RISK ANDCHAPTER

RATES OF
5 RETURN
(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Risk concepts
1

Answer: e

Diff: E

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. A stock with a beta of -1.0 has zero market risk.
e. The SML relates required returns to firms market risk.
The slope
and intercept of this line cannot be controlled by the financial
manager.

Risk measures
2

Answer: a

Diff: E

You observe the following information regarding Company X and Company Y:

Company X has a higher expected mean return than Company Y.

Company X has a lower standard deviation than Company Y.
Company X has a higher beta than Company Y.

Given this information, which of the following statements is most correct?

a.
b.
c.
d.
e.

Company X has a lower coefficient of variation than Company Y.

Company X has more company-specific risk than Company Y.
Company X is a better stock to buy than Company Y.
Statements a and b are correct.
Statements a, b, and c are correct.

Chapter 5 - Page 1

Market risk premium

3

Which of the following statements is most correct?

risk-free rate remains constant.)

Answer: c

Diff: E

(Assume that the

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.
Standard deviation
4

Asset A.
Asset B.
Both A and B.
Neither A nor B.
Cannot tell without more information.

Beta coefficient
.

Diff: E

A highly risk-averse investor is considering the addition of an asset to

a 10-stock portfolio. The two securities under consideration both have
, equal to 15 percent. However, the distribution
an expected return, k
of possible returns associated with Asset A has a standard deviation of
12 percent, while Asset Bs standard deviation is 8 percent.
Both
assets are correlated with the market with r equal to 0.75. Which asset
should the risk-averse investor add to his/her portfolio?
a.
b.
c.
d.
e.

Answer: b

Answer: d

Diff: E

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the
following statements must be true about these securities? (Assume the
market is in equilibrium.)
a.
b.
c.
d.
e.

When held in isolation, Stock A has greater risk than Stock B.

Stock B would be a more desirable addition to a portfolio than Stock A.
Stock A would be a more desirable addition to a portfolio than Stock B.
The expected return on Stock A will be greater than that on Stock B.
The expected return on Stock B will be greater than that on Stock A.

Chapter 5 - Page 2

Beta coefficient
6

Answer: c

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5.

following statements is most correct?

Diff: E

Which of the

a. Stock Ys return this year will be higher than Stock Xs return.

b. Stock Ys return has a higher standard deviation than Stock X.
c. If expected inflation increases (but the market risk premium is
unchanged), the required returns on the two stocks will increase by
the same amount.
d. If the market risk premium declines (leaving the risk-free rate
unchanged), Stock X will have a larger decline in its required return
than will Stock Y.
e. If you invest $50,000 in Stock X and $50,000 in Stock Y, your
portfolio will have a beta less than 1.0, provided the stock returns
on the two stocks are not perfectly correlated.
Required return
7

Answer: b

Diff: E

In the years ahead the market risk premium, (k M - kRF), is expected to

fall, while the risk-free rate, kRF, is expected to remain at current
levels. Given this forecast, which of the following statements is most
correct?
a. The required return for all stocks will fall by the same amount.
b. The required return will fall for all stocks but will fall more for
stocks with higher betas.
c. The required return will fall for all stocks but will fall less for
stocks with higher betas.
d. The required return will increase for stocks with a beta less than
1.0 and will decrease for stocks with a beta greater than 1.0.
e. The required return on all stocks will remain unchanged.

Risk and return

8

Answer: a

Diff: E

Over the past 75 years, we have observed that investments with higher
average annual returns also tend to have the highest standard deviations
in their annual returns.
This 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. Small-company stocks, large-company stocks, long-term corporate
bonds, long-term government bonds, U.S. Treasury bills.
b. Small-company stocks, long-term corporate bonds, large-company
stocks, long-term government bonds, U.S. Treasury bills.
c. Large-company stocks, small-company stocks, long-term corporate
bonds, U.S. Treasury bills, long-term government bonds.
d. U.S. Treasury bills, long-term government bonds, long-term corporate
bonds, small-company stocks, large-company stocks.
e. Large-company stocks, small-company stocks, long-term corporate
bonds, long-term government bonds, U.S. Treasury bills.

Chapter 5 - Page 3

Portfolio risk
9

Answer: b

Diff: E

Stock A and Stock B both have an expected return of 10 percent and a

standard deviation of 25 percent. Stock A has a beta of 0.8 and Stock B
has a beta of 1.2.
The correlation coefficient, r, between the two
stocks is 0.6. Portfolio P is a portfolio with 50 percent invested in
Stock A and 50 percent invested in Stock B.
Which of the following
statements is most correct?
a. Portfolio P has a coefficient of variation equal to 2.5.
b. Portfolio P has more market risk than Stock A but less market risk
than Stock B.
c. Portfolio P has a standard deviation of 25 percent and a beta of 1.0.
d. All of the statements above are correct.
e. None of the statements above is correct.

Portfolio risk, return, and beta

10

Answer: e

Diff: E

Which of the following statements is most correct?

a. A two-stock portfolio will always have a lower standard deviation
than a one-stock portfolio.
b. A two-stock portfolio will always have a lower beta than a one-stock
portfolio.
c. If portfolios are formed by randomly selecting stocks, a 10-stock
portfolio will always have a lower beta than a one-stock portfolio.
d. All of the statements above are correct.
e. None of the statements above is correct.

Portfolio risk and return

11

Answer: a

Diff: E

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 companyspecific 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.

Chapter 5 - Page 4

Portfolio risk and return

12

Answer: e

Diff: E

Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return
of 10.8 percent, and a standard deviation of 25 percent. Becky has a
$50,000 portfolio with a beta of 0.8, an expected return of 9.2 percent,
and a standard deviation of 25 percent. The correlation coefficient, r,
between Bobs and Beckys portfolios is 0. Bob and Becky are engaged to
be married.
Which of the following best describes their combined
$100,000 portfolio?
a. The combined portfolios expected return is a simple average of the
expected returns of the two individual portfolios (10%).
b. The combined portfolios beta is a simple average of the betas of the
two individual portfolios (1.0).
c. The combined portfolios standard deviation is less than a simple
average of the two portfolios standard deviations (25%), even though
there is no correlation between the returns of the two portfolios.
d. Statements a and b are correct.
e. All of the statements above are correct.

Portfolio risk and return

13

Answer: a

Diff: E

Your portfolio consists of $50,000 invested in Stock X and $50,000

invested in Stock Y. Both stocks have an expected return of 15 percent,
a beta of 1.6, and a standard deviation of 30 percent. The returns of
the two stocks are independent--the correlation coefficient, r, is zero.
Which of the following statements best describes the characteristics of
your portfolio?
a. Your portfolio has a beta equal to 1.6 and its expected return is 15
percent.
b. Your portfolio has a standard deviation of 30 percent and its
expected return is 15 percent.
c. Your portfolio has a standard deviation less than 30 percent and its
beta is greater than 1.6.
d. Your portfolio has a standard deviation greater than 30 percent and a
beta equal to 1.6.
e. Your portfolio has a beta greater than 1.6 and an expected return
greater than 15 percent.

Portfolio risk and return

14

Answer: b

Diff: E

In 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. The expected return of your portfolio will usually decline.
b. The company-specific risk of your portfolio will usually decline, but
the market risk will tend to remain the same.
c. Both the company-specific risk and the market risk of your portfolio
will decline.
d. The market risk and expected return of the portfolio will decline.
e. The company-specific risk will remain the same, but the market risk
will tend to decline.
Chapter 5 - Page 5

Portfolio risk and return

15

Answer: b

Diff: E

Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard
deviation of each stocks returns is 20 percent.
The returns are
independent of each other.
(In other words, the correlation
coefficient, r, between Stock X and Stock Y is zero.) Portfolio P has
50 percent of its wealth invested in Stock X and the other 50 percent is
invested in Stock Y.
Given this information, which of the following
statements is most correct?
a. Portfolio P has a standard deviation of 20 percent.
b. The required return on Portfolio P is the same as the required return
on the market (kM).
c. The required return on Portfolio P is equal to the market risk
premium (kM kRF).
d. Statements a and b are correct.
e. Statements a and c are correct.

Portfolio risk and return

16

Answer: e

Diff: E

Jane has randomly selected a portfolio of 20 stocks, and Dick has

randomly selected a portfolio of two stocks.
Which of the following
statements is most correct?
a. The required return on Janes portfolio must be higher than the
required return on Dicks portfolio because Jane is more diversified.
b. If the two portfolios have the same beta, Janes portfolio will have
less market risk but the same amount of company-specific risk as
Dicks portfolio.
c. If the two portfolios have the same beta, their required returns will
be the same but Janes portfolio will have more company-specific risk
than Dicks.
d. All of the statements above are correct.
e. None of the statements above is correct.

Portfolio risk and return

17

Answer: d

Diff: E

Stock A and Stock B each have an expected return of 12 percent, a beta

of 1.2, and a standard deviation of 25 percent. The returns on the two
stocks have a correlation of 0.6.
Portfolio P has half of its money
invested in Stock A and half in Stock B.
Which of the following
statements is most correct?
a.
b.
c.
d.
e.

Portfolio P has an expected return of 12 percent.

Portfolio P has a standard deviation of 25 percent.
Portfolio P has a beta of 1.2.
Statements a and c are correct.
All of the statements above are correct.

Chapter 5 - Page 6

Portfolio risk and return

18

Answer: e

Stocks A, B, and C all have an expected return of 10 percent and a

standard deviation of 25 percent. Stocks A and B have returns that are
independent of one another. (Their correlation coefficient, r, equals
zero.) Stocks A and C have returns that are negatively correlated with
one another (that is, r < 0). Portfolio AB is a portfolio with half its
money invested in Stock A and half invested in Stock B. Portfolio AC is
a portfolio with half its money invested in Stock A and half invested in
Stock C. Which of the following statements is most correct?
a.
b.
c.
d.
e.

Portfolio AB
Portfolio AB
Portfolio AC
Statements a
Statements a

has
has
has
and
and

an expected return of 10 percent.

a standard deviation of 25 percent.
a standard deviation that is less than 25 percent.
b are correct.
c are correct.

Portfolio risk and return

19

Diff: E

The portfolios expected return is 15 percent.

The portfolios beta is less than 1.2.
The portfolios standard deviation is 20 percent.
Statements a and b are correct.
All of the statements above are correct.

Portfolio risk and return

.

Answer: a

Stock A and Stock B each have an expected return of 15 percent, a

standard deviation of 20 percent, and a beta of 1.2. The returns of the
two stocks are not perfectly correlated; the correlation coefficient is
0.6.
You have put together a portfolio that consists of 50 percent
Stock A and 50 percent Stock B. Which of the following statements is
most correct?
a.
b.
c.
d.
e.

20

Diff: E

Answer: d

Diff: E

Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a
beta of 1.2. Portfolio P has equal amounts invested in each of the three
stocks. Each of the stocks has a standard deviation of 25 percent. The
returns of the three stocks are independent of one another (i.e., the
correlation coefficients all equal zero).
Which of the following
statements is most correct?
a. Portfolio Ps expected return is less than the expected return of
Stock C.
b. Portfolio Ps standard deviation is less than 25 percent.
c. Portfolio Ps realized return will always exceed the realized return
of Stock A.
d. Statements a and b are correct.
e. Statements b and c are correct.

Chapter 5 - Page 7

CAPM
21

Answer: b

Diff: E

The risk-free rate is 6 percent. Stock A has a beta of 1.0, while Stock
B has a beta of 2.0.
The market risk premium (k M kRF) is positive.
Which of the following statements is most correct?
a. Stock Bs required rate of return is twice that of Stock A.
b. If Stock As required return is 11 percent, the market risk premium
is 5 percent.
c. If the risk-free rate increases (but the market risk premium stays
unchanged), Stock Bs required return will increase by more than
Stock As.
d. Statements b and c are correct.
e. All of the statements above are correct.

CAPM and required return

22

Answer: c

Diff: E

In recent years, both expected inflation and the market risk premium
(kM kRF) have declined.
Assume that all stocks have positive betas.
Which of the following is likely to have occurred as a result of these
changes?
a. The average required return on the market, kM, has remained constant,
but the required returns have fallen for stocks that have betas
greater than 1.0.
b. The required returns on all stocks have fallen by the same amount.
c. The required returns on all stocks have fallen, but the decline has
been greater for stocks with higher betas.
d. The required returns on all stocks have fallen, but the decline has
been greater for stocks with lower betas.
e. The required returns have increased for stocks with betas greater
than 1.0 but have declined for stocks with betas less than 1.0.

CAPM and required return

Answer: c

Diff: E

23

. Assume that the risk-free rate is 5 percent. Which of the following

statements is most correct?
a. If a stocks beta doubles, the stocks required return will also
double.
b. If a stocks beta is less than 1.0, the stocks required return is
less than 5 percent.
c. If a stock has a negative beta, the stocks required return is less
than 5 percent.
d. All of the statements above are correct.
e. None of the statements above is correct.

Chapter 5 - Page 8

CAPM and required return

24

Answer: e

Diff: E

Stock X has a beta of 1.5 and Stock Y has a beta of 0.5. The market is
in equilibrium (that is, required returns equal expected returns).
Which of the following statements is most correct?
a. Since the market is in equilibrium, the required returns of the two
stocks should be the same.
b. If both expected inflation and the market risk premium (kM - kRF)
increase, the required returns of both stocks will increase by the
same amount.
c. If expected inflation remains constant but the market risk premium
(kM - kRF) declines, the required return of Stock X will decline but
the required return of Stock Y will increase.
d. All of the statements above are correct.
e. None of the statements above is correct.

CAPM and required return

25

Answer: b

Diff: E

Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a
beta of 1.2. Portfolio P has equal amounts invested in each of the three
stocks. Each of the stocks has a standard deviation of 25 percent. The
returns of the three stocks are independent of one another (i.e., the
correlation coefficients all equal zero).
Assume 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. The required return of all three stocks will increase by the amount
of the increase in the market risk premium.
b. The required return on Stock A will increase by less than the increase
in the market risk premium, while the required return on Stock C will
increase by more than the increase in the market risk premium.
c. The required return of all stocks will remain unchanged since there
was no change in their betas.
d. The required return of the average stock will remain unchanged, but
the returns of riskier stocks (such as Stock C) will decrease while
the returns of safer stocks (such as Stock A) will increase.
e. The required return of the average stock will remain unchanged, but
the returns of riskier stocks (such as Stock C) will increase while
the returns of safer stocks (such as Stock A) will decrease.

CAPM, beta, and required return

26

Answer: c

Diff: E

Currently, the risk-free rate is 6 percent and the market risk premium
is 5 percent. On the basis of this information, which of the following
statements is most correct?
a. If a stock has a negative beta, its required return must also be
negative.
b. If a stocks beta doubles, its required return must also double.
c. An index fund with beta = 1.0 has a required return of 11 percent.
d. Statements a and c are correct.
e. Statements b and c are correct.
Chapter 5 - Page 9

SML
27

Answer: a
Which of the following statements is incorrect?
a.
b.
c.
d.
e.

The slope of the security market line is measured by beta.

Two securities with the same stand-alone risk can have different betas.
Company-specific risk can be diversified away.
The market risk premium is affected by attitudes about risk.
Higher beta stocks have a higher required return.

SML
28

Diff: E

Answer: b

Diff: E

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,
(k M k 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.

SML
29

Answer: c

Diff: E

Stock A has a beta of 1.2 and a standard deviation of 20 percent. Stock

B has a beta of 0.8 and a standard deviation of 25 percent. Portfolio P
is a $200,000 portfolio consisting of $100,000 invested in Stock A and
$100,000 invested in Stock B. Which of the following statements is most
correct? (Assume that the required return is determined by the Security
Market Line.)
a.
b.
c.
d.
e.

Stock B has a higher required rate of return than Stock A.

Portfolio P has a standard deviation of 22.5 percent.
Portfolio P has a beta equal to 1.0.
Statements a and b are correct.
Statements a and c are correct.

SML

Answer: e

30

Nile Foods stock has a beta of 1.4 and Elbe Eateries stock has a beta of
0.7. Assume that the risk-free rate, kRF, is 5.5 percent and the market
risk premium, (kM kRF), equals 4 percent.
Which of the following
statements is most correct?

Diff: E

a. Since Niles beta is twice that of Elbes, its required rate of return
will also be twice that of Elbes.
b. If the risk-free rate increases but the market risk premium remains
unchanged, the required return will increase for both stocks but the
increase will be larger for Nile since it has a higher beta.
c. If the market risk premium increases but the risk-free rate remains
unchanged, Niles required return will increase (since it has a beta
greater than 1.0) but Elbes will decline (since it has a beta less
than 1.0).
d. All of the statements above are correct.
Chapter 5 - Page 10

e. None of the statements above is correct.

SML
31

Answer: c
Stock X has a beta of 0.6, while Stock Y has a beta of 1.4.
following statements is most correct?

Diff: E

Which of the

a. Stock Y must have a higher expected return and a higher standard

deviation than Stock X.
b. A portfolio consisting of $50,000 invested in Stock X and $50,000
invested in Stock Y will have a required return that exceeds that of
the overall market.
c. If the market risk premium decreases (but expected inflation is
unchanged), the required return on both stocks will decrease but the
decrease will be greater for Stock Y.
d. If expected inflation increases (but the market risk premium is
unchanged), the required return on both stocks will decrease by the
same amount.
e. If expected inflation decreases (but the market risk premium is
unchanged), the required return on both stocks will decrease but the
decrease will be greater for Stock Y.
SML
32

Answer: b

Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50 percent of
Portfolio P is invested in Stock A and 50 percent is invested in Stock B.
If the market risk premium (kM kRF) were to increase but the risk-free
rate (kRF) remained constant, which of the following would occur?
a. The required return will decrease by the same amount for
and Stock B.
b. The required return will increase for both stocks but the
be greater for Stock B than for Stock A.
c. The required return will increase for Stock A but will
Stock B.
d. The required return will increase for Stock B but will
Stock A.
e. The required return on Portfolio P will remain unchanged.

SML
33

Diff: E

both Stock A
increase will
decrease for
decrease for

Answer: e

Diff: E

Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio
P has 50 percent invested in both Stocks A and B.
Which of the
following would occur if the market risk premium increased by
1 percentage point? (Assume that the risk-free rate remains constant.)
a. The required return for Stock A would fall but the required return
for Stock B would increase.
b. The required return for Portfolio P would remain unchanged.
c. The required return for both stocks would increase by 1 percentage
point.
d. The required return for Stock A would increase by more than
1 percentage point, while the return for Stock B would increase by
Chapter 5 - Page 11

less than 1 percentage point.

e. The required return for Portfolio P would increase by 1 percentage
point.
SML
34

Answer: b

Diff: E

Assume that the risk-free rate remains constant, but that the market
risk premium declines. Which of the following is likely to occur?
a. The required return on a stock with a beta = 1.0 will remain the
same.
b. The required return on a stock with a beta < 1.0 will decline.
c. The required return on a stock with a beta > 1.0 will increase.
d. Statements b and c are correct.
e. All of the statements above are correct.

SML, CAPM, and beta

35

Answer: e

Diff: E

Which of the following statements is most correct?

a. The slope of the security market line is beta.
b. A stock with a negative beta must have a negative required rate of
return.
c. If a stocks beta doubles its required rate of return must double.
d. If a stock has a beta equal to 1.0, its required rate of return will
be unaffected by changes in the market risk premium.
e. None of the statements above is correct.

Risk analysis and portfolio diversification

36

Answer: d

Diff: E

Which of the following statements is most correct?

a. Portfolio diversification reduces the variability of the returns on
the individual stocks held in the portfolio.
b. If an investor buys enough stocks, he or she can, through
diversification, eliminate virtually all of the nonmarket (or
company-specific) risk inherent in owning stocks.
Indeed, if the
portfolio contained all publicly traded stocks, it would be riskless.
c. The required return on a firms common stock is determined by its
systematic (or market) risk. If the systematic risk is known, and if
that risk is expected to remain constant, then no other information
is required to specify the firms required return.
d. A securitys beta measures its nondiversifiable (systematic, or
market) risk relative to that of an average stock.
e. A stocks 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

37

Answer: c

Diff: E

Consider the following information for three stocks, Stock A, Stock B,

and Stock C.
The returns on each of the three stocks are positively
correlated, but they are not perfectly correlated. (That is, all of the
correlation coefficients are between 0 and 1.)
Expected
Return
10%
10
12

Stock
Stock A
Stock B
Stock C

Standard
Deviation
20%
20
20

Beta
1.0
1.0
1.4

Portfolio P has half of its funds invested in Stock A and half invested
in Stock B. Portfolio Q has one third of its funds invested in each of
the three stocks. The risk-free rate is 5 percent, and the market is in
equilibrium. (That is, required returns equal expected returns.) Which
of the following statements is most correct?
a.
b.
c.
d.
e.

Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Stock A.

P has a standard deviation of 20 percent.

Ps coefficient of variation is greater than 2.0.
Qs expected return is 10.67 percent.
Q has a standard deviation of 20 percent.
Ps required return is greater than the required return on

Medium:
Risk aversion
38

Answer: b

Diff: M

You have developed the following data on three stocks:

Stock
A
B
C

Standard Deviation
0.15
0.25
0.20

Beta
0.79
0.61
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 welldiversified portfolio.
a.
b.
c.
d.
e.

A;
A;
B;
C;
C;

A
B
A
A
B

Chapter 5 - Page 13

SML and risk aversion

39

Answer: e

Diff: M

Assume that investors become increasingly risk averse, so that the

market risk premium increases. Also, assume that the risk-free rate and
expected inflation remain the same.
Which of the following is most
likely to occur?
a. The required rate of return will decline for stocks that have betas
less than 1.0.
b. The required rate of return on the market, kM, will remain the same.
c. The required rate of return for each stock in the market will
increase by an amount equal to the increase in the market risk
premium.
d. Statements a and b are correct.
e. None of the statements above is correct.

Portfolio risk and return

40

Answer: c

Diff: M

In a portfolio of three different stocks, which of the following could

not be true?
a. The riskiness of the portfolio is less than the riskiness of each of
the stocks if each were held in isolation.
b. The riskiness of the portfolio is greater than the riskiness of one
or two of the stocks.
c. The beta of the portfolio is less than the beta of each of the
individual stocks.
d. The beta of the portfolio is greater than the beta of one or two of
the individual stocks betas.
e. None of the above (that is, they all could be true, but not
necessarily at the same time).

Portfolio risk and return

41

Answer: d

Diff: M

Stock A has an expected return of 10 percent and a standard deviation of

20 percent. Stock B has an expected return of 12 percent and a standard
deviation of 30 percent. The risk-free rate is 5 percent and the market
risk premium, kM - kRF, is 6 percent.
Assume that the market is in
equilibrium.
Portfolio P has 50 percent invested in Stock A and 50
percent invested in Stock B.
The returns of Stock A and Stock B are
independent of one another.
(That is, their correlation coefficient
equals zero.) Which of the following statements is most correct?
a.
b.
c.
d.
e.

Portfolio Ps expected return is 11 percent.

Portfolio Ps standard deviation is less than 25 percent.
Stock Bs beta is 1.25.
Statements a and b are correct.
All of the statements above are correct.

Chapter 5 - Page 14

Portfolio risk and return

42

Answer: d

Diff: M

Stock A has a beta of 1.2 and a standard deviation of 25 percent. Stock B

has a beta of 1.4 and a standard deviation of 20 percent. Portfolio P was
created by investing in a combination of Stocks A and B. Portfolio P has
a beta of 1.25 and a standard deviation of 18 percent.
Which of the
following statements is most correct?
a. Portfolio P has the same amount of money invested in each of the two
stocks.
b. The returns of the two stocks are perfectly positively correlated (r =
1.0).
c. Stock A has more market risk than Stock B but less stand-alone risk.
d. Portfolio Ps required return is greater than Stock As required return.
e. Stock A has more market risk than Portfolio P.

Portfolio risk
43

Answer: e

Diff: M

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 companyspecific 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.

Portfolio risk and beta

44

Answer: c

Stock A has a beta = 0.8, while Stock B has a beta = 1.6.

following statements is most correct?

Diff: M

Which of the

a. Stock Bs required return is double that of Stock As.

b. An equally weighted portfolio of Stock A and Stock B will have a beta
less than 1.2.
c. If market participants become more risk averse, the required return
on Stock B will increase more than the required return for Stock A.
d. All of the statements above are correct.
e. Statements a and c are correct.

Chapter 5 - Page 15

Portfolio risk and beta

45

Answer: e

Diff: M

Which of the following statements is most correct?

a. If you add enough randomly selected stocks to a portfolio, you can
completely eliminate all the market risk from the portfolio.
b. If you formed a portfolio that included a large number of low-beta
stocks (stocks with betas less than 1.0 but greater than -1.0), the
portfolio would itself have a beta coefficient that is equal to the
weighted average beta of the stocks in the portfolio, so the
portfolio would have a relatively low degree of risk.
c. If you were restricted to investing in publicly traded common stocks,
yet you wanted to minimize the riskiness of your portfolio as
measured by its beta, then according to the CAPM theory you should
invest some of your money in each stock in the market. That is, if
there were 10,000 traded stocks in the world, the least risky
portfolio would include some shares in each of them.
d. Diversifiable risk can be eliminated by forming a large portfolio, but
normally even highly-diversified portfolios are subject to market risk.
e. Statements b and d are correct.

Market risk
46

Company-specific risk that can be diversified away.

Market risk.
Systematic risk that can be diversified away.
Diversifiable risk.
Unsystematic risk that can be diversified away.

Beta coefficient
.

Diff: M

Inflation, recession, and high interest rates are economic events that
are characterized as
a.
b.
c.
d.
e.

47

Answer: b

Answer: a

Diff: M

Which of the following statements is most correct?

a. The 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 index.
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.
b. 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, kRF.
c. If you found a stock with a zero beta and held it as the only stock
in your portfolio, you would by definition have a riskless portfolio.
Your 1-stock portfolio would be even less risky if the stock had a
negative beta.
d. The beta of a portfolio of stocks is always larger than the betas of
any of the individual stocks.
e. All of the statements above are correct.

Chapter 5 - Page 16

Beta coefficient
48

Answer: d

You have developed data that give (1) the average annual returns on the
market for the past five years, and (2) similar information on Stocks A
and B. If these data are as follows, which of the possible answers best
describes the historical betas for A and B?
Years
1
2
3
4
5
a.
b.
c.
d.
e.

bA
bA
bA
bA
bA

Market
0.03
-0.05
0.01
-0.10
0.06

Stock A
0.16
0.20
0.18
0.25
0.14

Stock B
0.05
0.05
0.05
0.05
0.05

> 0; bB = 1
> +1; bB = 0
= 0; bB = -1
< 0; bB = 0
< -1; bB = 1

Beta coefficient
49

Diff: M

Answer: a

Diff: M

Which of the following statements is most correct?

a. Suppose the returns on two stocks are negatively correlated. One has a
beta of 1.2 as determined in a regression analysis, while the other has
a beta of -0.6. The returns on the stock with the negative beta will
be negatively correlated with returns on most other stocks in the
market.
b. Suppose 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.
That is, you are confident the market is
about to rise sharply. You should sell your high-beta stocks and buy
low-beta stocks in order to take advantage of the expected market move.
c. Collections Inc. is in the business of collecting past-due accounts for
other companies; that is, it is a collection agency.
Collections
revenues, profits, and stock price tend to rise during recessions. This
suggests that Collections Inc.s beta should be quite high, say 2.0,
because it does so much better than most other companies when the
economy is weak.
d. Statements a and b are correct.
e. Statements a and c are correct.

Chapter 5 - Page 17

Beta coefficient
50

Answer: c

Which of the following is

estimation?

not

Diff: M

a difficulty concerning beta and its

a. Sometimes a security or project does not have a past history that can
be used as a basis for calculating beta.
b. Sometimes, 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 true or expected future
beta.
c. The beta of an average stock, or the market, can change over time,
sometimes drastically.
d. Sometimes 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
51

Answer: d

Sun Microsystems,
Amazon.com,
Ford Motor Company,
Florida Power & Light,
Wal-Mart,

Beta
Beta
Beta
Beta
Beta

=
=
=
=
=

1.59.
1.70.
0.92.
1.52.
1.15.

SML
.

Certain firms and industries are characterized by consistently low or

high betas, depending on the particular situation. On the basis of that
notion, which of the following companies seems out of place with its
stated beta? (That is, one of the following companies definitely could
not have the indicated beta, while the other companies seem well matched
with their stated betas.)
a.
b.
c.
d.
e.

52

Diff: M

Answer: e

Diff: M

Which of the following statements is most correct?

a. The SML relates required returns to firms market risk. The slope and
intercept of this line cannot be controlled by the financial manager.
b. The slope of the SML is determined by the value of beta.
c. If 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 CAPM would indicate that the required rate of return on
the stock should be less than the risk-free rate for a welldiversified investor, assuming that the observed relationship is
expected to continue on into the future.
d. If investors become less risk averse, the slope of the Security Market
Line will increase.
e. Statements a and c are correct.

Chapter 5 - Page 18

SML
53

Answer: a

Other things held constant, (1) if the expected inflation rate decreases,
and (2) investors become more risk averse, the Security Market Line would
shift
a.
b.
c.
d.
e.

SML
54

Diff: M

Down and have a steeper slope.

Up and have a less steep slope.
Up and keep the same slope.
Down and keep the same slope.
Down and have a less steep slope.
Answer: b

Diff: M

Which of the following statements is most correct about a stock that has a
beta = 1.2?
a. If the stocks beta doubles its expected return will double.
b. If expected inflation increases 3 percent, the stocks expected return
will increase by 3 percent.
c. If the market risk premium increases by 3 percent the stocks expected
return will increase by less than 3 percent.
d. All of the statements above are correct.
e. Statements b and c are correct.

SML
55

Answer: b

Diff: M

Assume that the risk-free rate, kRF, increases but the market risk
premium, (kM kRF) declines. The net effect is that the overall expected
return on the market, kM, remains constant.
Which of the following
statements is most correct?
a. The required return will decline for stocks that have a beta less than
1.0 but will increase for stocks that have a beta greater than 1.0.
b. The required return will increase for stocks that have a beta less than
1.0 but will decline for stocks that have a beta greater than 1.0.
c. The required return of all stocks will fall by the amount of the
decline in the market risk premium.
d. The required return of all stocks will increase by the amount of the
increase in the risk-free rate.
e. Since the overall return on the market stays constant, the required
return on all stocks will remain the same.

Chapter 5 - Page 19

SML, CAPM, and portfolio risk

56

Answer: a

Diff: M

Which of the following statements is most correct?

a. An increase in expected inflation could be expected to increase the
required return on a riskless asset and on an average stock by the
same amount, other things held constant.
b. A graph of the SML would show required rates of return on the vertical
axis and standard deviations of returns on the horizontal axis.
c. If two normal or typical stocks were combined to form a 2-stock
portfolio, the portfolios expected return would be a weighted average
of the stocks expected returns, but the portfolios standard
deviation would probably be greater than the average of the stocks
standard deviations.
d. If investors became more risk averse, then (1) the slope of the SML
would increase and (2) the required rate of return on low-beta stocks
would increase by more than the required return on high-beta stocks.
e. The CAPM has been thoroughly tested, and the theory has been confirmed
beyond any reasonable doubt.

Portfolio return, CAPM, and beta

57

Answer: e

Diff: M

Which of the following statements is most correct?

a. If the returns from two stocks are perfectly positively correlated
(that is, the correlation coefficient is +1) and the two stocks have
equal variance, an equally weighted portfolio of the two stocks will
have a variance that is less than that of the individual stocks.
b. If a stock has a negative beta, its expected return must be negative.
c. According to the CAPM, stocks with higher standard deviations of
returns will have higher expected returns.
d. A portfolio with a large number of randomly selected stocks will have
less market risk than a single stock that has a beta equal to 0.5.
e. None of the statements above is correct.

CAPM and required return

58

Answer: d

Diff: M

Which of the following statements is most correct?

a. We would observe a downward shift in the required returns
stocks if investors believed that there would be deflation
economy.
b. If investors became more risk averse, then the new security
line would have a steeper slope.
c. If the beta of a company doubles, then the required rate of
will also double.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 5 - Page 20

of all
in the
market
return

Risk analysis and portfolio diversification

59

Answer: e

Diff: M

Which of the following statements is most correct?

a. If you add enough randomly selected stocks to a portfolio, you can
completely eliminate all the market risk from the portfolio.
b. If you form a large portfolio of stocks each with a beta greater than
1.0, this portfolio will have more market risk than a single stock
with a beta = 0.8.
c. Company-specific (or unsystematic) risk can be reduced by forming a
large portfolio, but normally even highly-diversified portfolios are
subject to market (or systematic) risk.
d. All of the statements above are correct.
e. Statements b and c are correct.

Portfolio diversification
60

Answer: c

Diff: M

Jane holds a large diversified portfolio of 100 randomly selected stocks

and the portfolios beta = 1.2.
Each of the individual stocks in her
portfolio has a standard deviation of 20 percent.
Jack has the same
amount of money invested in a single stock with a beta equal to 1.6 and a
standard deviation of 20 percent. Which of the following statements is
most correct?
a. Janes portfolio has a larger amount of company-specific risk since she
is holding more stocks in her portfolio.
b. Jane has a higher required rate of return, since she is more
diversified.
c. Janes portfolio has less market risk since it has a lower beta.
d. Statements b and c are correct.
e. None of the statements above is correct.

Portfolio risk and SML

61

Answer: e

Diff: M

Which of the following statements is most correct?

a. It 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. The market risk premium will increase if, on average, market
participants become more risk averse.
c. If 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.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 5 - Page 21

Tough:
CAPM
62

Answer: c

Diff: T

Which of the following statements is most correct?

a. According to CAPM theory, the required rate of return on a given stock
can be found by use of the SML equation:
ki = kRF + (kM - kRF)bi.

b.

c.

d.
e.
SML
63

Expectations for inflation are not reflected anywhere in this

equation, even indirectly, and because of that the text notes that the
CAPM may not be strictly correct.
If the required rate of return is given by the SML equation as set
forth in Statement a, there is nothing a financial manager can do to
change his or her companys cost of capital, because each of the
elements in the equation is determined exclusively by the market, not
by the type of actions a companys management can take, even in the
long run.
Assume that the required rate of return on the market is currently
kM = 15%, and that kM remains fixed at that level. If the yield curve
has a steep upward slope, the calculated market risk premium would be
larger if the 30-day T-bill rate were used as the risk-free rate than
if the 30-year T-bond rate were used as kRF.
Statements a and b are correct.
Statements a and c are correct.

Answer: d

Diff: T

Which of the following statements is most correct?

a. If investors become more risk averse but k RF remains constant, the
required rate of return on high-beta stocks will rise, the required
return on low-beta stocks will decline, but the required return on
an average-risk stock will not change.
b. If Mutual Fund A held equal amounts of 100 stocks, each of which had
a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with
betas of 1.0, then the two mutual funds would both have betas of 1.0.
Thus, they would be equally risky from an investors standpoint.
c. An investor who holds just one stock will be exposed to more risk
than an investor who holds a portfolio of stocks, assuming the
stocks are all equally risky.
Since the holder of the 1-stock
portfolio is exposed to more risk, he or she can expect to earn a
higher rate of return to compensate for the greater risk.
d. Assume that the required rate of return on the market, kM, is given
and fixed.
If the yield curve were upward-sloping, then the
Security Market Line (SML) would have a steeper slope if 1-year
Treasury securities were used as the risk-free rate than if 30-year
Treasury bonds were used for kRF.
e. None of the statements above is correct.

Chapter 5 - Page 22

Multiple Choice: Problems

Easy:
Required return
64

Diff: E

12.4%
13.4%
14.4%
15.4%
16.4%

CAPM and required return

.

Answer: b

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.
b.
c.
d.
e.

66

12.0%
12.2%
12.8%
13.2%
13.5%

Required return
.

Diff: E

The risk-free rate of interest, k RF, is 6 percent.

The overall stock
market has an expected return of 12 percent. Hazlett, Inc. has a beta of
1.2. What is the required return of Hazlett, Inc. stock?
a.
b.
c.
d.
e.

65

Answer: d

Answer: d

Diff: E

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.
b.
c.
d.
e.

15%
16%
17%
18%
20%

Chapter 5 - Page 23

CAPM and market risk premium

67

Answer: c

Diff: E

Consider the following information for three stocks, Stock A, Stock B,

and Stock C.
The returns on each of the three stocks are positively
correlated, but they are not perfectly correlated. (That is, all of the
correlation coefficients are between 0 and 1.)
Stock
Stock A
Stock B
Stock C

Expected
Return
10%
10
12

Standard
Deviation
20%
20
20

Beta
1.0
1.0
1.4

Portfolio P has half of its funds invested in Stock A and half invested
in Stock B. Portfolio Q has one third of its funds invested in each of
the three stocks. The risk-free rate is 5 percent, and the market is in
equilibrium. (That is, required returns equal expected returns.) What
is the market risk premium (kM - kRF)?
a.
b.
c.
d.
e.

4.0%
4.5%
5.0%
5.5%
6.0%

Market risk premium

68

Answer: d

Diff: E

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%

Beta coefficient
69

Answer: b

Diff: E

Given the following information, determine which beta coefficient for

Stock A is consistent with equilibrium:

A = 11.3%; kRF = 5%; kM = 10%

k
a.
b.
c.
d.
e.

0.86
1.26
1.10
0.80
1.35

Chapter 5 - Page 24

Beta coefficient
70

Answer: a

Assume that the risk-free rate is 5 percent and that the market risk
premium is 7 percent. If a stock has a required rate of return of 13.75
percent, what is its beta?
a.
b.
c.
d.
e.

1.25
1.35
1.37
1.60
1.96

Portfolio beta
71

Answer: b

1.165
1.235
1.250
1.284
1.333

Portfolio return
.

Answer: a

6.6%
6.8%
5.8%
7.0%
7.5%

Portfolio return
.

Diff: E

An investor is forming a portfolio by investing $50,000 in stock A that

has a beta of 1.50, and $25,000 in stock B that has a beta of 0.90. The
return on the market is equal to 6 percent and Treasury bonds have a
yield of 4 percent. What is the required rate of return on the
investors portfolio?
a.
b.
c.
d.
e.

73

Diff: E

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.
b.
c.
d.
e.

72

Diff: E

Answer: b

Diff: E

You are an investor in common stocks, and you currently hold a welldiversified portfolio that has an expected return of 12 percent, a beta
of 1.2, and a total value of $9,000. You plan to increase your portfolio
by buying 100 shares of AT&E at $10 a share. AT&E has an expected return
of 20 percent with a beta of 2.0. What will be the expected return and
the beta of your portfolio after you purchase the new stock?
a.
b.
c.
d.

p
k
p
k
p
k
p
k

=
=
=
=

20.0%;
12.8%;
12.0%;
13.2%;

bp
bp
bp
bp

=
=
=
=

2.00
1.28
1.20
1.40
Chapter 5 - Page 25

p = 14.0%; bp = 1.32
e. k
Portfolio risk and return
74

Answer: a

Portfolio Ps expected return is 11.5 percent.

Portfolio Ps standard deviation is 18.75 percent.
Portfolio Ps beta is less than 1.2.
Statements a and b are correct.
Statements a and c are correct.

Coefficient of variation
.

Stock A has an expected return of 12 percent, a beta of 1.2, and a

standard deviation of 20 percent. Stock B has an expected return of 10
percent, a beta of 1.2, and a standard deviation of 15 percent. Portfolio
P has $900,000 invested in Stock A and $300,000 invested in Stock B. The
correlation between Stock As returns and Stock Bs returns is zero (that
is, r = 0). Which of the following statements is most correct?
a.
b.
c.
d.
e.

75

Diff: E

Below are the

Industries:

Answer: b

stock
Year
2002
2001
2000
1999
1998

returns

for

the

past

five

years

for

Diff: E
Agnew

Stock Return
22%
33
1
-12
10

What was the stocks coefficient of variation during this 5-year period?
(Use the population standard deviation to calculate the coefficient of
variation.)
a. 10.80
b. 1.46
c. 15.72
d. 0.69
e. 4.22

Chapter 5 - Page 26

Medium:
Expected return
76

Answer: e

Diff: M

Assume a new law is passed that restricts investors to holding only one
asset. A risk-averse investor is considering two possible assets as the
asset to be held in isolation. The assets possible returns and related
probabilities (that is, the probability distributions) are as follows:
Asset X
P
k
0.10
-3%
0.10
2
0.25
5
0.25
8
0.30
10

Asset Y
P
k
0.05
-3%
0.10
2
0.30
5
0.30
8
0.25
10

Which asset should be preferred?

a.
b.
c.
d.
e.

Asset X, since its expected return is higher.

Asset Y, since its beta is probably lower.
Either one, since the expected returns are the same.
Asset X, since its standard deviation is lower.
Asset Y, since its coefficient of variation is
expected return is higher.

Expected return
77

Answer: c

a.
b.
c.
d.
e.

its

Diff: M

Pi
0.2
0.6
0.2

kJ
10%
15
20

15%; 6.50%
12%; 5.18%
15%; 3.16%
15%; 10.00%
20%; 5.00%

Required return
.

and

Given the following probability distribution, what are the expected

return and the standard deviation of returns for Security J?
State
1
2
3

78

lower

Answer: c

Diff: M

You are holding a stock that has a beta of 2.0 and is currently in
equilibrium. The required return on the stock is 15 percent, and the
return on an average stock is 10 percent. What would be the percentage
change in the return on the stock, if the return on an average stock
increased by 30 percent while the risk-free rate remained unchanged?
a.
b.
c.
d.
e.

+20%
+30%
+40%
+50%
+60%

Chapter 5 - Page 27

Required return
79

Answer: c

Oakdale Furniture Inc. has a beta coefficient of 0.7 and a required rate
of return of 15 percent. The market risk premium is currently 5 percent.
If the inflation premium increases by 2 percentage points, and Oakdale
acquires new assets that increase its beta by 50 percent, what will be
Oakdales new required rate of return?
a.
b.
c.
d.
e.

13.50%
22.80%
18.75%
15.25%
17.00%

Required return
80

Answer: e

7.0%
10.4%
12.0%
11.0%
10.0%

Expected and required returns

.

Diff: M

Partridge Plastics stock has an estimated beta of 1.4, and its required
rate of return is 13 percent. Cleaver Motors stock has a beta of 0.8,
and the risk-free rate is 6 percent.
What is the required rate of
return on Cleaver Motors stock?
a.
b.
c.
d.
e.

81

Diff: M

Answer: c

Diff: M

The realized returns for the market and Stock J for the last four years
are given below:
Year
1
2
3
4

Market
10%
15
-5
0

Stock J
5%
0
14
10

An average stock has an expected return of 12 percent and the market

risk premium is 4 percent.
If Stock Js expected rate of return as
viewed by a marginal investor is 8 percent, what is the difference
between Js expected and required rates of return?
a.
b.
c.
d.
e.

0.66%
1.25%
2.64%
3.72%
5.36%

Chapter 5 - Page 28

Expected and required returns

82

Answer: b

Diff: M

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 (kRF) is 7 percent and the market risk premium
(kM - kRF) 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

CAPM and required return

83

1.0%
2.5%
4.5%
5.4%
6.0%

CAPM and required return

.

Diff: M

HR Corporation has a beta of 2.0, while LR Corporations beta is 0.5.

The risk-free rate is 10 percent, and the required rate of return on an
average stock is 15 percent. Now the expected rate of inflation built
into kRF falls by 3 percentage points, the real risk-free rate remains
constant, the required 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 required returns on HRs and LRs stocks?
a.
b.
c.
d.
e.

84

Answer: e

Answer: a

Diff: M

Bradley Hotels has a beta of 1.3, while Douglas Farms has a beta of 0.7.
The required return on an index fund that holds the entire stock market
is 12 percent.
The risk-free rate of interest is 7 percent.
By how
much does Bradleys required return exceed Douglas required return?
a.
b.
c.
d.
e.

3.0%
6.5%
5.0%
6.0%
7.0%

Chapter 5 - Page 29

CAPM and required return

85

Answer: d

Company X has a beta of 1.6, while Company Ys beta is 0.7. The riskfree rate is 7 percent, and the required rate of return on an average
stock is 12 percent. Now the expected rate of inflation built into k RF
rises by 1 percentage point, the real risk-free rate remains constant,
the required return on the market rises to 14 percent, and betas remain
constant. After all of these changes have been reflected in the data,
by how much will the required return on Stock X exceed that on Stock Y?
a.
b.
c.
d.
e.

3.75%
4.20%
4.82%
5.40%
5.75%

CAPM and required return

86

Diff: M

Answer: e

Diff: M

Historical rates of return for the market and for Stock A are given
below:
Year
1
2
3
4

Market
6.0%
-8.0
-8.0
18.0

Stock A
8.0%
3.0
-2.0
12.0

If the required return on the market is 11 percent and the risk-free

rate is 6 percent, what is the required return on Stock A, according to
CAPM/SML theory?
a.
b.
c.
d.
e.

6.00%
6.57%
7.25%
7.79%
8.27%

Chapter 5 - Page 30

CAPM and required return

87

Answer: a

Diff: M

Some returns data for the market and for Countercyclical Corp. are given
below:
Year
1999
2000
2001
2002

Market
-2.0%
12.0
-8.0
21.0

Countercyclical
8.0%
3.0
18.0
-7.0

The required return on the market is 14 percent and the risk-free rate
is 8 percent.
What is the required return on Countercyclical Corp.
according to CAPM/SML theory?
a. 3.42%
b. 4.58%
c. 8.00%
d. 11.76%
e. 14.00%
Portfolio return
88

Answer: c

Diff: M

Stock X, Stock Y, and the market have had the following returns over the
past four years.
Year
1999
2000
2001
2002

Market
11%
7
17
-3

X
10%
4
12
-2

Y
12%
-3
21
-5

The risk-free rate is 7 percent. The market risk premium is 5 percent.

What is the required rate of return for a portfolio that consists of
$14,000 invested in Stock X and $6,000 invested in Stock Y?
a.
b.
c.
d.
e.

9.94%
10.68%
11.58%
12.41%
13.67%

Chapter 5 - Page 31

Portfolio return
89

Answer: b

Diff: M

The risk-free rate, kRF, is 6 percent and the market risk premium,
(kM kRF), is 5 percent. Assume that required returns are based on the
CAPM. Your $1 million portfolio consists of $700,000 invested in a stock
that has a beta of 1.2 and $300,000 invested in a stock that has a beta of
0.8. Which of the following statements is most correct?
a. The portfolios required return is less than 11 percent.
b. If the risk-free rate remains unchanged but the market risk premium
increases by 2 percentage points, the required return on your portfolio
will increase by more than 2 percentage points.
c. If the market risk premium remains unchanged but expected inflation
increases by 2 percentage points, the required return on your portfolio
will increase by more than 2 percentage points.
d. If the stock market is efficient, your portfolios expected return
should equal the expected return on the market, which is 11 percent.
e. None of the statements above is correct.

Portfolio return
90

Answer: c

Diff: M

A portfolio manager is holding the following investments:

Stock
X
Y
Z

Amount Invested
$10 million
20 million
40 million

Beta
1.4
1.0
0.8

The manager plans to sell his holdings of Stock Y. The money from the
sale will be used to purchase another $15 million of Stock X and another
$5 million of Stock Z. The risk-free rate is 5 percent and the market
risk premium is 5.5 percent. How many percentage points higher will the
required return on the portfolio be after he completes this transaction?
a.
b.
c.
d.
e.

0.07%
0.18%
0.39%
0.67%
1.34%

Portfolio return
91

Answer: b

Diff: M

Assume that the risk-free rate is 5.5 percent and the market risk premium
is 6 percent.
A money manager has $10 million invested in a portfolio
that has a required return of 12 percent. The manager plans to sell $3
million of stock with a beta of 1.6 that is part of the portfolio. She
plans to reinvest this $3 million into another stock that has a beta of
0.7. If she goes ahead with this planned transaction, what will be the
required return of her new portfolio?
a.
b.
c.
d.

10.52%
10.38%
11.31%
10.90%

Chapter 5 - Page 32

e.

8.28%

Chapter 5 - Page 33

Portfolio return
92

23.33%
33.33%
53.33%
66.66%
76.66%

CAPM and portfolio return

.

Diff: M

The current risk-free rate is 6 percent and the market risk premium is
5 percent. Erika is preparing to invest $30,000 in the market and she
wants her portfolio to have an expected return of 12.5 percent. Erika
is concerned about bearing too much stand-alone risk; therefore, she
will diversify her portfolio by investing in three different assets (two
mutual funds and a risk-free security). The three assets she will be
investing in are an aggressive growth mutual fund that has a beta of
1.6, an S&P 500 index fund with a beta of 1, and a risk-free security
that has a beta of 0. She has already decided that she will invest 10
percent of her money in the risk-free asset. In order to achieve the
desired expected return of 12.5 percent, what proportion of Erikas
portfolio must be invested in the S&P 500 index fund?
a.
b.
c.
d.
e.

93

Answer: a

Answer: d

Diff: M

Your portfolio consists of $100,000 invested in a stock that has a beta =

0.8, $150,000 invested in a stock that has a beta = 1.2, and $50,000
invested in a stock that has a beta = 1.8.
The risk-free rate is
7 percent. Last year this portfolio had a required rate of return of 13
percent.
This year nothing has changed except for the fact that the
market risk premium has increased by 2 percent (two percentage points).
What is the portfolios current required rate of return?
a. 5.14%
b. 7.14%
c. 11.45%
d. 15.33%
e. 16.25%

CAPM and portfolio return

94

Answer: b

Diff: M

Currently, the risk-free rate is 5 percent and the market risk premium
is 6 percent. You have your money invested in three assets: an index
fund that has a beta of 1.0, a risk-free security that has a beta of 0,
and an international fund that has a beta of 1.5. You want to have 20
percent of your portfolio invested in the risk-free asset, and you want
your overall portfolio to have an expected return of 11 percent. What
portion of your overall portfolio should you invest in the international fund?
a.
b.
c.
d.
e.

0%
40%
50%
60%
80%

Chapter 5 - Page 34

CAPM and portfolio return

95

Answer: c

Diff: M

A money manager is holding a $10 million portfolio that consists of the

following five stocks:
Stock
A
B
C
D
E

Amount Invested
$4 million
2 million
2 million
1 million
1 million

Beta
1.2
1.1
1.0
0.7
0.5

The portfolio has a required return of 11 percent, and the market risk
premium, kM kRF, is 5 percent. What is the required return on Stock C?
a.
b.
c.
d.
e.

7.2%
10.0%
10.9%
11.0%
11.5%

CAPM and portfolio return

96

12.00%
12.25%
13.17%
14.12%
13.67%

CAPM and portfolio return

.

Diff: M

You have been managing a $1 million portfolio. The portfolio has a beta
of 1.6 and a required rate of return of 14 percent. The current riskfree rate is 6 percent. Assume that you receive another $200,000. If
you invest the money in a stock that has a beta of 0.6, what will be the
required return on your $1.2 million portfolio?
a.
b.
c.
d.
e.

97

Answer: c

Answer: c

Diff: M

Currently, the risk-free rate, kRF, is 5 percent and the required return
on the market, kM, is 11 percent. Your portfolio has a required rate of
return of 9 percent. Your sister has a portfolio with a beta that is
twice the beta of your portfolio. What is the required rate of return
on your sisters portfolio?
a.
b.
c.
d.
e.

12.0%
12.5%
13.0%
17.0%
18.0%

Chapter 5 - Page 35

CAPM and portfolio return

98

Diff: M

1.12
1.20
1.22
1.10
1.15

Portfolio beta
.

Answer: b

You hold a diversified portfolio consisting of a $5,000 investment in

each of 20 different common stocks.
The portfolio beta is equal to
1.15. You have decided to sell one of your stocks, a lead mining stock
whose b is equal to 1.0, for $5,000 net and to use the proceeds to buy
$5,000 of stock in a steel company whose b is equal to 2.0. What will
be the new beta of the portfolio?
a.
b.
c.
d.
e.

100

20%
40%
50%
60%
80%

Portfolio beta
.

Diff: M

Stock A has an expected return of 10 percent and a beta of 1.0. Stock B

has a beta of 2.0. Portfolio P is a two-stock portfolio, where part of
the portfolio is invested in Stock A and the other part is invested in
Stock B.
Assume that the risk-free rate is 5 percent, that required
returns are determined by the CAPM, and that the market is in equilibrium
so that expected returns equal required returns.
Portfolio P has an
expected return of 12 percent. What proportion of Portfolio P consists
of Stock B?
a.
b.
c.
d.
e.

99

Answer: b

Answer: c

Diff: M

A mutual fund manager has a $200,000,000 portfolio with a beta = 1.2.

Assume that the risk-free rate is 6 percent and that the market risk
premium is also 6 percent. The manager expects to receive an additional
$50,000,000 in funds soon. She wants to invest these funds in a variety
of stocks.
After making these additional investments she wants the
funds expected return to be 13.5 percent. What should be the average
beta of the new stocks added to the portfolio?
a.
b.
c.
d.
e.

1.10
1.33
1.45
1.64
1.87

Chapter 5 - Page 36

Portfolio beta
101

Answer: e

Walter Jasper currently manages a $500,000 portfolio. He is expecting to

receive an additional $250,000 from a new client. The existing portfolio
has a required return of 10.75 percent. The risk-free rate is 4 percent
and the return on the market is 9 percent. If Walter wants the required
return on the new portfolio to be 11.5 percent, what should be the average
beta for the new stocks added to the portfolio?
a.
b.
c.
d.
e.

1.50
2.00
1.67
1.35
1.80

Portfolio return and beta

102

Diff: M

Answer: a

Diff: M

A portfolio manager is holding the following investments in her portfolio:

Stock
1
2
3

Amount
$300
200
500

Invested
million
million
million

Beta
0.7
1.0
1.6

The risk-free rate, kRF, is 5 percent and the portfolio has a required
return of 11.655 percent. The manager is thinking about selling all of
her holdings of Stock 3, and instead investing the money in Stock 4, which
has a beta of 0.9.
If she were to do this, what would be the new
portfolios required return?
a. 9.73%
b. 11.09%
c. 9.91%
d. 7.81%
e. 10.24%
Portfolio return and beta
103

Answer: e

Diff: M

A fund manager is holding the following stocks:

Stock
1
2
3
4

Amount Invested
$300 million
560 million
320 million
230 million

Beta
1.2
1.4
0.7
1.8

The risk-free rate is 5 percent and the market risk premium is also
5 percent. If the manager sells half of her investment in Stock 2 ($280
million) and puts the money in Stock 4, by how many percentage points will
her portfolios required return increase?
a. 0.36%
b. 0.22%
c. 2.00%
Chapter 5 - Page 37

d. 0.20%
e. 0.40%
Portfolio return and beta
104

Answer: e

A portfolio manager is managing a $10 million portfolio.

portfolio is invested in the following manner:
Investment
Stock 1
Stock 2
Stock 3
Stock 4

Dollar Amount Invested

$2 million
3 million
3 million
2 million

Diff: M

Currently the

Beta
0.6
0.8
1.2
1.4

Currently, the risk-free rate is 5 percent and the portfolio has an

expected return of 10 percent. Assume that the market is in equilibrium
so that expected returns equal required returns. The manager is willing
to take on additional risk and wants to instead earn an expected return
of 12 percent on the portfolio. Her plan is to sell Stock 1 and use the
proceeds to buy another stock. In order to reach her goal, what should
be the beta of the stock that the manager selects to replace Stock 1?
a.
b.
c.
d.
e.

1.40
1.75
2.05
2.40
2.60

Portfolio standard deviation

105

Answer: a

Diff: M

Here are the expected returns on two stocks:

Returns
Probability
0.1
0.8
0.1

X
-20%
20
40

Y
10%
15
20

If you form a 50-50 portfolio of the two stocks, what is the portfolios
standard deviation?
a.
b.
c.
d.
e.

8.1%
10.5%
13.4%
16.5%
20.0%

Chapter 5 - Page 38

Coefficient of variation
106

Answer: e

Diff: M

The CFO of Brady Boots has estimated the rates of return to Bradys stock,
depending on the state of the economy.
He has also compiled analysts
expectations for the economy.
Economy
Recession
Below average
Average
Above average
Boom

Probability
0.1
0.1
0.4
0.2
0.2

Return
-23%
-8
6
17
24

Given this data, what is the companys coefficient of variation? (Use the
population standard deviation, not the sample standard deviation when
calculating the coefficient of variation.)
a. 1.94
b. 25.39
c. 2.26
d. 5.31
e. 1.84
Coefficient of variation
107

Answer: b

Diff: M

Ripken Iron Works faces the following probability distribution:

State of
the Economy
Boom
Normal
Recession

Probability of
State Occurring
0.25
0.50
0.25

Stocks Expected
Return if this
State Occurs
25%
15
5

What is the coefficient of variation on the companys stock?

a.
b.
c.
d.
e.

0.06
0.47
0.54
0.67
0.71

Chapter 5 - Page 39

Coefficient of variation
108

Answer: c

An analyst has estimated how a particular

depending on what will happen to the economy:
State of
the Economy
Recession
Below Average
Average
Above Average
Boom

Probability of
State Occurring
0.10
0.20
0.40
0.20
0.10

stocks

return

Diff: M

will

vary

Stocks Expected
Return if this
State Occurs
-60%
-10
15
40
90

What is the coefficient of variation on the companys stock?

a.
b.
c.
d.
e.

2.121
2.201
2.472
3.334
3.727

Coefficient of variation
109

Answer: c

Diff: M

The following probability distributions of returns for two stocks have

been estimated:
Probability
0.3
0.4
0.3

Returns
Stock A
Stock B
12%
5%
8
4
6
3

What is the coefficient of variation for the stock that is less risky,
assuming you use the coefficient of variation to rank riskiness?
a.
b.
c.
d.
e.

3.62
0.28
0.19
0.66
5.16

Chapter 5 - Page 40

Coefficient of variation
110

Answer: d

Diff: M

A financial analyst is forecasting the expected return for the stock of

Himalayan Motors.
The analyst estimates the following probability
distribution of returns:
Probability
20%
40
20
10
10

Return
-5%
10
20
25
50

On the basis of this analysts forecast, what is the stocks coefficient

of variation?
a.
b.
c.
d.
e.

0.80
0.91
0.96
1.04
1.10

Coefficient of variation
111

Answer: b

A stock market analyst estimates that there is a 25 percent chance the

economy will be weak, a 50 percent chance the economy will be average, and
a 25 percent chance the economy will be strong.
The analyst estimates
that Hartley Industries stock will have a 5 percent return if the economy
is weak, a 15 percent return if the economy is average, and a 30 percent
return if the economy is strong. On the basis of this estimate, what is
the coefficient of variation for Hartley Industries stock?
a.
b.
c.
d.
e.

0.61644
0.54934
0.75498
3.62306
0.63432

Coefficient of variation
112

Diff: M

Answer: b

Diff: M

An analyst has estimated Williamsport Equipments returns under the

following economic states:
Economic State
Recession
Below average
Above average
Boom

Probability
0.20
0.30
0.30
0.20

Expected Return
-24%
-3
+15
+50

What is Williamsports estimated coefficient of variation?

a. 0.36
b. 2.80
c. 2.86
Chapter 5 - Page 41

d. 2.95
e. 3.30
Coefficient of variation
113

Answer: e

Diff: M

Stock Z has had the following returns over the past five years:
Year
1998
1999
2000
2001
2002

Return
10%
12
27
-15
30

What is the companys coefficient of variation

population standard deviation to calculate CV.)

(CV)?

(Use

the

a. 99.91
b. 35.76
c. 9.88
d. 2.79
e. 1.25
Beta coefficient
114

1.6
1.7
1.8
1.9
2.0

Beta coefficient
.

Diff: M

An investor has $5,000 invested in a stock that has an estimated beta of

1.2, and another $15,000 invested in the stock of the company for which
she works. The risk-free rate is 6 percent and the market risk premium
is also 6 percent. The investor calculates that the required rate of
return on her total ($20,000) portfolio is 15 percent. What is the beta
of the company for which she works?
a.
b.
c.
d.
e.

115

Answer: a

Answer: e

Diff: M

Portfolio P has 30 percent invested in Stock X and 70 percent in Stock Y.

The risk-free rate of interest is 6 percent and the market risk premium
is 5 percent.
Portfolio P has a required return of 12 percent and
Stock X has a beta of 0.75. What is the beta of Stock Y?
a.
b.
c.
d.
e.

0.21
1.20
0.96
1.65
1.39

Chapter 5 - Page 42

CAPM and beta coefficient

116

Answer: d

A money manager is managing the account

investor holds the following stocks:
Stock
A
B
C
D

Amount Invested
$2,000,000
5,000,000
3,000,000
5,000,000

of

large

Diff: M

investor.

The

Estimated Beta
0.80
1.10
1.40
????

The portfolios required rate of return is 17 percent.

The risk-free
rate, kRF, is 7 percent and the return on the market, k M, is 14 percent.
What is Stock Ds estimated beta?
a.
b.
c.
d.
e.

1.256
1.389
1.429
2.026
2.154

Market return
117

Answer: d

Diff: M

The returns of United Railroad Inc. (URI) are listed below, along with
the returns on the market:
Year
1
2
3
4
5

URI
-14%
16
22
7
-2

Market
-9%
11
15
5
-1

If the risk-free rate is 9 percent and the required return on URIs

stock is 15 percent, what is the required return on the market? Assume
the market is in equilibrium. (Hint: Think rise over run.)
a. 4%
b. 9%
c. 10%
d. 13%
e. 16%

Chapter 5 - Page 43

Tough:
Portfolio required return
118

Answer: a

Diff: T

A money manager is holding the following portfolio:

Stock
1
2
3
4

Amount Invested
$300,000
300,000
500,000
500,000

Beta
0.6
1.0
1.4
1.8

The risk-free rate is 6 percent and the portfolios required rate of

return is 12.5 percent.
The manager would like to sell all of her
holdings of Stock 1 and use the proceeds to purchase more shares of
Stock 4.
What would be the portfolios required rate of return
following this change?
a.
b.
c.
d.
e.

13.63%
10.29%
11.05%
12.52%
14.33%

Multiple Part:
(The following information applies to the next two problems.)
A portfolio manager has a $10 million portfolio, which consists of $1 million
invested in 10 separate stocks.
The portfolio beta is 1.2.
The risk-free
rate is 5 percent and the market risk premium is 6 percent.
CAPM and portfolio return
119

Answer: d

Diff: E

Answer: c

Diff: M

What is the portfolios required return?

a. 6.20%
b. 9.85%
c. 12.00%
d. 12.20%
e. 12.35%

CAPM and portfolio return

120

The manager sells one of the stocks in her portfolio for $1 million. The
stock she sold has a beta of 0.9. She takes the $1 million and uses the
money to purchase a new stock that has a beta of 1.6.
What is the
required return of her portfolio after purchasing this new stock?
a.
b.
c.
d.
e.

10.75%
12.35%
12.62%
13.35%
14.60%

Chapter 5 - Page 44

Web Appendix 5A
Multiple Choice: Conceptual
Medium:
Beta calculation
121

5A-

Answer: b

Diff: M

Which of the following statements is most correct?

a. The CAPM is an ex ante model, which means that all of the variables
should be historical values that can reasonably be projected into
the future.
b. The beta coefficient used in the SML equation should reflect the
expected volatility of a given stocks return versus the return on
the market during some future period.
c. The general equation: Y = a + bX + e, is the standard form of a
simple linear regression where b = beta, and X equals the
independent return on an individual security being compared to Y,
the return on the market, which is the dependent variable.
d. The rise-over-run method is not a legitimate method of estimating
beta because it measures changes in an individual securitys return
regressed against time.

Multiple Choice: Problems

Easy:
Beta calculation
5A-122.

Answer: c

Diff: E

Given the following returns on Stock J and the market during the
last three years, what is the beta coefficient of Stock J?
(Hint:
Think rise over run.)
Year
1
2
3
a.
b.
c.
d.
e.

Stock J
-13.85%
22.90
35.15

Market
-8.63%
12.37
19.37

0.92
1.10
1.75
2.24
1.45

Chapter 5 - Page 45

Medium:
Beta and base year sensitivity
123

5A-

Answer: a

Given the following returns on Stock Q and the market during the
last three years, what is the difference in the calculated beta
coefficient of Stock Q when Year 1-Year 2 data are used as compared to
Year 2-Year 3 data? (Hint: Think rise over run.)
Year
1
2
3
a.
b.
c.
d.
e.

Stock Q
6.30%
-3.70
21.71

Market
6.10%
12.90
16.20

9.17
1.06
6.23
0.81
0.56

Beta calculation
5A-124.

Diff: M

Answer: b

Diff: M

Stock X, and the market have had the following rates of returns over
the past four years.
Year
1999
2000
2001
2002

Stock X
12%
5
11
-7

Market
14%
2
14
-3

60 percent of your portfolio is invested in Stock X, and the remaining

40 percent is invested in Stock Y.
The risk-free rate is 6 percent
and the market risk premium is also 6 percent. You estimate that 14
percent is the required rate of return on your portfolio. What is the
beta of Stock Y?
a.
b.
c.
d.
e.

1.33
1.91
2.00
2.15
2.33

Chapter 5 - Page 46

Beta calculation
125

5A-

Answer: c

Hanratty Inc.s stock and the stock market

following returns over the past five years:
Year
1
2
3
4
5

Hanratty
13%
18
-5
23
6

have

Diff: E

generated

the

Market (kM)
9%
15
-2
19
12

On the basis of these historical returns, what is the estimated beta

of Hanratty Inc.s stock?
a.
b.
c.
d.
e.

0.7839
0.9988
1.2757
1.3452
1.5000

Beta calculation
5A-

126

Answer: a

Diff: E

Below are the returns for the past five years for Stock S and for the
overall market:
Year
1998
1999
2000
2001
2002

Stock S
12%
34
-29
-11
45

Market (kM)
8%
28
-20
-4
30

What is Stock Ss estimated beta?

a.
b.
c.
d.
e.

1.43
0.69
0.91
1.10
1.50

Chapter 5 - Page 47

Multiple Part:
(The following information applies to the next two problems.)
You have been asked to use a CAPM analysis to choose between Stocks R and S,
with your choice being the one whose expected rate of return exceeds its
required rate of return by the widest margin. The risk-free rate is 6 percent,
and the required return on an average stock (or the market) is 10 percent.
, is
Your security analyst tells you that Stock Ss expected rate of return, k
, is equal to
equal to 11 percent, while Stock Rs expected rate of return, k
12 percent. The CAPM is assumed to be a valid method for selecting stocks, but
the expected return for any given investor (such as you) can differ from the
required rate of return for a given stock. The 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 required rates of return:
Year
1
2
3

Stock R
-15%
5
25

Stock S
0%
5
10

Market
-5%
5
15

Note:
The averages of the historical returns are not needed, and they are
generally not equal to the expected future returns.
Beta calculation
5A-127.

Diff: M

Calculate both stocks betas. What is the difference between the betas?
That is, what is the value of betaR - betaS? (Hint: The graphical method
of calculating the rise over run, or (Y 2 Y1) divided by (X2 X1) may aid
you.)
a.
b.
c.
d.
e.

0.0
1.0
1.5
2.0
2.5

Required rate of return

5A-128.

Answer: c

Answer: e

Diff: M

Set up the SML equation and use it to calculate both stocks required
rates of return, and compare those required returns with the expected
returns given above.
You should invest in the stock whose expected
return exceeds its required return by the widest margin. What is the
- k)?
widest margin, or greatest excess return ( k
a.
b.
c.
d.
e.

0.0%
0.5%
1.0%
2.0%
3.0%

Chapter 5 - Page 48

CHAPTER 5
ANSWERS AND SOLUTIONS

1.

Risk concepts

Answer: e

Diff: E

2.

Risk measures

Answer: a

Diff: E

Statement a is correct, since the coefficient of variation is equal to the

standard deviation divided by the mean. The remaining statements are false.
3.

Market risk premium

CAPM equation:

Answer: c

Diff: E

ks = kRF + (kM - kRF)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.
4.

Standard deviation

Answer: b

Diff: E

5.

Beta coefficient

Answer: d

Diff: E

6.

Beta coefficient

Answer: c

Diff: E

Statement a is false; Y has a higher required return because it is more risky,

but it may still end up actually earning a lower return than X. Statement b is
false; beta tells us about the covariance of the stock with the market.
It
tells us nothing about the stocks individual standard deviations. Statement c
is correct from the CAPM: ks = kRF + (kM kRF)b. Statement d is false from the
CAPM. Statement e is false; the portfolio beta, bp, is calculated as (0.5
0.5) + (0.5 1.5) = 1.0.
7.

Required return

Answer: b

Diff: E

The easiest way to see this is to write out the CAPM:

k s = kRF + (kM kRF)b.
Clearly, a change in the market risk premium is going to have the most effect on
firms with high betas. Consequently, statement b is the correct choice.
8.

Risk and return

Answer: a

Diff: E

9.

The correct answer is statement a.

Stocks are riskier than bonds, with
stocks in small companies being riskier than stocks in larger companies. From
there, corporate bonds are riskier than government bonds, and longer-term
government bonds are riskier than shorter-term ones.
Portfolio risk
Answer: b Diff: E
The 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. Therefore, although the expected return on the
portfolio will be the weighted average of the two returns (10 percent), the
CV will not be equal to 25%/10%. Therefore, statement a is false. Remember,
market risk is measured by beta.
The beta of the portfolio will be the

weighted average of the two betas; therefore, it will be less than the beta
of the high-beta stock (B), but more than the beta of the low-beta stock (A).
Therefore, the market risk of the portfolio will be higher than As, but
lower than Bs. Therefore, statement b is correct. Because the correlation
between the two stocks is less than one, the portfolios standard deviation
will be less than 25 percent. Therefore, statement c is false.
10.

Portfolio risk, return, and beta

Answer: e

Diff: E

The trick here is to notice the word always in each of the answers. If you
can find even one exception to the statement, then the statement will not
always be true.
The exception to statement a is if the correlation coefficient, r, = 1.0.
While this is unlikely to ever happen, theoretically it is still possible.
Therefore, there is an exception, so we cannot necessarily say always.
Therefore, statement a is false.
Beta has nothing to do with the number of
stocks in a portfolio. You can take a stock with a beta of 0.4, and a stock
with a beta of 1.6, and combine them (with equal weights) in a portfolio. The
portfolio beta will now be 1.0, which is higher than a portfolio of just the
first stock. Therefore, statement b is false. Statement c is false for the
same reason that statement b is false.
Consequently, the correct choice is
statement e.
11.

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.
12.

Portfolio risk and return

Answer: e

Diff: E

13.

Portfolio risk and return

Answer: a

Diff: E

The portfolio will have an expected return equal to the weighted average of the
individual stock returns.
The portfolios beta will also be equal to the
weighted average of the individual stock betas. The standard deviation of the
portfolio will be less than 30 percent, because the stocks have a correlation
coefficient of less than one. Therefore, the portfolios beta will equal 1.6,
its standard deviation is less than 30 percent, and its expected return is 15
percent. The correct answer must be statement a.

14.

Portfolio risk and return

Answer: b

Diff: E

Since we are randomly adding stocks, eventually your portfolio will have the
same expected return as the market, on average. Therefore, unless we are told
that the current expected return is higher than the market average, we have no
reason to believe that the expected return will decline. Therefore, statement
a is false. If we randomly add stocks to the portfolio, the company-specific
risk will decline because the standard deviation of the portfolio will be
declining. However, the market risk (as measured by beta) will tend to remain
the same, for the same reason that in statement a the expected return was
unlikely to change. Therefore, statement b is correct. As in statement a, we
know there is no reason to believe that the market risk of the portfolio (as
measured by beta) will decline. Therefore, statement c is false. Neither the
market risk nor the expected return on the portfolio are expected to decline

(see above), so statement d is false. The company-specific risk (as measured

by the standard deviation of the portfolio) will decline and market risk is not
expected to change. Therefore, statement e is false.
15.

Portfolio risk and return

Answer: b

Diff: E

Statement a is false.
Since the correlation coefficient is less than one,
there is a benefit from diversification so the portfolios standard deviation
is less than 20 percent. Statement b is correct. The beta of the portfolio is
the weighted average of the two betas. So the portfolios beta is calculated
as: 0.5 0.7 + 0.5 1.3 = 1.0. Since the beta of the portfolio is equal to
1.0 and the beta of the market is equal to 1.0, the portfolio must have the
same return as the market. Statement c is false. The required return would be
equal to: kp = kRF + (kM - kRF)bp.
16.

Portfolio risk and return

Answer: e

Diff: E

A portfolio of randomly-selected stocks should, on average, have a beta of 1.0.

Therefore, both portfolios should have the same required return.
Therefore,
statement a is false.
Beta is the measure of market risk, while standard
deviation is the measure of diversifiable risk. Since both portfolios have the
same beta, they will have the same market risk. Since Jane has more stocks in
her portfolio, she is more diversified and will have less company-specific risk
than Dick. Therefore, statement b is false.
Jane has more stocks in her
portfolio, so she is more diversified and will have less company-specific risk
than Dick. Therefore, statement c is false. Since statements a, b, and c are
false, the correct choice is statement e.
17.

Portfolio risk and return

Answer: d

Diff: E

18.

Remember, for portfolios you can take averages of betas and returns, but not
standard deviations. So, the portfolio will have a return of 12 percent (because
both stocks have returns of 12 percent) and a beta of 1.2 (both stocks have betas
of 1.2).
However, since the correlation coefficient is less than 1.0, the
portfolios standard deviation will be less than the average of the two stocks
standard deviations. (That is, the portfolios standard deviation will be less
than 25 percent.) So, statements a and c are correct; therefore, the correct
choice is statement d.
Portfolio risk and return
Answer: e Diff: E
Remember, you can always find the portfolio required return by finding the
weighted average return of the stocks in the portfolio. You can always find
the portfolio beta by finding the weighted average beta of the stocks in the
portfolio.
You cannot find the standard deviation by finding the weighted
average standard deviation of the stocks in the portfolio, unless r = 1.0.
The portfolio standard deviation is not a weighted average of the individual
stocks standard deviations. How-ever, since the 2 correlation coefficients
are less than 1, we know the portfolios standard deviation will be less than
25 percent.
Since statements a and c are correct, the correct choice is
statement e.

19.

Portfolio risk and return

Answer: a

Diff: E

Statement a is true; the others are false.

Since both stocks betas are
equal to 1.2, the portfolio beta will equal 1.2.
Because the stocks
correlation coefficient is less than one, the portfolios standard deviation
will be lower than 20 percent.

20.

Portfolio risk and return

Answer: d

Diff: E

The correct answer is statement d.

Statement a is correct; Stock C has a
higher beta than Portfolio P.
Statement b is correct; the stocks are less
than perfectly correlated (r 1), hence the portfolio standard deviation must
be less than 25%. Statement c is incorrect; the expected returns of Portfolio
P are greater than the expected returns of Stock A, but the realized returns
cannot be known ex ante. Therefore statement d is the correct choice.
21.

CAPM

Answer: b

Diff: E

The CAPM is written as: k s = kRF + (kM kRF)b. Statement a is false based on
the CAPM equation. Statement b is correct on the basis of the CAPM equation.
Statement c is false; the required returns will increase by the same amount.
22

CAPM

and

required

Answer: c

return

Diff: E

You need to think about the CAPM to answer this question: ks = kRF + (kM kRF)b.
From the statement in the question k RF and (kM kRF) have both declined.
Statement a is false; the average required return on the market must have
declined too. Statement b is false; the size of the decline depends on the beta
of the stock. Statement c is correct. Statement d is false. This must be, if
statement c is correct. Statement e is false because the required returns will
have fallen for all stocks.

23.

CAPM and required return

Answer: c

Diff: E

The correct answer is statement c. Here, the required rate is ks = 5% + b RPM. If

a stocks beta doubles, b becomes 2b. So, k s = 5% + 2b RPM. But doubling its
required return would require the equation to be 2(5% + b RPM) = 10% + 2b
RPM. So, statement a is incorrect. Statement b would be correct only if the
beta coefficient were negative. Therefore, statement b is incorrect. Statement c
is correct. If b < 0 and RPM > 0, then (b RPM) < 0. So, ks < 5%.
24.

CAPM and required return

Answer: e

Diff: E

The correct answer is statement e.

Since Stock X is riskier, its required
return should be higher, so statement a is incorrect.
Since the betas of
Stock A and Stock B are different, statement b will be incorrect in most
circumstances. Although some situations exist where this holds, in general,
it will not be true. So, statement b is not always correct. Statement c is
always incorrect.
The required return for both stocks will decline.
So,
statement e is the correct choice.
25.

CAPM and required return

Answer: b

Diff: E

The correct answer is statement b. Remember, the market risk premium is the
slope of the Security Market Line.
This means high-beta stocks experience
greater increases in their required returns, while low-beta stocks experience
smaller increases in their required returns.
Statement a is incorrect.
Statement b is correct; stocks with a beta less than 1 increase by less than

the increase in the market risk premium, and vice versa.

Statement c is
incorrect; since the market risk premium is changing, required returns must
change too.
Statements d and e are incorrect for the same reason that
statement c is incorrect.
26

CAPM,

beta,

and

required

Answer: c
kRF = 6%; RPM = 5%; CAPM equation:

return

Diff: E

ks = kRF + (kM - kRF)b.

Statement a is false. Just because a stock has a negative beta does not mean
its return is also negative. For example, if its beta were -0.5, its return
would be as follows:
k = kRF + RPM(b)
= 6% + 5%(-0.5)
= 6% + (-2.5%)
= 3.5%.
Statement b is also false. If the beta doubles, the second term in the CAPM
equation above will double; however, kRF will not double, so the overall return
will not double. Statement c is correct. If b = 1.0, then:
k = kRF + RPM(b)
= 6% + 5%(1.0)
= 11%.
27.

SML

Answer: a

Diff: E

The slope of the SML is determined by the size of the market risk premium, k M
- kRF, which depends on investor risk aversion.
28.

SML

Answer: b

Diff: E

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

kM kRF. Statement c is false, since ks = kRF + (kM kRF)b. The remaining
statements are false.
29.

SML

Answer: c

Diff: E

Statement c is correct; the others are false.

Stock A will have a higher
required rate of return than B because A has the higher beta.
The standard deviation of a portfolio is not the average of the standard
deviations of the component stocks. The portfolio beta is a weighted average
of the component stocks betas; therefore, bp = 1.0.
30

SML
Answer: e

Diff: E

The CAPM states ks = kRF + (kM - kRF)b. Working through each statement, it is
apparent that none of the statements is consistent with the formula.
Therefore, statement e is the best choice.
31.

SML

Answer: c

Diff: E

Stock Y will have a higher expected return than Stock X does (because its beta
is higher), but we are told nothing about its standard deviation. Remember,

beta has nothing to do with standard deviation. Therefore, statement a is

false. The expected return of a portfolio of $50,000 in each stock will have a
required return that is the weighted average of the returns on both stocks.
Since each one has a weight of , it will be a simple average. The portfolios
beta will be the average of the two betas ((0.6 + 1.4)/2 = 1.0). The portfolio
has the same beta that the market portfolio does and, therefore, the same
required return that the market has. Therefore, statement b is false. If the
market risk premium decreases, the slope of the SML will decrease. Therefore,
the required returns of stocks with higher betas will decrease more.
Therefore, Stock Ys required return will fall by more than Stock Xs.
Therefore, statement c is correct.
If the expected inflation increases, the
SML will have a parallel shift up, and the required returns on all stocks will
increase by the same amount, not decrease. Therefore, statement d is false.
If expected inflation decreases, the SML will have a parallel shift down, and
the required returns on all stocks will decrease by the same amount. Therefore,
statement e is false.

32.

SML

Answer: b

Diff: E

Remember, the market risk premium is the slope of the line in the SML diagram.
The line is anchored at the y-axis, and when the market risk premium changes,
the line rotates around that point. Also remember the SML equation is k s =
kRF + (kM - kRF)b. Statement a is implying a parallel shift of the line, and
that is incorrect.
A review of the equation shows that, because beta is
multiplied by the market risk premium, changes in the market risk premium will
affect stocks with different betas differently. Statement b is correct.
The
slope of the line will increase, so required returns on stocks with betas
closer to 0 will increase by less than returns on stocks with higher betas. A
review of the equation 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.
Statement c is false because it is the reverse of statement b, which we have
already stated is true. Statement d is false because an increase in the market
risk premium will increase the required return on all stocks with positive
betas. Statement e is false. The portfolio beta is the weighted average of
the individual stocks betas. In this case, the portfolio beta will be 1.0.
It is clear from the SML equation that a portfolio with a beta of 1.0 will be
affected by changes in the market risk premium.
33.

SML

Answer: e

Diff: E

If the market risk premium (kM - kRF) increases, the required return on all
stocks with positive betas would increase. Therefore, statement a is false.
Since the required return for all positive beta stocks will increase, the
return for Portfolio P must increase as well.
Therefore, statement b is
false. The required return on Stock A will increase by 0.7 percent, and the
required return on Stock B will increase by 1.3 percent. Therefore, statement
c is false. Statement d is the opposite of what would actually happen, so
statement d is false. The beta for Portfolio P is 1.0[(50% 0.7) + (50%
1.3)]. Therefore, the change in the portfolios required return will be b
(kM - kRF) = 1.0 1% = 1%. Therefore, statement e is correct.

34

.
Answer: b
The correct answer is statement b.
slope of the SML declines.

SML
N

Diff: E

If the risk premium declines, then the

A
B

1.0

beta

At first, the line could be drawn at A. Then when the risk premium declines,
it will look more like B.
Statements a and c are incorrect. The required
return on all stocks will fall. Therefore, statement b is correct.
35.

SML, CAPM, and beta

Answer: e

Diff: E

Statement e is correct; the others are false. The market risk premium is the
slope of the SML. If a stock has a negative beta, this does not mean its
required return is negative. A doubling of a stocks beta doesnt mean that
its required return will double. The required return is a function of k RF,
kM, and beta. The required return is affected by the market risk premium.
36.

Risk analysis and portfolio diversification

Answer: d

Diff: E

A securitys beta does indeed measure market risk relative to that of an

average stock. Diversification reduces the variability of the port-folios
return. An investor, through diversification, can eliminate company-specific
risk; however, a portfolio containing all publicly-traded stocks would still
be exposed to market risk. The CAPM specifies a stocks required return as:
ks = kRF + (kM - kRF)b. Thus, the risk-free rate and the market risk premium
are needed along with a stocks beta to determine its required return.
A
stocks 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.

37.

Miscellaneous risk concepts

Answer: c

Diff: E

The correct answer is statement c.

Statement a is incorrect.
Since the
correlation is not 1.00, the standard deviation of the portfolio is less than
20%. For the same reason, Statement d is also incorrect. Since Portfolio Ps
standard deviation is less than 20%, its CV (/ X ) is less than 2.0.
So,
statement b is incorrect. And, statement e is incorrect since Portfolio Ps
required return equals that of Stock A. Portfolio Qs required return = (10%
+ 10% + 12%)/3 = 10.67%. So, statement c is the correct choice.
38.

Risk aversion

Answer: b

Diff: M

39.

SML and risk aversion

Answer: e

Diff: M

40.

Portfolio risk and return

Answer: c

Diff: M

41.

Portfolio risk and return

Answer: d

Diff: M

The correct answer is statement d. Statement a is correct; the expected return

of a portfolio is a weighted average of the returns of each of the component
stocks. Hence, kP = wAkA + wBkB = 0.5(10%) + 0.5(12%) = 11%. Statement b is
also correct; since the correlation coefficient is zero, the standard deviation
of the portfolio must be less than the weighted average of the standard
deviations of each of the component stocks. Statement c is incorrect; Stock
Bs beta can be calculated using: k B = kRF + (kM kRF)b. 12% = 5% + (6%)b.
Therefore, Stock Bs beta is 1.16. So statement d is the correct choice.
42.

Portfolio risk and return

Answer: d

Diff: M

The correct answer is statement d. If the same amount were invested in Stocks A
and B, the portfolio beta would be (1/2) 1.2 + (1/2) 1.4 = 1.30. This is not
the beta of the portfolio, so statement a is incorrect. Since the standard
deviation of the portfolio is less than the standard deviation of both Stock A
and Stock B, they cannot be perfectly correlated. If they were, the standard
deviation of the portfolio would be between 20% and 25%, inclusive.
So,
statement b is incorrect. Since the beta of Stock B is higher than that of Stock
A, Stock B has more market risk; so, statement c is incorrect. Since the beta of
the portfolio is higher than the beta of Stock A, the portfolio has a higher
required return than Stock A; therefore, statement d is true. Statement e is
incorrect; since the beta of Stock A is less than the beta of the portfolio,
Stock A has less market risk than the portfolio.
43.

Portfolio risk

Answer: e

Diff: M

44.

Portfolio risk and beta

Answer: c

Diff: M

45.

Portfolio risk and beta

Answer: e

Diff: M

46.

Market risk

Answer: b

Diff: M

47.

Beta coefficient

Answer: a

Diff: M

48.

Beta coefficient

Answer: d

Diff: M

49.

Beta coefficient

Answer: a

Diff: M

50.

Beta coefficient

Answer: c

Diff: M

51.

Beta coefficient

Answer: d

Diff: M

The correct answer is statement d. Except for Florida Power & Light (FP&L),
the remaining four companies and betas are all in line with the nature of the
firms and their industries. However, FP&L (a utility company) is out of place.
Its indicated beta of 1.52 puts it in the same league as technology
frontrunners Sun Microsystems and Amazon.com. A more reasonable beta estimate
for FP&L would be somewhere between 0.50 and 0.70.
52.

SML

Answer: e

Diff: M

53.

SML

Answer: a

Diff: M

54.

SML

Answer: b

Diff: M

55.

SML

Answer: b

Diff: M

The correct answer is statement b. A simple example helps here. Assume kRF is
originally 5%. And the RPM is 3%. Then, ks = 5% + (3%)b. Recall that the
market has a beta of 1.0. So, the market requires a return of 8%. Let k RF now
be 6%, and the RPM fall to 2%. The market still has a required return of 8%.
Statement a is incorrect; for any beta between zero and one, you can see that
the new required return is higher. For example, a stock with a beta of 0.5
had an original required return of 6.5%, but now has a required return of 7%.
Just the opposite happens for stocks with a beta greater than one. Statement
b is correct, for just the opposite reason. For example, a stock with a beta
of
2.0
originally
had
a
required
return
=
5% + (3%)2.0 = 11%, but now has a required return of 6% + (2%)2.0 = 10%. It
has fallen. A beta between zero and one will yield just the opposite result.
From the explanations above, both statements c and d are clearly incorrect.
For some stocks, the required return will rise; for others, the required
return will fall.
56.

SML, CAPM, and portfolio risk

Answer: a

An increase in expected inflation would lead to an

intercept of the SML. If risk aversion were unchanged,
SML would remain constant. Therefore, there would be a
in the SML, which would result in an increase in k M
expected increase in inflation.

57.

Portfolio return, CAPM, and beta

Diff: M

increase in k RF, the

then the slope of the
parallel upward shift
that is equal to the

Answer: e

Diff: M

Statement e is correct because none of the statements are correct. Statement a

is false because if the returns of 2 stocks were perfectly positively

correlated the portfolios variance would equal the variance of each of the
stocks. Statement b is false. A stock can have a negative beta and still have
a positive return because ks = kRF + (kM kRF)b. Statement c is false. According
to the CAPM, stocks with higher betas have higher expected returns. Betas are
a measure of market risk, while standard deviation is a measure of stand-alone
risk--but not a good measure. The coefficient of variation is a better measure
of stand-alone risk. The portfolios beta (the measure of market risk) will be
dependent on the beta of each of the randomly selected stocks in the portfolio.
However, the portfolios beta would probably approach bM = 1, which would
indicate higher market risk than a stock with a beta equal to 0.5.
58.

CAPM and required return

Answer: d

Diff: M

59.

Risk analysis and portfolio diversification

Answer: e

Diff: M

60.

Portfolio diversification

Answer: c

Diff: M

Statement c is correct; the others are false. Holding a portfolio of stocks

reduces company-specific risk. Diversification lowers risk; consequently, it
reduces the required rate of return.
Beta measures market risk, the lower
the beta the lower the market risk.
61.

Portfolio risk and SML

Answer: e

Diff: M

62.

CAPM

Answer: c

Diff: T

63.

SML

Answer: d

Diff: T

64.

Required return

Answer: d

Diff: E

Answer: b

Diff: E

ks = kRF + (kM - kRF)b

= 6% + (12% - 6%)1.2
= 13.2%.
65.

66.

Required return
Step 1:

We must determine the market risk premium using the CAPM equation
with data inputs for Stock A:
kA = kRF + (kM kRF)bA
11% = 5% + (kM kRF)1.0
6% = (kM kRF).

Step 2:

We can now find the required return of Stock B using the CAPM
equation with data inputs for Stock B:
kB = kRF + (kM kRF)bB
kB = 5% + (6%)1.4
kB = 13.4%.

CAPM and required return

Answer: d

Diff: E

kRF = k* + IP = 3% + 5% = 8%.
ks = 8% + (5%)2.0 = 18%.
67.

CAPM and market risk premium

Using Stock A (or any stock),

Answer: c

Diff: E

10% = kRF + (kM kRF)bA

10% = 5% + (kM kRF)1.0
(kM kRF) = 5%.
68.

Market risk premium

Answer: d

Diff: E

Answer: b

Diff: E

Answer: a

Diff: E

Answer: b

Diff: E

Answer: a

Diff: E

12.25% = 5% + (RPM)1.15
7.25% = (RPM)1.15
RPM = 6.3043% 6.30%.
69.

Beta coefficient
In equilibrium
A = 11.3%.
kA = k
kA = kRF + (kM - kRF)b
11.3% = 5% + (10% - 5%)b
b = 1.26.

70.

Beta coefficient
13.75% = 5% + (7%)b
8.75% = 7%b
b = 1.25.

71.

Portfolio beta
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.

72.

Portfolio return

The portfolios beta is a weighted average of the individual security betas

as follows:
($50,000/$75,000)1.5 + ($25,000/$75,000)0.9 = 1.3.
return is then simply: 4% + (6% - 4%)1.3 = 6.6%.
73.

Portfolio return

The required rate of

Answer: b

Diff: E

p
= 0.9(12%) + 0.1(20%) = 12.8%.
k
bp = 0.9(1.2) + 0.1(2.0) = 1.28.

74

Portfolio risk and return

Answer: a

Diff: E

The 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 = 1.0.
The total portfolio value will be $900,000 + $300,000 = $1,200,000.
Expected return:
$900,000
$300,000
12% +
10% = 11.5%.
$1,200,000
$1,200,000

Beta:
$900,000
$300,000
1.2 +
1.2 = 1.2.
$1,200,000
$1,200,000
=
=
=
=
75.

[0.75(12% - 11.5%)2 + 0.25(10% - 11.5%)2]

[0.1875% + 0.56250%]
[0.75%]
0.86603%.

Coefficient of variation

Answer: b

Diff: E

Using your financial calculator you find the mean to be 10.8% and the
population standard deviation to be 15.715%. The coefficient of variation is
just the standard deviation divided by the mean, or 15.715%/10.8% = 1.4551
1.46.
76.

Expected return

X
k

kY
2X
2X

Answer: e

Diff: M

= 0.10(-3%) + 0.10(2%) + 0.25(5%) + 0.25(8%) + 0.30(10%) = 6.15%.

= 0.05(-3%) + 0.10(2%) + 0.30(5%) + 0.30(8%) + 0.25(10%) = 6.45%.
= 0.10(-3% - 6.15%)2 + 0.10(2% - 6.15%)2 + 0.25(5% - 6.15%)2
+ 0.25(8% - 6.15%)2 + 0.30(10% - 6.15%)2
= 15.73%; X = 3.97%.

CVX = 3.97%/6.15% = 0.645.

2Y
2Y

= 0.05(-3% - 6.45%)2 + 0.10(2% - 6.45%)2 + 0.30(5% - 6.45%)2

+ 0.30(8% - 6.45%)2 + 0.25(10% - 6.45%)2
= 10.95%; Y = 3.31%.

CVY = 3.31%/6.45% = 0.513.

77

Therefore, Asset Y has a higher expected return and lower coefficient of

variation and hence it would be preferred.

Expected return

Answer: c

Diff: M

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

k

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 =
78.

0.001 = 0.0316 = 3.16%.

Required return
Step 1:

Solve
15% =
15% =
kRF =

for risk-free rate

kRF + (10% - kRF)2.0
kRF + 20% - 2kRF
5%.

Answer: c

Diff: M

Step 2: Calculate new market return

kM increases by 30%, so kM = 1.3(10%) = 13%.
Step 3: Calculate new required return on stock
ks = 5% + (13% - 5%)2 = 21%.
Step 4: Calculate percentage change in return on stock

21% - 15%
= 40%.
15%
79.

Required return

Answer: c

Diff: M

Before: ks = 15% = kRF + (5%)0.7; kRF = 15% - 3.5%; kRF = 11.5%.

New kRF = 11.5% + 2.0% = 13.5%.
New beta = 0.7 1.5 = 1.05.
After: New required rate of return:
ks = 13.5% + (5%)1.05 = 18.75%.
80.

81.

Required return

Answer: e

Step 1:

Calculate the market risk premium (kM - kRF) using the information
for Partridge:
13%= 6% + (kM - kRF)1.4
kM - kRF= 5%.

Step 2:

Now calculate the required return for Cleaver:

ks = 6% + (5%)0.8 = 10%.

Expected and required returns

Answer: c

Use the calculators regression function to find betaj.

kRF. Note that RPM = kM - kRF, so
4% = 12% - kRF
kRF = 8%.

82.

Diff: M

Find kJ = 8% + 4%(-0.66) = 5.36%.

= 8.00% - 5.36% = 2.64%.
Expected and required returns

Diff: M

It is -0.6600. Find

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
A
B
C
D
E

Expected Return
9.01%
7.06%
5.04%
8.74%
11.50%

7%
7%
7%
7%
7%

Required Return
+ 2%(1.7)
= 10.40%
+ 2%(0.0)
= 7.00%
+ 2%(-0.67) = 5.66%
+ 2%(0.87) = 8.74%
+ 2%(2.50) = 12.00%

Expected-Required
-1.39%
0.06%
-0.62%
0.00%
-0.50%

Clearly, security B is the best alternative.

83.

CAPM and required return

Answer: e

Diff: M

bHR = 2.0;
kRF = 10%.
kM = 15%.
Now SML:
kHR = 7% +
kLR = 7% +
84.

bLR = 0.5. No changes occur.

Decreases by 3% to 7%.
Falls to 11%.
ki = kRF + (kM - kRF)bi.
(11% - 7%)2 = 7% + 4%(2)
= 15%
(11% - 7%)0.5 = 7% + 4%(0.5) = 9
Difference
6%

CAPM and required return

Answer: a

Diff: M

An index fund will have a beta of 1.0.

If k M is 12 percent (given in the
problem) and the risk-free rate is 7 percent, you can calculate the market risk
premium (RPM).
ks = kRF + (RPM)b
12% = 7% + (RPM)1.0
5% = RPM.
Now, you can use the RPM, the kRF, and the two stocks betas to calculate
their required returns.
Bradley:
ks = kRF + (RPM)b
= 7% + (5%)1.3
= 7% + 6.5%
= 13.5%.
Douglas:
ks = kRF + (RPM)b
= 7% + (5%)0.7
= 7% + 3.5%
= 10.5%.

85.

The difference in their required returns is:

13.5% - 10.5% = 3.0%.
CAPM and required return
bX = 1.6; bY = 0.7; kRF = 7%; kM = 12%.
Inflation increases by 1%, but k* remains constant.
rises to 14%.

Answer: d

Diff: M

k RF increases by 1%; kM

Before inflation change:

kX = 7% + 5%(1.6) = 15%.
kY = 7% + 5%(0.7) = 10.5%.
After inflation change:
kX = 8% + (14% - 8%)1.6 = 17.6%.
kY = 8% + (14% - 8%)0.7 = 12.2%.
kX - kY = 17.6% - 12.2% = 5.4%.
86.

CAPM and required return

kA = 6% + (11% - 6%)bA.
Calculate bA as follows using a financial calculator:
6 Input 8 +
-8 Input 3 +
-8 Input -2 +
18 Input 12 +

Answer: e

Diff: M

 ,m
0 y
swap
bA = 0.4534.
kA = 6% + 5%(0.4534) = 8.2669% 8.27%

87.

CAPM and required return

Answer: a

Diff: M

Answer: c

Diff: M

With your financial calculator input the following:

-2 Input 8 +
12 Input 3 +
-8 Input 18 +
21 Input -7 +

,m
0 y
swap
bC = -0.76.
kC = 8% + (14% - 8%)(-0.76) = 8% - 4.58% = 3.42%.
88
Portfolio return

Calculate bX
calculator.
bX
kX
kY
kp

89.

=
=
=
=

and

bY

for the stocks using the regression function of a

0.7358; bY = 1.3349.
7% + 5%(0.7358) = 10.679%.
7% + 5%(1.3349) = 13.6745%.
14/20(10.679%) + 6/20(13.6745%) = 11.58%.

Portfolio return

Answer: b

Diff: M

Statement b is correct; all the other statements are false. If the market risk
premium increases by 2 percent and kRF remains unchanged, then the portfolios
return will increase by 2%(1.08) = 2.16%. Statement a is false, since k p = 6% +
(5%)bp.
The portfolios beta is calculated as 0.7(1.2) + 0.3(0.8) = 1.08.
Therefore, kp = 6% + 5%(1.08) = 11.4%. Statement c is false. If k RF increases
by 2 percent, but RPM remains unchanged, the portfolios return will increase by
2 percent. Statement d is false. Market efficiency states that the expected
p = kp = 11.4%.
return should equal the required return; therefore, k
90.

Portfolio return

Answer: c

Find the initial portfolios beta and its required return.

new beta and new required return. Then subtract the two.
Step 1:

Diff: M

Then, find the

The portfolio beta is the weighted average beta of the stocks in the
portfolio. The total invested is $70 million ($10 + $20 + $40).

$10
$20
$40
(1.4) +
(1.0) +
(0.8)
$70
$70
$70

bOld =

bOld = 0.9429.
kOld = kRF + (kM kRF)b
= 5% + (5.5%)(0.9429)
= 10.1857%.
Step 2:

Now, change the weights.

The amount of X owned is now $25 million

($10 + $15), the amount of Y owned is now $0 million, and the amount
of Z owned is $45 million ($40 + $5).

$25
$0
$45
(1.4) +
(1.0) +
(0.8)
$
70
$
70

$70

bNew =

bNew = 1.0143.
kNew = kRF + (kM kRF)b
= 5% + (5.5%)(1.0143)
= 10.5786%.
Step 3:

91

Now subtract the two returns:

10.5786% - 10.1857% = 0.3929%.

Portfolio return
Answer: b

Data given:
kRF = 5.5%
RPM = 6%
Step 1:

Diff: M

Current portfolio = $10 million

kp = 12%

Calculate the portfolios current beta.

ks = kRF + (RPM)b
12% = 5.5% + (6%)b
1.0833 = b.

The portfolio beta is the weighted average of the betas of the individual
stocks in the portfolio. If you sell $3 million of a stock that has a beta
of 1.6, what will be the beta of the remaining stocks?
Step 2:

Calculate the beta of the remaining stocks in the portfolio.

1.0833 = ($3/$10)(1.6) + ($7/$10)X
0.6033 = ($7/$10)X
0.8619 = X.

0.8619 is the beta of the $7 million of stocks that remain.

to the portfolio beta when the new stock is added?
Step 3:

Calculate the new portfolios beta.

b = ($7/$10)(0.8619) + ($3/$10)(0.7)
= 0.6033 + 0.21
= 0.8133.

Step 4:

Calculate the new portfolios required return.

ks = kRF + (RPM)b
= 5.5% + (6%)0.8133
= 5.5% + 4.88%

Now what happens

= 10.38%.
92

. Portfolio return

Answer: a

Diff: M

The aggressive growth mutual fund has an expected return of:

kAGMF = 6% + (5%)1.6 = 14%.
The S&P 500 index fund has an expected return of:
kSP500 = 6% + 1.0(5%) = 11%.
So, to get the return she desires, Erika must solve for X, the percentage of
her portfolio invested in the S&P 500 index fund:
12.5%
11.9%
-0.7%
0.2333

=
=
=
=

0.10(6%) + (0.90 X)(14%) + X(11%)

12.6% - 14%X + 11%X
-3%X
X.

So invest 23.33% in the S&P 500 index fund, invest 66.67% in the aggressive
growth fund, and invest 10.00% in the risk-free asset.
(Note that the
percentage totals must add up so that 100% of the funds are invested.)
93.

CAPM and portfolio return

Answer: d

Diff: M

Answer: b

Diff: M

$100,000
$150,000
$50,000
(0.8) +
(1.2) +
(1.8)
$300,000
$300,000
$300,000
bp = 1.1667.
bp =

Last year: k = 13%

13% = 7% + RPM(1.1667)
6% = RPM(1.1667)
RPM = 5.1429%.
This year:
k = 7% +(5.1429% + 2%)1.1667
k = 15.33%.
94.

CAPM and portfolio return

Step 1:

Determine the returns on each of the 3 assets:

kRF = 5%; kM - kRF = 6%.
kRF = 5%.
kIndex = kRF + (kM - kRF)b
= 5% + (6%)(1.0)
= 11%.
kInt'l = 5% + (6%)(1.5)
= 14%.

Step 2:

Let X be the portion of the portfolio invested in the international

fund, and let (0.8 X) be the portion invested in the index fund:
11% = 0.2(kRF) + (X)(kInt'l) + (0.8 - X)(kIndex)
11% = 0.2(5%) + (14%)X + (0.8)(11%) - (11%)X
11% = 1% + 14%X + 8.8% 11%X
11% - 1% - 8.8% = (14% - 11%)X
1.2% = 3%X
X = 0.4.

Therefore, 40 percent should be invested in the international fund.

95.

CAPM and portfolio return

Answer: c

Diff: M

You are given the required return on the portfolio, the RP M, and enough
information to calculate the beta of the original portfolio.
With this
information you can find kRF.
Once you have kRF, you can find the required
return on Stock C.
Step 1:

Find the portfolio beta:

Take a weighted average of the individual stocks betas to find the
portfolio beta. The total amount invested in the portfolio is:
$4 million + $2 million + $2 million + $1 million + $1 million = $10
million.
The weighted average portfolio beta is:

$4
$2
$2
$1
$1
(1.2)
(1.1)
(1.0)
(0.7)
(0.5)
$10
$10
$10
$10
$10
bp 1.02.
bp

96

Step 2:

Use the CAPM and the portfolios required return to calculate k RF,
the risk-free rate:
kp = kRF + RPM(bp)
11% = kRF + 5%(1.02)
5.9% = kRF.

Step 3:

Use the CAPM to calculate the required return on Stock C:

kC = kRF + RPM(bC)
kC = 5.9% + 5%(1.0)
kC = 10.9%.

CAPM

and

portfolio

Answer: c

return

Diff: M

Step 1:

Determine the market risk premium from the CAPM:

0.14 = 0.06 + (kM - kRF)1.6
(kM - kRF) = 0.05.

Step 2:

Calculate the beta of the new portfolio:

The beta of the new portfolio is ($200,000/$1,200,000)(0.6)
($1,000,000/$1,200,000)(1.6) = 1.4333.

Step 3:

Calculate the required return on the new portfolio:

The required return on the new portfolio is:

6% + (5%)(1.4333) = 13.16667% 13.17%.

97

98

CAPM and portfolio return

Answer: c

Diff: M

Step 1:

Determine the beta of your portfolio:

9% = 5% + (11% - 5%)b
b = 0.66667.

Step 2:

Determine the beta of your sisters portfolio:

Sisters beta = 0.66667 2 = 1.3333.

Step 3:

Determine the required return of your sisters portfolio:

5% + (11% - 5%)(1.3333) = 13%.
CAPM
and
portfolio

Answer: b

Diff: M

return
N

kA = 10%; bA = 1.0; bB = 2.0; kRF = 5%; kP = 12%; X = % of Stock B in portfolio.

Step 1:

Determine market risk premium, RPM.

kA = 0.05 + RPM(1.0)
0.10 = 0.05 + RPM(1.0)
RPM = 0.05.

Step 2:

Calculate expected return of Stock B.

kB = 0.05 + 0.05(2.0) = 0.15.

Let X% of Portfolio P be in Stock B, so (1 - X)% is in Stock A. The expected

return of Portfolio P is the weighted average of the expected returns of the
two stocks.
0.12
0.12
0.02
X
99.

=
=
=
=

0.15X + (1 - X)(0.10).
0.15X + 0.10 0.10X
0.05X
0.40 = 40%.

Portfolio beta
Before:

After:
100.

Answer: b

Diff: M

1.15 = 0.95(bR) + 0.05(1.0)

0.95(bR) = 1.10
bR = 1.1579.
bp = 0.95(bR) + 0.05(2.0) = 1.10 + 0.10 = 1.20.

Portfolio beta

Answer: c

Diff: M

After additional investments are made, for the entire fund to have an
expected return of 13.5%, the portfolio must have a beta of 1.25 as shown by
13.5% = 6% + (6%)b. Since the funds beta is a weighted average of the betas
of all the individual investments, we can calculate the required beta on the
additional investment as follows:
1.25 =

($200,000,000 1.2)
($50,000,000 X)
+
$250,000,000
$250,000,000

1.25 = 0.96 + 0.2X

0.29 = 0.2X

X = 1.45.

101.

Portfolio beta

Answer: e

Diff: M

Find the beta of the original portfolio (b Old) as 10.75% = 4% + (9% - 4%)b Old or
bOld = 1.35. To achieve an expected return of 11.5%, the new portfolio must have
a beta (bNew) of 11.5% = 4% + (9% - 4%) bNew or bNew = 1.5. To construct a
portfolio with a bNew = 1.5, the added stocks must have an average beta (b Avg)
such that:
1.5
1.5
0.6
bAvg
102.

=
=
=
=

($250,000/$750,000)bAvg + ($500,000/$750,000)1.35
0.333bAvg + 0.90
0.333bAvg
1.8.

Portfolio return and beta

Answer: a

Diff: M

Step 1:

Calculate the beta of the original portfolio:

Right now, the total dollars invested in the portfolio is:
$300 + $200 + $500 = $1,000 million. The portfolios beta is:
b = 0.7($300/$1,000) + 1.0($200/$1,000) + 1.6($500/$1,000)
= 1.21.

Step 2:

Calculate the market risk premium using the CAPM, given the original
beta calculated in Step 1:
kp = kRF + (kM - kRF)b
11.655% = 5% + (kM - kRF)1.21
6.655% = 1.21(kM - kRF)
5.5% = kM - kRF.

Step 3:

Calculate the new portfolios beta:

Now, if she changes her portfolio and gets rid of Stock 3 (with a
beta of 1.6) and replaces it with Stock 4 (with a beta of 0.9), the
new portfolios beta will be:
b = 0.7($300/$1,000) + 1.0($200/$1,000) + 0.9($500/$1,000)
= 0.86.

Step 4:

Calculate the new portfolios required return:

The required return will be:
kp = 5.0% + 5.5%(0.86)
kp = 9.73%.

103.

Portfolio return and beta

Answer: e

Diff: M

You need to find the beta of the portfolio now and after the change. Then,
use the betas in the CAPM to find the two different returns.
Step 1:

Determine the betas of the two portfolios:

The total amount invested in the portfolios is: $300 + $560 + $320 +
$230 = $1,410 million. (Note that the 2nd portfolio changes only in
the composition of the stocks, not the amount invested.)
bOld = ($300/$1,410)1.2 + ($560/$1,410)1.4 + ($320/$1,410)0.7 +
($230/$1,410)1.8
= 1.2638.
Now, create the new portfolio by selling $280 million of Stock 2 and
reinvesting it in Stock 4. The new portfolios beta will be:
bNew = ($300/$1,410)1.2 + [($560 - $280)/$1,410]1.4 +
($320/$1,410)0.7 + [($230 + $280)/$1,410]1.8
= 1.3433.

Step 2:

Determine the returns of the two portfolios:

kpOld = kRF + (kM - kRF)b
= 5% + (5%)1.2638
= 11.3190%.
kpNew = kRF + (kM - kRF)b
= 5% + (5%)1.3433
= 11.7165%.

The difference is:

104.

11.7165% 11.3190% = 0.3975% 0.40%.

Portfolio return and beta

Answer: e

Diff: M

The total portfolio is worth $10,000,000 so the beta of the portfolio is:
(2/10) 0.6 + (3/10) 0.8 + (3/10) 1.2 + (2/10) 1.4 = 1.0.
kp = 10%; bp = 1.

With this, we can determine the market risk premium (RPM):

10% = kRF + (RPM)bp

10% = 5% + (RPM)1.0
5% = RPM.
The manager wants an expected return k p = 12%.
portfolio with a beta of 1.4. To check this:

So, the manager needs a

kp = kRF + (RPM)bp
= 5% + (5%)1.4 = 12%.
The manager has $2,000,000 to invest in a stock with a beta of X.
stock, the new portfolio beta is:
(2/10)X + (3/10) 0.8 + (3/10) 1.2 + (2/10) 1.4 = 1.4.
0.2X + 0.24 + 0.36 + 0.28 = 1.4
0.2X = 0.52

With this

105.

X = 2.60.

bX = 2.60.
Portfolio standard deviation

Answer: a

Diff: M

Fill in the columns for XY and product, and then use the formula to
)2P calculation with a
calculate the standard deviation. We did each (k - k
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
0.1
0.8
0.1

XY =
106

((k

Portfolio XY
-5.0%
17.5
30.0

Product
-0.5%
14.0
3.0

=
16.5%
k

)2P) = 8.07% 8.1%.

- k

Coefficient of variation
Answer: e

Diff: M

= (0.1)(-23%) + (0.1)(-8%) + (0.4)(6%) + (0.2)(17%) + (0.2)(24%)

k
= -2.3% + -0.8% + 2.4% + 3.4% + 4.8%
= 7.5%.

= [0.1(-23% - 7.5%)2 + 0.1(-8% - 7.5%)2 + 0.4(6% - 7.5%)2 +

0.2(17% - 7.5%)2 + 0.2(24% - 7.5%)2]
= [93.025% + 24.025% + 0.9% + 18.05% + 54.45%]
= 13.80036%.

CV = / k
= 13.80036%/7.5%
= 1.84.
107.

Coefficient of variation

Answer: b

Diff: M

The expected rate of return will equal 0.25(25%) + 0.5(15%) + 0.25(5%) = 15%. The
variance of the expected return is:
0.25(25% - 15%)2 + 0.5(15% -15%)2 + 0.25(5% - 15%)2 = 0.0050.
The standard deviation is the square root of 0.0050 = 0.0707.
And, CV = 0.0707/0.15 = 0.47.
108.

Coefficient of variation

Answer: c

Diff: M

CV = Standard deviation/Expected return.

Expected return = 0.1(-60%) + 0.2(-10%) + 0.4(15%) + 0.2(40%) + 0.1(90%)
= 15%.

Standard
2
deviation = [0.1(-60% - 15%) +

0.2(-10% - 15%)2 + 0.4(15% -15%)2

+ 0.2(40% - 15%)2 + 0.1(90% - 15%)2]1/2

= 37.081%.
CV = 37.081%/15% = 2.4721.

109.

Coefficient of variation

Answer: c

Diff: M

Expected return for stock A is 0.3(12%) + 0.4(8%) + 0.3(6%) = 8.6%.

Expected return for stock B is 0.3(5%) + 0.4(4%) + 0.3(3%) = 4%.
Standard deviation for stock A is:
[0.3(12% - 8.6%)2 + 0.4(8% - 8.6%)2 + 0.3(6% - 8.6%)2]1/2 = 2.3749%.

110
.

Similarly, the standard deviation for stock B is 0.7746%.

CVA = 2.3749%/8.6% = 0.28.
CVB = 0.7746%/4% = 0.19.
Coefficient of variation

Answer: d

Diff: M

= 0.2(-5%) + 0.4(10%) + 0.2(20%) + 0.1(25%) + 0.1(50%)

k
= -1% + 4% + 4% + 2.5% + 5%
= 14.5%.

= [0.2(-5% - 14.5%)2 + 0.4(10% - 14.5%)2 + 0.2(20% - 14.5%)2 + 0.1(25% - 14.5%)2 +

0.1(50% - 14.5%)2]1/2
= (0.0076 + 0.0008 + 0.0006 + 0.0011 + 0.0126) 1/2
= 0.1507.

111
.

CV = / k
= 0.1507/0.145
= 1.039 1.04.
Coefficient of variation

Answer: b

Diff: M

Step 1:

Calculate the mean for the data:

= 0.25(5%) + 0.50(15%) + 0.25(30%)
k
= 16.25%.

Step 2:

Calculate the population standard deviation for the data:

= [0.25(5% - 16.25%)2 + 0.5(15% - 16.25%)2 + 0.25(30% - 16.25%)2]1/2

= (0.003164 + 0.000078 + 0.004727) 1/2
= (0.007969)1/2 = 0.089268 = 8.9268%.

The coefficient of variation is 8.9268%/16.25% = 0.54934.

112

Coefficient

of

Answer: b

variation
Diff: M

E(ROE) = (0.2 -24%) + (0.3 -3%) + (0.3 15%) + (0.2 50%)

E(ROE) = -4.8% - 0.9% + 4.5% + 10%
E(ROE) = 8.8%.
ROE = [0.2(-24% - 8.8%)2 + 0.3(-3% - 8.8%)2 + 0.3(15% - 8.8%)2 + 0.2(50% - 8.8%)2]1/2
ROE = [215.168% + 41.772% + 11.532% + 339.488%] 1/2
ROE = [607.960%]1/2 = 24.6568%.

24.6568%
= 2.80.
8.8%
Coefficient of variation
CV =

113.

Answer: e

Diff: M

CV is equal to the standard deviation divided by the average return.

114.

Step 1:

Determine the population standard deviation using your calculator:

10 +
12 +
27 +
15 +/- +
30 +
Then select x,y to find 15.9925%.

Step 2:

Determine the mean return using your calculator:

x , y to find x = 12.8%.

Step 3:

Determine the coefficient of variation:

CV = 15.9925%/12.8%
= 1.2494 1.25.

Beta coefficient
First
15% =
9% =
bp =

Answer: a

Diff: M

find the portfolios beta:

6% + (6%)bp
6%bp
1.5.

Let bc be the beta of the company for which she works. The portfolios beta
is a weighted average of the individual betas of the stocks in the portfolio.
Therefore,

115.

1.5
1.5
1.2
bC

=
=
=
=

Beta coefficient
Step 1:

($5,000/$20,000)1.2 + ($15,000/$20,000)bC.
0.3 + 0.75bC
0.75bC
1.6.

Answer: e

Diff: M

Determine the portfolios beta:

The portfolios beta is the weighted average of the betas of the
individual stocks in the portfolio.
bp = 0.3(bX) + 0.7(bY)
bp = 0.3(0.75) + 0.7(bY)

We have two unknowns. However, we can solve for the portfolios beta
by using the CAPM:
kp = kRF + (kM - kRF)bp.
For
12%
6%
1.2
Step 2:

116.

the portfolio, we have:

= 6% + (5%)bp
= (5%)bp
= bp.

Solve
bp
1.2
0.975
bY

for Stock Ys beta:

= 0.3(0.75) + 0.7(bY)
= 0.225 + 0.7(bY)
= 0.7(bY)
= 1.3929 1.39.

CAPM and beta coefficient

Answer: d

Diff: M

Portfolio beta is found from the CAPM:

17% = 7% + (14% - 7%)bp
bp = 1.4286.
The portfolio beta is a weighted average of the betas of the stocks within
the portfolio.
1.4286 = ($2/$15)(0.8) + ($5/$15)(1.1) + ($3/$15)(1.4) + ($5/$15)bD
1.4286 = 0.1067 + 0.3667 + 0.2800 + (5/15)bD
0.6752 = 5/15bD
bD = 2.026.
117.

Market return
b =

Rise

ks = 15%
6%
4%
kM

118.

Run

=
=
=
=

Y
X

22 - 16
15 - 11

6
4

Diff: M

Answer: a

Diff: T

= 1.5.

9% + (kM - 9%)1.5
(kM - 9%)1.5
kM - 9%
13%.

Portfolio required return

Step 1:

Answer: d

Find the beta of the original portfolio by taking a weighted average of

the individual stocks betas. We calculate a beta of 1.3.

$300,000

(0.6)
$1,600,000

$300,000
$1,600,000 (1)

$500,000
$1,600,000 (1.4)

$500,000
$1,600,000 (1.8)

Step 2:

Find the market risk premium using the original portfolio.

ks = 0.125 = 0.06 + (kM - kRF)1.3. If you substitute for all the values
you know, you calculate a market risk premium of 0.05.

Step 3:

Calculate the new portfolios beta.

The question asks for the new portfolios required rate of return.
We have all of the necessary information except the new portfolios

beta.
Now, Stock 1 has 0 weight (we sold it) and Stock 4 has a
weight of $800,000/$1,600,000 = 0.5. The portfolios new beta is:

$300,000
(1)
$1,600,000

Step 4:
119.

$500,000
(1.4)
$1,600,000

$800,000
(1.8) 1.525.
$1,600,000

Find the portfolios required return.

Thus, ks = 0.06 + (0.05)1.525 = 13.625% 13.63%.

CAPM and portfolio return

Answer: d

Diff: E

This is a straight-forward application of the CAPM. We are given the riskfree rate, the market risk premium, and the portfolio beta.
kp = kRF + (kM kRF)bp
kp = 5% + (6%)1.2
kp = 12.2%.

120.

CAPM and portfolio return

Answer: c

We must calculate the beta of the new portfolio.

we can solve for the new portfolio beta:

Diff: M

From the definition of beta,

10

Portfolio beta =

i1

bi is the beta for the 10 individual stocks.

10
10

1.2 =

bi

i 1

10
10

12 =

i1

So, if the portfolio manager sells a stock that has a beta of 0.9 and replaces
it with a stock with a beta of 1.6, that means the sum of the betas for the
new portfolio is 0.7 higher than before. Dividing the new sum of betas by 10

gives us the new portfolio beta.

12.7/10 = bp
1.27 = bp.
Alternatively, you can calculate the portfolios new beta as follows:
1.2 = 0.9br + 0.1(0.9)
1.11 = 0.9br
1.2333 = br; beta of remaining stocks in portfolio.
bp = 0.9(1.2333) + 0.1(1.6)
= 1.11 + 0.16
= 1.27. (beta of new portfolio)
Now,
kp =
kp =
kp =

we can calculate the required return of the new portfolio.

kRF + (kM kRF)bp
5% + 6%(1.27)
12.62%.

WEB APPENDIX 5A SOLUTIONS

1215A-. Beta calculation

Answer: b

Diff: M

1225A-. Beta calculation

Answer: c

Diff: E

Rise/Run = (Y1 Y0)/(X1 X0) = (JYear 2 JYear 1)/(MYear 2 MYear 1)

= (22.90% (-13.85%))/(12.37% (-8.63%)) = 36.75%/21.0%
beta = 1.75.
1235A-. Beta and base year sensitivity

Answer: a

Diff: M

Year 1Year 2 data:

Rise/Run = (Y1 Y0)/(X1 X2)
= (-3.7% 6.30%)/(12.90% 6.10%) = -10.0%/6.8%
beta = -1.47.
Year 2 Year 3 data:
beta = (21.71% (-3.70%))/(16.20% 12.90%) = 25.41%/3.3% = 7.70.
Difference:

betaY2

Y3

betaY1

Y2

= 7.70 (-1.47) = 9.17.

1245A-. Beta calculation

Answer: b

Diff: M

Answer: c

Diff: E

Calculate beta of stock X:

Enter into 10-B market return first!
bx = 0.9484.
k
14%
8%
bp

=
=
=
=

kRF + (kM - kRF)bp

6% + 6%bp
6%b
1.333.

bp
1.333
0.7643
bY

=
=
=
=

0.6(bX) + 0.4(bY)
0.6(0.9484) + 0.4bY
0.4bY
1.9107 1.91.

1255A-. Beta calculation

Using the linear regression function of the HP 10-B calculator, enter the
market return and the corresponding stock return and find the slope of the
predicted regression line. Slope = b = 1.2757.
1265A-. Beta calculation

Answer: a

Diff: E

Answer: c

Diff: M

Enter the following input data in the calculator:

8
INPUT 12 +
28
INPUT 34 +
20 +/- INPUT 29 +/- +
4 +/- INPUT 11 +/- +
30
INPUT 45 +
,m SWAP to find beta = 1.432 1.43.
Press 0 y
1275A-. Beta calculation

.a. Plot the returns of Stocks R and S and the market.

Return on Stock
(%)

StockR

25

StockS

- 15

15

Return on Market (%)

-15

b. Calculate beta using the rise over run method or calculator regression
function.

Y2 - Y1
= beta
X2 - X1

StockR:

25 - 5
20
=
= 2.0 = betaR.
15 - 5
10

StockS:

10 - 5
5
=
= 0.5 = betaS.
15 - 5
10

c. The difference in betas is: BetaR - BetaS = 2.0 - 0.5 = 1.5.

1285A-. Required rate of return

Answer: e

Diff: M

a. Draw SML.
Required Rate
of Return (%)
16

SML

kR = 14
12

R 12%
k

S 11%
k

kM = 10

R kR
k
S kS
k

kS = 8
kRF = 6
4
2

|
0.2

|
1.0

b. Calculate required returns for Stocks R and S.

kR = 6% + (10% - 6%)2.0 = 14%.

|
2.0

Risk, beta

kS = 6% + (10% - 6%)0.5 = 8%.

c. Calculate the difference between the expected and required returns.
k = 12% - 14% = -2.0%.
k
R
R

k = 11% - 8% = 3.0%.
k
S
S

k = 3.0%.
d. Widest margin = k
S
S