Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)

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Question 1

  1. Which of the following statements is CORRECT?  (Assume that the risk-free rate is a constant.)

    Answer

    If the market risk premium increases by 1%, 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.
    The effect of a change in the market risk premium depends on the slope of the yield curve.
    If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
    If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
    The effect of a change in the market risk premium depends on the level of the risk-free rate.

2 points

Question 2

  1. You have the following data on three stocks:

    Stock                Standard Deviation                 Beta
    A                               20%                             0.59
    B                               10%                             0.61
    C                               12%                             1.29

    If you are a strict risk minimizer, you would 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.

    Answer

    A; A.
    A; B.
    B; A.
    C; A.
    C; B.

2 points

Question 3

  1. Inflation, recession, and high interest rates are economic events that are best characterized as being

    Answer

    systematic risk factors that can be diversified away.
    company-specific risk factors that can be diversified away.
    among the factors that are responsible for market risk.
    risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.
    irrelevant except to governmental authorities like the Federal Reserve.

2 points

Question 4

  1. Which of the following statements is CORRECT?

    Answer

    The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.
    If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio.
    The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns.  One 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.  However, this historical beta may differ from the beta that exists in the future.
    The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
    It is theoretically possible for a stock to have a beta of 1.0.  If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.

2 points

Question 5

  1. Which of the following statements is CORRECT?

    Answer

    A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.
    A portfolio that consists of 40 stocks that are not highly correlated with “the market” will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations.
    A two-stock portfolio will always have a lower beta than a one-stock portfolio.
    If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio.
    A stock with an above-average standard deviation must also have an above-average beta.

2 points

Question 6

  1. Which of the following statements is CORRECT?

    Answer

    A 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.
    If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks.  Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless.
    The required return on a firm’s common
    stock is, in theory, determined solely by its market risk.  If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm’s required return.
    Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio.
    A security’s beta measures its non-diversifiable, or market, risk relative to that of an average stock.
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