You are on page 1of 30

Financial Management: Principles and Applications, 11e (Titman)

Chapter 8 Risk and Return-Capital Market Theory


8.1 Portfolio Returns and Portfolio Risk
1) Which of the following investments is clearly preferred to the others?
Return
Risk
A
14%
12%
B
22%
20%
C
18%
16%
A) Investment A
B) Investment B
C) Investment C
D) Cannot be determined
Answer: D
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) You are considering investing in U.S. Steel. Which of the following is an example of
nondiversifiable risk?
A) Risk resulting from foreign expropriation of U.S. Steel property
B) Risk resulting from oil exploration by Marathon Oil (a U.S. Steel subsidy)
C) Risk resulting from a strike against U.S. Steel
D) None of the above
Answer: D
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) You are considering buying some stock in Continental Grain. Which of the following is an
example of nondiversifiable risk?
A) Risk resulting from a general decline in the stock market
B) Risk resulting from a news release that several of Continental's grain silos were tainted
C) Risk resulting from an explosion in a grain elevator owned by Continental
D) Risk resulting from an impending lawsuit against Continental
Answer: A
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff

1
Copyright 2011 Pearson Education, Inc.

4) If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a
40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what is the
expected rate of return?
A) 12%
B) 13%
C) 14%
D) 15%
Answer: B
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a
40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what would be
the standard deviation?
A) 2.24
B) 2.56
C) 2.83
D) 2.98
Answer: A
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) You are considering investing in a project with the following possible outcomes:
Probability of Investment
States
Occurrence
Returns
State 1: Economic boom 15%
16%
State 2: Economic growth 45%
12%
State 3: Economic decline 25%
5%
State 4: Depression
15%
-5%
Calculate the expected rate of return and standard deviation of returns for this investment.
A) 9.8%, 7.0%
B) 7.0%, 43.6%
C) 8.3%, 6.6%
D) 8.3%, 16.1%
Answer: C
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff

2
Copyright 2011 Pearson Education, Inc.

7) The prices for the Guns and Hoses Corporation for the first quarter of 1992 are given below.
Find the holding period return for February.
Month End
Price
January
$135.28
February
$119.40
March
$141.57
A) 18.56%
B) 13.30%
C) -11.73%
D) 8.83%
Answer: C
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: holding period return
Principles: Principle 3: Cash Flows Are the Source of Value
8) Wilson, Inc. is expecting the following returns on their stock and related probabilities.
Calculate Wilson's expected return.
State
Probability
Return
Boom
30%
30%
Normal
70%
10%
A) 16%
B) 14%
C) 12%
D) 10%
Answer: A
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff

3
Copyright 2011 Pearson Education, Inc.

Use the following information, which describes the possible outcomes from investing in a
particular asset, to answer the following question(s).
State of the EconomyProbability of the States Percentage Returns
Economic recession
25%
5%
Moderate economic growth
55%
10%
Strong economic growth
20%
13%
9) The expected return from investing in the asset is:
A) 9.00%.
B) 9.35%.
C) 10.00%.
D) 10.55%.
Answer: B
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
10) The standard deviation of returns is:
A) 8.00%.
B) 7.63%.
C) 4.68%.
D) 2.76%.
Answer: D
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) What is the expected rate of return for an investment that has the following expected
scenario? If there is an 18% probability of a recession, 2.0% return; if there is a 65% probability
of a moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2%
return.
A) 11.25%
B) 7.33%
C) 8.95%
D) 9.59%
Answer: C
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff

4
Copyright 2011 Pearson Education, Inc.

12) What is the expected return on an investment that has the following expected scenario? If
there is a 10% probability of a booming economy, $250 return; if there is a 70% probability of a
moderate economy, $154 return; if there is a 20% probability of a declining economy, $50 return.
A) $154.00
B) $142.80
C) $65.00
D) $15.12
Answer: B
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
Use the following information, which describes the expected return and standard deviation for
three different assets, to answer the following question(s).
Asset X
Expected return 9.5%
Standard deviation

Asset Y
8.8%
4.9%

Asset Z
9.5%
5.5%

5.5%

13) If an investor must choose between investing in either Asset X or Asset Y, then:
A) she will always choose Asset X over Asset Y.
B) she will always choose Asset Y over Asset X.
C) she will be indifferent between investing in Asset X and Asset Y.
D) none of the above.
Answer: A
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) If an investor must choose between investing in either Asset X or Asset Z, then:
A) he will always choose Asset X over Asset Z.
B) he will always choose Asset Z over Asset X.
C) he will be indifferent between investing in Asset X and Asset Z.
D) none of the above.
Answer: A
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff

5
Copyright 2011 Pearson Education, Inc.

15) Which of the following is NOT an example of factors that affect systematic risk?
A) Changes in general interest rates
B) A firm wins a lawsuit dealing with patent infringement
C) Our country declares war in the Persian Gulf
D) Environmental awareness increases throughout the country
Answer: B
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: systematic risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
16) Which of the following best measures the risk of holding an asset in isolation (i.e., standalone risk)?
A) The mean co-variance
B) The standard deviation
C) The coefficient of optimization
D) The standard asset pricing model
E) The omegatron
Answer: B
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
17) What is a practical measure that is used to quantify the risk of a single investment?
A) The systematic variation
B) The Fisher effect
C) The IRP
D) The standard deviation
Answer: D
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
18) What is the standard deviation of an investment that has the following expected scenario? If
there is an 18% probability of a recession, 2.0% return; if there is a 65% probability of a
moderate economy, 9.5% return; if there is a 17% probability of a strong economy, 14.2% return.
A) 3.68%
B) 1.23%
C) 8.47%
D) 6.66%
Answer: A
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff
6
Copyright 2011 Pearson Education, Inc.

19) You are considering investing in a firm that has the following possible outcomes:
Economic boom: probability of 25%; return of 25%
Economic growth: probability of 60%; return of 15%
Economic decline: probability of 15%; return of -5%
What is the expected rate of return on the investment?
A) 15.0%
B) 11.7%
C) 14.5%
D) 25.0%
Answer: C
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
20) Which of the following is an adequate method of achieving portfolio diversification?
A) Invest in various bonds and stocks.
B) Invest in stocks of different industries.
C) Invest internationally.
D) All of the above.
E) None of the above.
Answer: D
Diff: 1
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: systematic risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
21) You have been employed by Telemetry Medical Instruments (TMI) for seven years and
participate in their 401 (k) plan by having 5% of your paycheck invested in the plan. You have
been so impressed with the performance of the company's stock that you currently have all of
your 401 (k) money invested in TMI's common stock. What does prudent investment
management suggest that you do about risk?
A) Close out your 401 (k) and put the money in the bank.
B) Increase your payroll deduction from 5% to 10% but keep all funds invested in TMI.
C) Close out your 401 (k) and invest in T-bills.
D) Take some of your investment out of TMI's common stock and invest it in the stocks and
bonds of other firms.
Answer: D
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff

7
Copyright 2011 Pearson Education, Inc.

22) You bought Chemtron stock for $45 a year ago. It is selling for $54 today. What is your
holding period return?
A) 9%
B) 11%
C) 6%
D) 20%
Answer: D
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: holding period return
Principles: Principle 3: Cash Flows Are the Source of Value
23) You purchased the stock of Sargent Motors at a price of $75.75 one year ago today. If you
sell the stock today for $89.00, what is your holding period return?
A) 35.00%
B) 12.50%
C) 17.50%
D) 25.00%
Answer: C
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: holding period return
Principles: Principle 3: Cash Flows Are the Source of Value
24) Which of the following statements is correct?
A) Portfolio diversification reduces the variability of the returns on the individual stocks held in
a portfolio.
B) Portfolio A has but one security, while Portfolio B has 100 securities. Because of
diversification, we would expect Portfolio B to have lower risk.
C) If an investor buys enough stocks, he or she can, through diversification, eliminate all market
risk.
D) Diversification can be achieved by purchasing stocks that are perfectly positively correlated.
Answer: B
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff

8
Copyright 2011 Pearson Education, Inc.

25) Your broker mailed you your year-end statement. You have $25,000 invested in Dow
Chemical, $18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The
annualized returns for these stocks is 16.5% for Dow, 12.0% for GM, 18.5% for Microsoft, and
15.3% for Nike. What is the return of your entire portfolio?
A) 15.60%
B) 18.55%
C) 16.25%
D) 9.00%
Answer: C
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
26) According to the experts, a model portfolio should consist of a mix of securities that over the
long run should look something like this: cash or money market accounts, 5%; bonds, 25%;
domestic stocks, 35%; international stocks, 35%. What is the determination of the proportions of
various securities within a portfolio referred to as?
A) Risk assessment
B) Capital asset modeling
C) Beta selection
D) Portfolio regression
E) Asset allocation
Answer: E
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: portfolio composition
Principles: Principle 2: There Is a Risk-Return Tradeoff
27) By investing in different securities, an investor can lower his exposure to risk.
Answer: TRUE
Diff: 1
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
28) The greater the dispersion of possible returns, the riskier is the investment.
Answer: TRUE
Diff: 1
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: standard deviation
Principles: Principle 2: There Is a Risk-Return Tradeoff

9
Copyright 2011 Pearson Education, Inc.

29) For the most part, there has been a positive relation between risk and return historically.
Answer: TRUE
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
30) The benefit from diversification is far greater when the diversification occurs across asset
types.
Answer: TRUE
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
31) Investing in foreign stocks is one way to improve diversification of a portfolio.
Answer: TRUE
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
32) You are considering a security with the following possible rates of return:
Probability Return (%)
0.20
9.6
0.30
12.0
0.30
14.4
0.20
16.8
a. Calculate the expected rate of return.
b. Calculate the standard deviation of the returns.
Answer:
a. R = (0.2)(9.6) + (0.3)(12.0) + (0.3)(14.4) + (0.2 )(16.8) = 13.2%
b. s(R) = [(9.6 - 13.2)2 (0.2) + (12 - 13.2)2(0.3)
+ (14.4 - 13.2)2(0.3) + (16.8 - 13.2)2(0.2)]1/2 = 2.459%
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff

10
Copyright 2011 Pearson Education, Inc.

33) Using the following information for McDonovan, Inc.'s stock, calculate their expected return
and standard deviation.
State
Probability
Return
Boom
20%
40%
Normal
60%
15%
Recession
20%
(20%)
Answer: Ki = (Ki)(Pi) = (.20)(40%) + (.60)(15%) + (.20)(-20%)
= 8% + 9% - 4% = 13%
2
i = ((Ki K) Pi).5
i = ((40%-13%)2(.2) + (15%-13%)2 (.6) + (-20%-13%)2 (.2)).5 = 19.13%
Diff: 2
Topic: 8.1 Portfolio Returns and Portfolio Risk
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
8.2 Systematic Risk and the Market Portfolio
1) The capital asset pricing model:
A) provides a risk-return trade-off in which risk is measured in terms of the market returns.
B) provides a risk-return trade-off in which risk is measured in terms of beta.
C) measures risk as the coefficient of variation between security and market rates of return.
D) depicts the total risk of a security.
Answer: B
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) The appropriate measure for risk according to the capital asset pricing model is:
A) the standard deviation of a firm's cash flows.
B) alpha.
C) beta.
D) probability of correlation.
Answer: C
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff

11
Copyright 2011 Pearson Education, Inc.

3) You are considering investing in Ford Motor Company. Which of the following is an example
of diversifiable risk?
A) Risk resulting from the possibility of a stock market crash
B) Risk resulting from uncertainty regarding a possible strike against Ford
C) Risk resulting from an expected recession
D) Risk resulting from interest rates decreasing
Answer: B
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
4) Sterling Incorporated has a beta of 1.0. If the expected return on the market is 12%, what is
the expected return on Sterling Incorporated's stock?
A) 9%
B) 10%
C) 12%
D) Insufficient information is provided
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Which of the following has a beta of zero?
A) A risk-free asset
B) The market
C) A high-risk asset
D) Both A and B
Answer: A
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) Beta is a statistical measure of:
A) hyperbolic.
B) total risk.
C) the standard deviation.
D) the relationship between an investment's returns and the market return.
Answer: D
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff

12
Copyright 2011 Pearson Education, Inc.

7) A stock's beta is a measure of its:


A) systematic risk.
B) unsystematic risk.
C) company-specific risk.
D) diversifiable risk.
Answer: A
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) If you hold a portfolio made up of the following stocks:
Investment Value Beta
Stock A
$2,000
1.5
Stock B
$5,000
1.2
Stock C
$3,000
.8
What is the beta of the portfolio?
A) 1.17
B) 1.14
C) 1.32
D) Can't be determined from information given
Answer: B
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) Changes in the general economy, such as changes in interest rates or tax laws, represent what
type of risk?
A) Firm-specific risk
B) Market risk
C) Unsystematic risk
D) Diversifiable risk
Answer: B
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff

13
Copyright 2011 Pearson Education, Inc.

10) A stock with a beta greater than 1.0 has returns that are ________ volatile than the market,
and a stock with a beta of less than 1.0 exhibits returns which are ________ volatile than those of
the market portfolio.
A) more, more
B) more, less
C) less, more
D) less, less
Answer: B
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) You hold a portfolio with the following securities:
Percent
Security
of Portfolio
Beta
Return
X Corporation
20%
1.35
14%
Y Corporation
35%
.95
10%
Z Corporation
45%
.75
8%
Compute the expected return and beta for the portfolio.
A) 10.67%, 1.02
B) 9.9%, 1.02
C) 34.4%, .94
D) 9.9%, .94
Answer: D
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
12) The beta of ABC Co. stock is the slope of:
A) the security market line.
B) the characteristic line for a plot of returns on the S&P 500 versus returns on short-term
Treasury bills.
C) the arbitrage pricing line.
D) the characteristic line for a plot of ABC Co. returns against the returns of the market portfolio
for the same period.
Answer: D
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff

14
Copyright 2011 Pearson Education, Inc.

13) You are thinking of adding one of two investments to an already well diversified portfolio.
Security A
Security B
Expected return = 12%
Expected return = 12%
Standard deviation of returns = 20.9% Standard deviation of returns = 10.1%
Beta = .8
Beta = 2
If you are a risk-averse investor:
A) security A is the better choice.
B) security B is the better choice.
C) either security would be acceptable.
D) cannot be determined with information given.
Answer: A
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) The market (systematic) risk associated with an individual stock is most closely identified
with the:
A) variance of the returns of the stock.
B) variance of the returns of the market.
C) beta of the stock.
D) standard deviation of the stock.
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
15) Which of the following is NOT an example of systematic risk?
A) Inflation
B) Recession
C) Management risk
D) Interest rate risk
Answer: C
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: systematic risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
16) What type of risk can investors reduce through diversification?
A) All risk
B) Systematic risk only
C) Unsystematic risk only
D) Uncertainty
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: unique risk
15
Copyright 2011 Pearson Education, Inc.

Principles: Principle 2: There Is a Risk-Return Tradeoff


17) Which of the following statements is true?
A) A stock with a beta of zero has a very low level of systematic risk.
B) A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta of
1.0.
C) A stock with a beta less than 1.0 has lower nondiversifiable risk than a stock with a beta of
1.0.
D) A stock with a beta less than 1.0 has higher nondiversifiable risk than a stock with a beta of
1.0.
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
18) Currently, the expected return on the market is 12.5% and the required rate of return for
Alpha, Inc. is 12.5%. Therefore, Alpha's beta must be:
A) less than 1.0.
B) greater than 1.0.
C) equal to 1.0.
D) unknown based on the information provided.
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
19) Investment risk is:
A) the probability of achieving a return that is greater than what was expected.
B) the probability of achieving a beta coefficient that is less than what was expected.
C) the probability of achieving a return that is less than what was expected.
D) the probability of achieving a standard deviation that is less than what was expected.
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff

16
Copyright 2011 Pearson Education, Inc.

20) Which of the following statements is true?


A) Systematic, or market, risk can be reduced through diversification.
B) Both systematic and unsystematic risk can be reduced through diversification.
C) Unsystematic, or company, risk can be reduced through diversification.
D) Neither systematic nor unsystematic risk can be reduced through diversification.
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
21) Which of the following is a good measure of the relationship between an investment's returns
and the market's returns?
A) The beta coefficient
B) The standard variation
C) The CPI
D) The S&P 500 Index
Answer: A
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
22) Which of the following is generally used to measure the market when calculating betas?
A) The Dow Jones Transportations
B) The Standard & Poors 500
C) The Value Line Quantam Index
D) The Lehman Brothers Bond Index
Answer: B
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
23) Your broker mailed you your year-end statement. You have $25,000 invested in Dow
Chemical, $18,000 tied up in GM, $36,000 in Microsoft stock, and $11,000 in Nike. The betas
for each of your stocks are 1.55 for Dow, 1.12 for GM, 2.39 for Microsoft, and .76 for Nike.
What is the beta of your portfolio?
A) 1.46
B) 1.70
C) 2.60
D) 0.41
Answer: B
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: portfolio beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
17
Copyright 2011 Pearson Education, Inc.

24) You are considering a portfolio of three stocks with 30% of your money invested in company
X, 45% of your money invested in company Y, and 25% of your money invested in company Z.
If the betas for each stock are 1.22 for company X, 1.46 for company Y, and 1.03 for company Z,
what is the portfolio beta?
A) 1.24
B) 1.00
C) 1.28
D) 1.33
Answer: C
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: portfolio beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
25) Beta is a measurement of the relationship between a security's returns and the general
market's returns.
Answer: TRUE
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
26) Total risk equals unique security risk times systematic risk.
Answer: FALSE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
27) The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in
terms of beta.
Answer: TRUE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
28) The relevant risk to an investor is that portion of the variability of returns that cannot be
diversified away.
Answer: FALSE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff

18
Copyright 2011 Pearson Education, Inc.

29) Stocks with higher betas are usually more stable than stocks with lower betas.
Answer: FALSE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
30) A stock with a beta of 1.0 would earn the risk-free rate.
Answer: FALSE
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: market return
Principles: Principle 2: There Is a Risk-Return Tradeoff
31) Unsystematic risk can be eliminated through diversification.
Answer: TRUE
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: unique risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
32) Beta is a measure of systematic risk.
Answer: TRUE
Diff: 1
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
33) The market rewards assuming additional unsystematic risk with additional returns.
Answer: FALSE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: unique risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
34) The market rewards assuming additional systematic risk with additional returns.
Answer: TRUE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: systematic risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
35) Betas for individual stocks tend to be stable.
Answer: FALSE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
19
Copyright 2011 Pearson Education, Inc.

36) A stock with a beta greater than 1.0 has lower nondiversifiable risk than a stock with a beta
of 1.0.
Answer: FALSE
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
37) Briefly discuss why there is no reason to believe that the market will reward investors with
additional returns for assuming unsystematic risk.
Answer: Through diversification, risk can be lowered without sacrificing returns. The market
rewards investors for the systematic risk that cannot be eliminated through proper asset
allocation in a diversified portfolio.
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
38) Provide an intuitive discussion of beta and its importance for measuring risk.
Answer: Beta is an important measure that indicates the systematic risk of a given investment.
Since systematic risk cannot be diversified away, investors are compensated for taking this risk.
Beta compares the market risk of a particular investment with the market risk of the market, and
the risk premium necessary for a stock is directly proportional to the risk premium for the market
as a whole. When the risk premium is added to the risk free rate, this results in the required
return for the stock.
Diff: 2
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: diversifying risk
Principles: Principle 2: There Is a Risk-Return Tradeoff
39) The stock of the Preston Corporation is expected to pay a dividend of $6 during the coming
year. Dividends are expected to grow far into the future at 8%. Investors have recently evaluated
future market return variance to be 0.0016 and the covariance of returns for Preston and the
market as 0.00352. Assuming a required market return of 14% and a risk-free rate of 6%, at what
price should the stock of Preston sell?
Answer: Beta = 0.00352/0.0016 = 2.2
K = 0.06 + 2.2(0.14 - 0.06)
K = 0.236
P = $6/(0.236 - 0.08) = $6/0.156 = $38.46
Diff: 3
Topic: 8.2 Systematic Risk and the Market Portfolio
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff

20
Copyright 2011 Pearson Education, Inc.

8.3 The Security Market Line and the CAPM


1) The risk-return relationship for each financial asset is shown on:
A) the capital market line.
B) the New York Stock Exchange market line.
C) the security market line.
D) none of the above.
Answer: C
Diff: 1
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) Siebling Manufacturing Company's common stock has a beta of .8. If the expected risk-free
return is 7% and the market offers a premium of 8% over the risk-free rate, what is the expected
return on Siebling's common stock?
A) 7.8%
B) 13.4%
C) 14.4%
D) 8.7%
Answer: B
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) Huit Industries' common stock has an expected return of 14.4% and a beta of 1.2. If the
expected risk-free return is 8%, what is the expected return for the market (round your answer to
the nearest .1%)?
A) 7.7%
B) 9.6%
C) 12.0%
D) 13.3%
Answer: D
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff

21
Copyright 2011 Pearson Education, Inc.

4) Tanzlin Manufacturing's common stock has a beta of 1.5. If the expected risk-free return is 9%
and the expected return on the market is 14%, what is the expected return on the stock?
A) 13.5%
B) 21.0%
C) 16.5%
D) 21.5%
Answer: C
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Given the capital asset pricing model, a security with a beta of 1.5 should return ________, if
the risk-free rate is 6% and the market return is 11%.
A) 13.5%
B) 14.0%
C) 14.5%
D) 15.0%
Answer: A
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) The security market line (SML) relates risk to return, for a given set of market conditions. If
expected inflation increases, which of the following would most likely occur?
A) The market risk premium would increase.
B) Beta would increase.
C) The slope of the SML would increase.
D) The SML line would shift up.
Answer: D
Diff: 3
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) The security market line (SML) relates risk to return, for a given set of market conditions. If
risk aversion increases, which of the following would most likely occur?
A) The market risk premium would increase.
B) Beta would increase.
C) The slope of the SML would increase.
D) The SML line would shift up.
Answer: A
Diff: 3
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff
22
Copyright 2011 Pearson Education, Inc.

8) The Elvis Alive Corporation, makers of Elvis memorabilia, has a beta of 2.35. The return on
the market portfolio is 13%, and the risk-free rate is 7%. According to CAPM, what is the risk
premium on a stock with a beta of 1.0?
A) 11.75%
B) 18.75%
C) 6%
D) 13%
Answer: C
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) Bell Weather, Inc. has a beta of 1.25. The return on the market portfolio is 12.5%, and the riskfree rate is 5%. According to CAPM, what is the required return on this stock?
A) 20.62%
B) 9.37%
C) 14.37%
D) 15.62%
Answer: C
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
10) The rate on six-month T-bills is currently 5%. Andvark Company stock has a beta of 1.69
and a required rate of return of 15.4%. According to CAPM, determine the return on the market
portfolio.
A) 11.15%
B) 6.15%
C) 17.07%
D) 14.11%
Answer: A
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff

23
Copyright 2011 Pearson Education, Inc.

11) You are going to invest all of your funds in one of three projects with the following
distribution of possible returns:
Project 1
Project 2
Standard Deviation 12% Standard Deviation 19.5%
Probability
Return
Probability
Return
50% Chance
20%
30% Chance
30%
50% Chance
-4%
40% Chance
10%
30% Chance
-20%
Project 3
Standard Deviation 12%
Probability
Return
10% Chance
30%
40% Chance
15%
40% Chance
10%
10% Chance
-21%
If you are a risk-averse investor, which one should you choose?
A) Project 1
B) Project 2
C) Project 3
Answer: C
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
12) The return on the market portfolio is currently 13%. Battmobile Corporation stockholders
require a rate of return of 21%, and the stock has a beta of 3.5. According to CAPM, determine
the risk-free rate.
A) 7%
B) 14.7%
C) 9.8%
D) 24.2%
Answer: C
Diff: 3
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff

24
Copyright 2011 Pearson Education, Inc.

13) Hefty stock has a beta of 1.2. If the risk-free rate is 7% and the market risk premium is 6.5%,
what is the required rate of return on Hefty?
A) 14.8%
B) 14.4%
C) 12.4%
D) 13.5%
Answer: A
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) The market risk premium is measured by:
A) beta.
B) market return less risk-free rate.
C) T-bill rate.
D) standard deviation.
Answer: B
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff
15) Marjen stock has a required return of 20%. The expected market return is 15%, and the beta
of Marjen's stock is 1.5. Calculate the risk-free rate.
A) 4%
B) 5%
C) 6%
D) 7%
Answer: B
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff

25
Copyright 2011 Pearson Education, Inc.

16) You are thinking about purchasing 1,000 shares of stock in the following firms:
Number of SharesFirm's Beta
Firm A
100
0.75
Firm B
200
1.47
Firm C
200
0.82
Firm D
600
1.60
If you purchase the number of shares specified, then the beta of your portfolio will be:
A) 1.16.
B) 1.35.
C) 1.00.
D) .85.
E) Cannot be determined with information given.
Answer: E
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
Use the following information to answer the following question(s).
Beta
1
1.25
0.6

Market
Firm A
Firm B
Market Return

10%

Risk Free Rate 2%

17) The market risk premium is:


A) 2%.
B) 4%.
C) 6%.
D) 8%.
Answer: D
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
18) Firm A's risk premium is:
A) 2%.
B) 4%.
C) 6%.
D) 8%.
E) 10%.
Answer: E
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: risk, return
26
Copyright 2011 Pearson Education, Inc.

Principles: Principle 2: There Is a Risk-Return Tradeoff


19) Firm B's risk premium is:
A) 2.66%.
B) 4.8%.
C) 6.3%.
D) 8.1%.
Answer: B
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
20) The required rate of return for Firm A is:
A) 4%.
B) 8%.
C) 12%.
D) 16%.
E) Cannot be determined with information given.
Answer: C
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: expected return
Principles: Principle 2: There Is a Risk-Return Tradeoff
21) Calculate the current beta for Mercury, Inc. The rate on 30-year U.S. Treasury bonds is
currently 8%. The market risk premium is 5%. Mercury returned 18% to its stockholders in the
latest year.
A) 1.00
B) 1.75
C) 1.25
D) 2.00
E) 1.50
Answer: D
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff

27
Copyright 2011 Pearson Education, Inc.

22) The rate of return on the S&P 500 is 16.2%. Epsilon has a beta of 1.85. If the T-bond rate is
5.9%, what should investors expect as a rate of return on Epsilon's stock?
A) 16.2%
B) 22.1%
C) 18.5%
D) 25.0%
Answer: D
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
23) Which of the following statements is true?
A) An average stock has a beta of 1.0.
B) A stock having a beta of greater than 1.0 is a higher-than-average-risk stock.
C) A stock having a beta of less than 1.0 is a lower-than-average-risk stock.
D) All of the above.
E) None of the above.
Answer: D
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: beta
Principles: Principle 2: There Is a Risk-Return Tradeoff
24) The risk-free rate is currently 6.5%. Acid Battery Company stockholders require a rate of
return of 27.5%, and the stock has a beta of 2.1. What is the current market risk premium?
A) 6.90%
B) 21.00%
C) 13.65%
D) 10.00%
Answer: D
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
25) U.S. Treasury bonds currently yield 6%. Consolidated Industries stock has a beta of 1.5. The
rate of return on the S&P 500 is presently 18%. What is the rate of return that Consolidated
Industries stockholders require?
A) 6%
B) 24%
C) 18%
D) 27%
Answer: B
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
28
Copyright 2011 Pearson Education, Inc.

26) Amalgamated Aluminum stock has a beta of 1.2. Today's market risk premium is 13%.
Amalgamated Aluminum stockholders require a rate of return of 22%. What is the present riskfree rate?
A) 6.40%
B) 22.00%
C) 4.60%
D) 15.60%
Answer: A
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
27) If investors expected inflation to increase in the future, what would happen to the security
market line (SML)?
A) The slope of the SML would rise.
B) The SML would shift downward, but the slope would remain the same.
C) The slope of the SML would fall.
D) The SML would shift up, but the slope would remain the same.
Answer: D
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff
28) What would happen if investors became more risk averse?
A) The slope of the SML would rise.
B) The SML would shift downward but the slope would remain the same.
C) The slope of the SML would fall.
D) The SML would shift downward and the slope of the SML would fall.
Answer: A
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff
29) A security with a beta of zero has a required rate of return equal to the overall market rate of
return.
Answer: FALSE
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff

29
Copyright 2011 Pearson Education, Inc.

30) The return for the market during the next period is expected to be 16%; the risk-free rate is
10%. Calculate the required rate of return for a stock with a beta of 1.5.
Answer: K = 10% + 1.5(16% - 10%) = 19%
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
31) Asset A has a required return of 18% and a beta of 1.4. The expected market return is 14%.
What is the risk-free rate? Plot the security market line.
Answer: K = Krf + (Km - Krf)b
18% = X + (14% - X)1.4
18% - X =19.6% - 1.4X
.4X = 1.6%
X = 4% = Risk - free Rate = Krf
Diff: 3
Topic: 8.3 The Security Market Line and the CAPM
Keywords: security market line
Principles: Principle 2: There Is a Risk-Return Tradeoff
32) Security A has an expected rate of return of 22% and a beta of 2.5. Security B has a beta of
1.20. If the Treasury bill rate is 10%, what is the expected rate of return for security B?
Answer: RA = RF + BA(Rm - Rf)
.22 = .10 + 2.5 (Rm - .10)
.12 = 2.5 (Rm - .10) = 2.5 Rm - .25
.37 = 2.5 Rm
.148 = Rm
RB = Rf + BB(Rm - Rf)
RB = .10 + 1.20(.148 - .10)
RB = .1576
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff
33) AA & Co. has a beta of .656. If the expected market return is 13.2% and the risk-free rate is
5.7%, what is the appropriate required return of AA & Co. using the CAPM model?
Answer: Required Rate of Return = Risk-Free Rate + (Market Return - Risk-Free Rate) Beta =
5.7% + (13.2% - 5.7%) 0.656 = 10.62%
Diff: 2
Topic: 8.3 The Security Market Line and the CAPM
Keywords: CAPM
Principles: Principle 2: There Is a Risk-Return Tradeoff

30
Copyright 2011 Pearson Education, Inc.