Sample Exam 3

Please answer the following questions by selecting the best possible answer on the
Scantron sheet provided to you.
1
. Which of the following statements is most correct? (Assume that the risk-free
rate remains constant.)
a. If the market risk premium increases by 1 percentage point, then the required
return on all stocks will rise by 1 percentage point.
b. If the market risk premium increases by 1 percentage point, then the required
return will increase for stocks that have a beta greater than 1.0, but it will
decrease for stocks that have a beta less than 1.0.
c. If the market risk premium increases by 1 percentage point, then the required
return will increase by 1 percentage point for a stock that has a beta equal to
1.0.
d. Statements a and c are correct.
e. None of the statements above is correct.
2
. Which of the following statements best describes what would be expected to
happen as you randomly add stocks to your portfolio?
a. Adding more stocks to your portfolio reduces the portfolios company-specific
risk.
b. Adding more stocks to your portfolio reduces the beta of your portfolio.
c. Adding more stocks to your portfolio increases the portfolios expected return.
d. Statements a and c are correct.
e. All of the statements above are correct.
3
. Which of the following statements is most correct?
a. The slope of the security market line is beta.
b. The slope of the security market line is the market risk premium, (r M r R F ).
c. If you double a companys beta its required return more than doubles.
d. Statements a and c are correct.
e. Statements b and c are correct.
4
. You have developed the following data on three stocks:

Stock Standard Deviation Beta

A 0.15 0.79
B 0.25 0.61
C 0.20 1.29

If you are a risk minimizer, you should choose Stock if it is to be held in

isolation and Stock if it is to be held as part of a well-diversified portfolio.
a. A; A
b. A; B
c. B; A
d. C; A
e. C; B
5
. Which of the following statements is most correct?
a. Market participants are able to eliminate virtually all market risk if they hold a
large diversified portfolio of stocks.
b. Market participants are able to eliminate virtually all company-specific risk if
they hold a large diversified portfolio of stocks.
c. It is possible to have a situation where the market risk of a single stock is less
than that of a well diversified portfolio.
d. Statements a and c are correct.
e. Statements b and c are correct.
6
. Inflation, recession, and high interest rates are economic events that are
characterized as
a. Company-specific risk that can be diversified away.
b. Market risk.
c. Systematic risk that can be diversified away.
d. Diversifiable risk.
e. Unsystematic risk that can be diversified away.
7
. The risk-free rate is 5 percent. Stock A has a beta = 1.0 and Stock B has a beta =
1.4. Stock A has a required return of 11 percent. What is Stock Bs required
return?
a. 12.4%
b. 13.4%
c. 14.4%
d. 15.4%
e. 16.4%
8
. Calculate the required rate of return for Mercury Inc., assuming that investors
expect a 5 percent rate of inflation in the future. The real risk-free rate is equal to
3 percent and the market risk premium is
5 percent. Mercury has a beta of 2.0, and its realized rate of return has averaged
15 percent over the last 5 years.
a. 15%
b. 16%
c. 17%
d. 18%
e. 20%
9
. A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and
the risk-free rate is 5 percent. What is the market risk premium?
a. 1.30%
b. 6.50%
c. 15.00%
d. 6.30%
e. 7.25%
10
. You hold a diversified portfolio consisting of a $10,000 investment in each of 20
different common stocks (that is, your total investment is $200,000). The
portfolio beta is equal to 1.2. You have decided to sell one of your stocks that has
a beta equal to 0.7 for $10,000. You plan to use the proceeds to purchase another
stock that has a beta equal to 1.4. What will be the beta of the new portfolio?
a. 1.165
b. 1.235
c. 1.250
d. 1.284
e. 1.333
11
. Given the following probability distribution, what are the expected return and the
standard deviation of returns for Security J?

State Pi rJ
1 0.2 10%
2 0.6 15
3 0.2 20

a. 15%; 6.50%
b. 12%; 5.18%
c. 15%; 3.16%
d. 15%; 10.00%
e. 20%; 5.00%
12
. You have been scouring The Wall Street Journal looking for stocks that are good
values and have calculated expected returns for five stocks. Assume the risk-free
rate (rRF) is 7 percent and the market risk premium (r M - rRF) is 2 percent. Which
security would be the best investment? (Assume you must choose just one.)

Expected Return Beta

a. 9.01% 1.70
b. 7.06% 0.00
c. 5.04% -0.67
d. 8.74% 0.87
e. 11.50% 2.50
13
. Here are the expected returns on two stocks:

Returns
Probability X Y
0.1 -20% 10%
0.8 20 15
0.1 40 20

If you form a 50-50 portfolio of the two stocks, what is the portfolios standard
deviation? (Hint: Calculate the portfolio return for each state and then compute
the expected return and standard deviation for the portfolio.)
a. 8.1%
b. 10.5%
c. 13.4%
d. 16.5%
e. 20.0%

14
. For the foreseeable future, the real risk-free rate of interest, k*, is expected to
remain at 3 percent. Inflation is expected to steadily increase over time. The
maturity risk premium equals 0.1(t - 1)%, where t represents the bonds maturity.
On the basis of this information, which of the following statements is most correct?
a. The yield on 10-year Treasury securities must exceed the yield on
2-year Treasury securities.
b. The yield on 10-year Treasury securities must exceed the yield on
5-year corporate bonds.
c. The yield on 10-year corporate bonds must exceed the yield on 8-year Treasury
securities.
d. Statements a and b are correct.
e. Statements a and c are correct.
15
. Which of the following factors are likely to lead to an increase in nominal interest
rates?
a. Households increase their savings rate.
b. Companies see an increase in their production opportunities that leads to an
increase in the demand for funds.
c. There is an increase in expected inflation.
d. Statements b and c are correct.
e. All of the statements above are correct.
16
. Assume that the expectations theory describes the term structure of interest rates.
Which of the following statements is most correct?
a. In equilibrium long-term rates equal short term rates.
b. An upward-sloping yield curve implies that interest rates are expected to
decline in the years ahead.
c. The maturity risk premium is zero.
d. Statements a and b are correct.
e. None of the statements above is correct.
17
. Assume that the expectations theory holds. Which of the following statements
about Treasury bill rates is most correct? (2-year rates apply to bonds that will
mature in two years, 3-year rates apply to bonds that will mature in 3 years, and so
on).
a. If 2-year rates exceed 1-year rates, then the market expects interest rates to rise.
b. If 2-year rates are 7 percent, and 3-year rates are 7 percent, then
5-year rates must also be 7 percent.
c. If 1-year rates are 6 percent and 2-year rates are 7 percent, then the market
expects 1-year rates to be 6.5 percent in one year.
d. Statements a and c are correct.
e. Statements b and c are correct.
18
. The real risk-free rate of interest is 3 percent. Inflation is expected to be 4 percent
this coming year, jump to 5 percent next year, and increase to 6 percent the year
after (Year 3). According to the expectations theory, what should be the interest rate
on 3-year, risk-free securities today?
a. 18%
b. 12%
c. 6%
d. 8%
e. 10%
19
. One-year government bonds yield 6 percent and 2-year government bonds yield 5.5
percent. Assume that the expectations theory holds. What does the market believe
the rate on 1-year government bonds will be one year from today?
a. 5.00%
b. 5.50%
c. 5.75%
d. 6.00%
e. 7.00%
20
. One-year Treasury securities yield 5 percent, 2-year Treasury securities yield 5.5
percent, and 3-year Treasury securities yield 6 percent. Assume that the
expectations theory holds. What does the market expect will be the yield on 1-year
Treasury securities two years from now?
a. 6.0%
b. 6.5%
c. 7.0%
d. 7.5%
e. 8.0%
21
. You observe the following yield curve for Treasury securities:

Maturity Yield
1 year 5.5%
2 years 5.8
3 years 6.0
4 years 6.3
5 years 6.5

Assume that the pure expectations hypothesis holds. What does the market expect
will be the yield on 4-year securities, 1 year from today?
a. 6.00%
b. 6.30%
c. 6.40%
d. 6.75%
e. 7.30%
22
. Given the following data, find the expected rate of inflation during the next year.

r* = real risk-free rate = 3%.

Maturity risk premium on 10-year T-bonds = 2%. It is zero on 1-year bonds,
and a linear relationship exists.
Default risk premium on 10-year, A-rated bonds = 1.5%.
Liquidity premium = 0%.
Going interest rate on 1-year T-bonds = 8.5%.

a. 3.5%
b. 4.5%
c. 5.5%
d. 6.5%
e. 7.5%
23
. Drongo Corporations 4-year bonds currently yield 7.4 percent and have an inflation
premium of 3.5%. The real risk-free rate of interest, r*, is 2.7 percent and is assumed
to be constant. The maturity risk premium (MRP) is estimated to be 0.1%(t - 1),
where t is equal to the time to maturity. The default risk and liquidity premiums for
this companys bonds total 0.9 percent and are believed to be the same for all bonds
issued by this company. If the average inflation rate is expected to be 5 percent for
years 5, 6, and 7, what is the yield on a 7-year bond for Drongo Corporation?
a. 8.70%
b. 8.34%
c. 7.40%
d. 9.20%
e. 8.54%
1. Market risk premium Answer: c Diff: E

CAPM equation: rs = rRF + (rM - rRF)b

If the market risk premium (measured by kM - kRF) goes up by 1.0, then the required return for
each stock will change by its beta times 1.0. Therefore, a stock with a beta of 0.5 will see its
required return go up by 0.5 percentage point. Therefore, statement a is false. As just shown in
statement a, a stock with a beta of 0.5 will see its required return increase by 0.5 percentage
point. All stocks with positive betas will see their required returns increase. Therefore,
statement b is false. If the market risk premium increases by 1 percentage point, then the
required return increases by 1.0 times the stocks beta. Therefore, the required return of a stock
with a beta coefficient equal to 1.0 will increase by 1 percentage point, and statement c is
correct.
2. Portfolio risk and return Answer: a Diff: E

Statements b and c are false. Randomly adding more stocks will have no
effect on the portfolios beta or expected return.

3. SML Answer: b Diff: E

Statement b is correct. Statement a is false, since the slope of the SML is

rM rRF. Statement c is false, since r s = rRF + (rM rRF)b. The remaining
statements are false.

4. Risk aversion Answer: b Diff: M

5. Portfolio risk Answer: e Diff: M

6. Market risk Answer: b Diff: M

7. Required return Answer: b Diff: E N

Step 1: We must determine the market risk premium using the CAPM equation with data
inputs for Stock A:
rA = rRF + (rM rRF)bA
11%= 5% + (rM rRF)1.0
6% = (rM rRF).

Step 2: We can now find the required return of Stock B using the CAPM equation with data
inputs for Stock B:
rB = rRF + (rM rRF)bB
rB = 5% + (6%)1.4
rB = 13.4%.

8. CAPM and required return Answer: d Diff: E

rRF = r* + IP = 3% + 5% = 8%.
rs = 8% + (5%)2.0 = 18%.

9. Market risk premium Answer: d Diff: E

12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.3043% 6.30%.
10. Portfolio beta Answer: b Diff: E

1.2 = 1/20(0.7) + (19/20)b

b is average beta for other 19 stocks.
1.165 = (19/20)b.
New Beta = 1.165 + 1/20(1.4) = 1.235.
11. Expected return Answer: c Diff: M

rJ = (0.2)(0.10) + (0.6)(0.15) + (0.2)(0.20) = 0.15 = 15.0%.

Expected return = 15.0%.

J2 = (0.2)(0.10 - 0.15)2 + 0.6(0.15 - 0.15)2 + (0.2)(0.20 - 0.15)2 = 0.001.

Standard deviation = 0.001 = 0.0316 = 3.16%.

12. Expected and required returns Answer: b Diff: M

By calculating the required returns on each of the securities and comparing

required and expected returns, we can identify which security is the best
investment alternative; that is, the security for which the expected return
exceeds the required return by the largest amount. The expected and required
returns and the differences between them are shown below:

Security Expected Return Required Return Expected-Required

A 9.01% 7% + 2%(1.7) = 10.40% -1.39%
B 7.06% 7% + 2%(0.0) = 7.00% 0.06%
C 5.04% 7% + 2%(-0.67) = 5.66% -0.62%
D 8.74% 7% + 2%(0.87) = 8.74% 0.00%
E 11.50% 7% + 2%(2.50) = 12.00% -0.50%
Clearly, security B is the best alternative.

13. Portfolio standard deviation Answer: a Diff: M

Fill in the columns for XY and product, and then use the formula to
calculate the standard deviation. We did each (k - k )2P calculation with a
calculator, stored the value, did the next 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 square root, and had XY = 8.1%.

Probability Portfolio XY Product

0.1 -5.0% -0.5%
0.8 17.5 14.0
0.1 30.0 3.0

k = 16.5%

XY = ((r - r )2P) = 8.07% 8.1%.

14. Yield curve Answer: e Diff: E

The required return on Treasuries is r = r* + IP + MRP. Inflation increases,

so the IP on a 10-year Treasury is higher than the IP on a 2-year Treasury.
Also, MRP = 0.1%(t - 1). MRP on the 2-year Treasury = 0.1%(2 - 1) = 0.1%.
MRP on the 10-year Treasury = 0.1%(10 - 1) = 0.9%. Therefore, both the MRP and
the IP on the 10-year Treasury exceed the MRP and the IP on the 2-year
 Treasury, so the overall yield on the 10-year Treasury must be higher than the
yield on the 2-year Treasury. Therefore, statement a is true.

r(Treasury) = r* + IP + MRP. r(Corporate) = r* + IP + DRP + LP + MRP. Since

the corporate bond has the extra risk premia, it will have a higher yield for
two bonds of the same maturity, but in statement b the bonds have different
maturities, so we cannot say for sure that this is true or false. Therefore,
statement b is false.

Yield

Corporate

Treasury

Maturity
8 10

Since we know that the corporate bond has to have a higher yield than the
Treasury bond for all bonds of the same maturity, we know the yield curve for
the corporate bond must be higher than the yield curve for the Treasury bond.
We also know that the yield curve is upward sloping because inflation steadily
increases over time. If you look at the graph, its obvious that statement c
must be true. Since statements a and c are both true, then statement e is the
correct choice.

15. Interest rates Answer: d Diff: E N

The correct answer is statement d. An increase in household savings increases

money available, shifting the supply curve to the right, causing interest rates
to fall. So, statement a is incorrect. Both statements b and c are correct.
An increase in demand will increase interest rates, and an increase in expected
inflation will increase interest rates. So, statement d is the correct choice.

16. Expectations theory Answer: c Diff: E

This is assumed by the expectations theory.

17. Expectations theory Answer: a Diff: M

Statement a is correct; the other statements are false. Knowing 2-year rates
and 3-year rates permits no inference regarding 5-year rates. However, knowing
2-year rates and 3-year rates beginning in two years would permit applying the
expectations theory to infer 5-year rates. Given the data concerning one- and
2-year rates in statement c, the market expects 1-year rates in one year to be
8%.

18. Expected interest rates Answer: d Diff: E N

4% + 5% + 6%
Average inflation = = 5%.
3
rRF = r* + IP = 3% + 5% = 8%.
19. Expected interest rates Answer: a Diff: E

If the 1-year rate in one year is X; (6% + X)/2 = 5.5%; X = 5%.

20 . Expected interest rates

Answer: c Diff: E

If 2r1 is the yield on a 1-year treasury in two years, we can say:

3 6% = (2 5.5% + 2k1)
18% = 11% + 2k1
2r1 = 7%.
21. Expected interest rates Answer: d Diff: E N

The pure expectations hypothesis allows us to say that a long-term security

yield is comprised of a weighted average of securities with shorter
maturities.

6.5% = (5.5% + 4X)/5

32.5% = 5.5% + 4X
27.0% = 4X
6.75% = X.

22. Inflation rate Answer: c Diff: E

rNom = r* + IP + DRP + LP + MRP

8.5% = 3% + IP + 0 + 0 + 0
IP = 5.5%.
23

. Expected interest rates Answer: b Diff: M

The MRP for the 4-year bond is 0.1%(4 - 1) = 0.3%. Find the 4-year IP as 7.4% =
2.7% + 0.3% + 0.9% + IP4, or IP4 = 3.5%. Calculate the 7-year IP as [3.5%(4) +
5%(3)]/7 = 4.14%. The MRP for the 7-year bond is 0.1%(7 - 1) = 0.6%. Finally, the
yield on the 7-year bond is 2.7% + 0.6% + 0.9% + 4.14% = 8.34%.