 M 1!.)21)5B2
I -).0B M -!.9B M ).5B M 0.5B M 5.9B
I :.6B.
I U!.11-)0B - :.6B2
)
M !.11-9B - :.6B2
)
M !.51<B - :.6B2
)
M
!.)11:B - :.6B2
)
M !.)1)5B - :.6B2
)
V
T
I UA0.!)6B M )5.!)6B M !.AB M 19.!6B M 65.56BV
T
I 10.9!!0<B.
+S I ;
k
Q
I 10.9!!0<B;:.6B
I 1.95.
1!:& !oefficient of variation Answer: b Diff: M
#he e.pected rate of return will e'ual !.)61)6B2 M !.6116B2 M !.)616B2 I 16B. #he
variance of the e.pected return is-
!.)61)6B - 16B2
)
M !.6116B -16B2
)
M !.)616B - 16B2
)
I !.!!6!.
#he standard deviation is the s'uare root of !.!!6! I !.!:!:.
nd, +S I !.!:!:;!.16 I !.5:.
1!9& !oefficient of variation Answer: c Diff: M
+S I $tandard deviation;H.pected return.
H.pected return I !.11-<!B2 M !.)1-1!B2 M !.5116B2 M !.)15!B2 M !.11A!B2
I 16B.
deviation
$tandard
I U!.11-<!B - 16B2
)
M !.)1-1!B - 16B2
)
M !.5116B -16B2
)
M !.)15!B - 16B2
)
M !.11A!B - 16B2
)
V
1;)
I 0:.!91B.
+S I 0:.!91B;16B I ).5:)1.
1!A& !oefficient of variation Answer: c Diff: M
H.pected return for stock is !.011)B2 M !.519B2 M !.01<B2 I 9.<B.
H.pected return for stock 8 is !.016B2 M !.515B2 M !.010B2 I 5B.
$tandard deviation for stock is-
U!.011)B - 9.<B2
)
M !.519B - 9.<B2
)
M !.01<B - 9.<B2
)
V
1;)
I ).0:5AB.
$imilarly, the standard deviation for stock 8 is !.::5<B.
+S
I ).0:5AB;9.<B I !.)9.
+S
8
I !.::5<B;5B I !.1A.
11!
& !oefficient of variation Answer: d Diff: M
k
QI !.)1-6B2 M !.511!B2 M !.)1)!B2 M !.11)6B2 M !.116!B2
I -1B M 5B M 5B M ).6B M 6B
I 15.6B.
I U!.)1-6B - 15.6B2
)
M !.511!B - 15.6B2
)
M !.)1)!B - 15.6B2
)
M !.11)6B - 15.6B2
)
M
!.116!B - 15.6B2
)
V
1;)
I 1!.!!:< M !.!!!9 M !.!!!< M !.!!11 M !.!1)<2
1;)
I !.16!:.
+S I ;
k
Q
I !.16!:;!.156
I 1.!0A 1.!5.
111
& !oefficient of variation Answer: b Diff: M
$tep 1- +alculate the mean for the data-
k
Q I !.)616B2 M !.6!116B2 M !.)610!B2
I 1<.)6B.
$tep )- +alculate the population standard deviation for the data-
I U!.)616B - 1<.)6B2
)
M !.6116B - 1<.)6B2
)
M !.)610!B - 1<.)6B2
)
V
1;)
I 1!.!!01<5 M !.!!!!:9 M !.!!5:):2
1;)
I 1!.!!:A<A2
1;)
I !.!9A)<9 I 9.A)<9B.
#he coefficient of variation is 9.A)<9B;1<.)6B I !.65A05.
11) . !oefficient of variation
Answer: b Diff: M
H1R?H2 I 1!.) -)5B2 M 1!.0 -0B2 M 1!.0 16B2 M 1!.) 6!B2
H1R?H2 I -5.9B - !.AB M 5.6B M 1!B
H1R?H2 I 9.9B.
R?H
I U!.)1-)5B - 9.9B2
)
M !.01-0B - 9.9B2
)
M !.0116B - 9.9B2
)
M !.)16!B - 9.9B2
)
V
1;)
R?H
I U)16.1<9B M 51.::)B M 11.60)B M 00A.599BV
1;)
R?H
I U<!:.A<!BV
1;)
I )5.<6<9B.
+S I
B 9 . 9
B <6<9 . )5
I ).9!.
110& !oefficient of variation Answer: e Diff: M
+S is e'ual to the standard deviation divided by the average return.
$tep 1- Eetermine the population standard deviation using your calculator-
1! M
1) M
): M
16 M;- M
0! M
#hen select .,y to find 16.AA)6B.
$tep )- Eetermine the mean return using your calculator-
y , . to find . I 1).9B.
$tep 0- Eetermine the coefficient of variation-
+S I 16.AA)6B;1).9B
I 1.)5A5 1.)6.
115& Beta coefficient Answer: a Diff: M
>irst find the portfolio(s beta-
16B I <B M 1<B2b
p
AB I <Bb
p
b
p
I 1.6.
&et b
c
be the beta of the company for which she works. #he portfolio(s beta
is a weighted average of the individual betas of the stocks in the portfolio.
#herefore, 1.6 I 1=6,!!!;=)!,!!!21.) M 1=16,!!!;=)!,!!!2b
+.
1.6 I !.0 M !.:6b
+
1.) I !.:6b
+
b
+
I 1.<.
116& Beta coefficient Answer: e Diff: M
$tep 1- Eetermine the portfolio(s beta-
#he portfolio(s beta is the weighted average of the betas of the
individual stocks in the portfolio.
b
p
I !.01b
,
2 M !.:1b
*
2
b
p
I !.01!.:62 M !.:1b
*
2
We have two unknowns. 7owever, we can solve for the portfolio(s beta
by using the +P%-
k
p
I k
R>
M 1k
%
- k
R>
2b
p
.
>or the portfolio, we have-
1)B I <B M 16B2b
p
<B I 16B2b
p
1.) I b
p
.
$tep )- $olve for $tock *(s beta-
b
p
I !.01!.:62 M !.:1b
*
2
1.) I !.))6 M !.:1b
*
2
!.A:6 I !.:1b
*
2
b
*
I 1.0A)A 1.0A.
11<& !APM and beta coefficient Answer: d Diff: M
Portfolio beta is found from the +P%-
1:B I :B M 115B - :B2b
p

b
p
I 1.5)9<.
#he portfolio beta is a weighted average of the betas of the stocks within
the portfolio.
1.5)9< I 1=);=1621!.92 M 1=6;=16211.12 M 1=0;=16211.52 M 1=6;=162b
E
1.5)9< I !.1!<: M !.0<<: M !.)9!! M 16;162b
E
!.<:6) I 6;16b
E
b
E
I ).!)<.
11:& Market return Answer: d Diff: M
b I
Run
Rise
I
,
*
I
11 - 16
1< - ))
I
5
ind the beta of the original portfolio by taking a weighted average of
the individual stocks( betas. We calculate a beta of 1.0.
1
]
1
,
_
,
_
,
_
,
_
11.92
=1,<!!,!!!
=6!!,!!!
11.52
=1,<!!,!!!
=6!!,!!!
112
=1,<!!,!!!
=0!!,!!!
1!.<2
=1,<!!,!!!
=0!!,!!!
$tep )- >ind the market risk premium using the original portfolio.
k
s
I !.1)6 I !.!< M 1k
%
- k
R>
21.0. 3f you substitute for all the values
you know, you calculate a market risk premium of !.!6.
$tep 0- +alculate the new portfolio(s beta.
#he 'uestion asks for the new portfolio(s re'uired rate of return.
We have all of the necessary information e.cept the new portfolio(s
beta. 4ow, $tock 1 has ! weight 1we sold it2 and $tock 5 has a
weight of =9!!,!!!;=1,<!!,!!! I !.6. #he portfolio(s new beta is-
+
,
_
112
=1,<!!,!!!
=0!!,!!!
+
,
_
11.52
=1,<!!,!!!
=6!!,!!!
. 6)6 . 1 11.92
=1,<!!,!!!
=9!!,!!!
,
_
$tep 5- >ind the portfolio(s re'uired return.

#hus, k
s
I !.!< M 1!.!621.6)6 I 10.<)6B 10.<0B.
11A& !APM and portfolio return Answer: d Diff: E N
#his is a straight-forward application of the +P%. We are given the risk-
free rate, the market risk premium, and the portfolio beta.
k
p
I k
R>
M 1k
%
C k
R>
2b
p
k
p
I 6B M 1<B21.)
k
p
I 1).)B.
1)!& !APM and portfolio return Answer: c Diff: M N
We must calculate the beta of the new portfolio. >rom the definition of beta,
we can solve for the new portfolio beta-
Portfolio beta I
1!
b
1!
1 i
i
. b
i
is the beta for the 1! individual stocks.
1.) I
1!
b
1!
1 i
i
1) I
1!
1 i
i
b .
$o, if the portfolio manager sells a stock that has a beta of !.A and replaces
it with a stock with a beta of 1.<, that means the sum of the betas for the
new portfolio is !.: higher than before. Eividing the new sum of betas by 1!
gives us the new portfolio beta.
1).:;1! I b
p
1.): I b
p
.
lternatively, you can calculate the portfolio(s new beta as follows-
1.) I !.Ab
r
M !.11!.A2
1.11 I !.Ab
r
1.)000 I b
r
G beta of remaining stocks in portfolio.
b
p
I !.A11.)0002 M !.111.<2
I 1.11 M !.1
M 1k
%
C k
R>
2b
p
k
p
I 6B M <B11.):2
k
p
I 1).<)B.
1)1'A(& Beta calculation Answer: b Diff: M
1))'A(& Beta calculation Answer: c Diff: E
Rise;Run I 1*
1
C *
!
2;1,
1
C ,
!
2 I 1D
*ear )
C D
*ear 1
2;1%
*ear )
C %
*ear 1
2
I 1)).A!B C 1-10.96B22;11).0:B C 1-9.<0B22 I 0<.:6B;)1.!B
beta I 1.:6.
1)0'A(& Beta and base #ear sensitivit# Answer: a Diff: M
*ear 1C*ear ) data-
Rise;Run I 1*
1
C *
!
2;1,
1
C ,
)
2
I 1-0.:B C <.0!B2;11).A!B C <.1!B2 I -1!.!B;<.9B
beta I -1.5:.
*ear ) C *ear 0 data-
beta I 1)1.:1B C 1-0.:!B22;11<.)!B C 1).A!B2 I )6.51B;0.0B I :.:!.
Eifference-
+E/ APPE%D"0 !A #&-(T"&%#
beta
*) C *0
C beta
*1 C *)
I :.:! C 1-1.5:2 I A.1:.
1)5'A(& Beta calculation Answer: b Diff: M
+alculate beta of stock ,-
Hnter into 1!-8 market return firstY
b
.
I !.A595.
k I k
R>
M 1k
%
- k
R>
2b
p
15B I <B M <Bb
p
9B I <Bb
b
p
I 1.000.
b
p
I !.<1b
,
2 M !.51b
*
2
1.000 I !.<1!.A5952 M !.5b
*
!.:<50 I !.5b
*
b
*
I 1.A1!: 1.A1.
1)6'A(& Beta calculation Answer: c Diff: E
@sing the linear regression function of the 7P 1!-8 calculator, enter the
market return and the corresponding stock return and find the slope of the
predicted regression line. $lope I b I 1.):6:.
1)<'A(& Beta calculation Answer: a Diff: E
Hnter the following input data in the calculator-
9 34P@# 1) M
)9 34P@# 05 M
)! M;- 34P@# )A M;- M
5 M;- 34P@# 11 M;- M
0! 34P@# 56 M
Press ! yQ,m $WP to find beta I 1.50) 1.50.
1):'A(& Beta calculation Answer: c Diff: M
.a. Plot the returns of $tocks R and $ and the market.
Return on $tock
1B2

$tock
R
)6
$tock
$

Return on %arket 1B2
-16 16
-16
b. +alculate beta using the rise over run method or calculator regression
function.
1 )
1 )
, - ,
* - *
I beta $tock
R
-
6 - 16
6 - )6
I
1!
)!
I ).! I beta
R
.
$tock
$
-
6 - 16
6 - 1!
I
1!
6
I !.6 I beta
$
.
c. #he difference in betas is- 8eta
R
- 8eta
$
I ).! - !.6 I 1.6.
1)9'A(& Required rate of return Answer: e Diff: M
a. Eraw $%&.
Re'uired Rate
of Return 1B2
1<
k
R
I 15
1)
k
%
I 1!
k
$
I 9
k
R>
I <
5
)
| | | | | | | | | |
!.) 1.! ).! Risk, beta
1)B k
Q
R

B 11 k
Q
$

R
k k
Q
R
<
$ $
k k
Q
>
$%&
b. +alculate re'uired returns for $tocks R and $.
k
R
I <B M 11!B - <B2).! I 15B.
k
$
I <B M 11!B - <B2!.6 I 9B.
c. +alculate the difference between the e.pected and re'uired returns.
R R
k k
Q
I 1)B - 15B I -).!B.
$ $
k k
Q
I 11B - 9B I 0.!B.
d. Widest margin I
$ $
k k
Q
I 0.!B.

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Finman Chap5

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(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

k I !.A11)B2 M !.11)!B2 I 1).9B.

I <B M 111B - <B2b

as follows using a financial calculator-

I <B M 6B1!.56052 I 9.)<<AB 9.):B

$tep 5- >ind the portfolio(s re'uired return.

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