FIN 534 Quiz4 week 5

1) Which of the following statements is CORRECT?

Answer

a)A two-stock portfolio will always have a lower standard

deviation than a one-stock portfolio.

b)A portfolio that consists of 40 stocks that are not highly

correlated with “the market” will probably be less risky than a

portfolio of 40 stocks that are highly correlated with the market,

assuming the stocks all have the same standard deviations.

c)A two-stock portfolio will always have a lower beta than a

one-stock portfolio.

d)If portfolios are formed by randomly selecting stocks, a

10-stock portfolio will always have a lower beta than a one-stock

portfolio.

e)A stock with an above-average standard deviation must also

have an above-average beta.

2 points

Question 2

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%, betas of 1.6, and standard deviations of 30%. The returns of

the two stocks are independent, so the correlation coefficient

between them, rXY, is zero. Which of the following statements best

describes the characteristics of your 2-stock portfolio?

Answer

a)Your portfolio has a standard deviation of 30%, and its

expected return is 15%.

b)Your portfolio has a standard deviation less than 30%, and its

beta is greater than 1.6.

c)Your portfolio has a beta equal to 1.6, andits expected return

is 15%.

d)Your portfolio has a beta greater than 1.6, and its expected

return is greater than 15%.

e)Your portfolio has a standard deviation greater than 30% and a

beta equal to 1.6.

Question 3

Assume that in recent years both expected inflation and the

market risk premium (rM− rRF) have declined. Assume also that all

stocks have positive betas. Which of the following would be most

likely to have occurred as a result of these changes?

Answer

The required returns on all stocks have fallen, but the

decline has been greater for stocks with lower betas.

The required returns on all stocks have fallen, but the

fall has been greater for stocks with higher betas.

The average required return on the market, rM, has

remained constant, but the required returns have fallen for stocks

that have betas greater than 1.0.

Required returns have increased for stocks with betas

greater than 1.0 but have declined for stocks with betas less than

1.0.

The required returns on all stocks have fallen by the same

amount

Question 4

1. Which of the following statements is CORRECT?

Answer

The beta of a portfolio of stocks is always smaller than

the betas of any of the individual stocks.

If you found a stock with a zero historical beta and held

it as the only stock in your portfolio, you would by definition

have a riskless portfolio.

The beta coefficient of a stock is normally found by

regressing past returns on a stock against past market returns. One

could also construct a scatter diagram of returns on the stock

versus those on the market, estimate the slope of the line of best

fit, and use it as beta. However, this historical beta may differ

from the beta that exists in the future.

The beta of a portfolio of stocks is always larger than

the betas of any of the individual stocks.

It is theoretically possible for a stock to have a beta of

1.0. If a stock did have a beta of 1.0, then, at least in theory,

its required rate of return would be equal to the risk-free

(default-free) rate of return, rRF.

2 points

Question 5

1. Which is the best measure of risk for a single asset held in

isolation, and which is the best measure for an asset held in a

diversified portfolio?

Answer

Variance; correlation coefficient.

Standard deviation; correlation coefficient.

Beta; variance.

Coefficient of variation; beta.

Beta; beta.

2 points

Question 6

1. Bob has a $50,000 stock portfolio with a beta of 1.2, an

expected return of 10.8%, and a standard deviation of 25%. Becky

also has a $50,000 portfolio, but it has a beta of 0.8, an expected

return of 9.2%, and a standard deviation that is also 25%. The

correlation coefficient, r, between Bob’s and Becky’s portfolios is

zero. If Bob and Becky marry and combine their portfolios, which of

the following best describes their combined $100,000 portfolio?

Answer

The combined portfolio’s expected return will be less than

the simple weighted average of the expected returns of the two

individual portfolios, 10.0%.

The combined portfolio’s beta will be equal to a simple

weighted average of the betas of the two individual portfolios,

1.0; its expected return will be equal to a simple weighted average

of the expected returns of the two individual portfolios, 10.0%;

and its standard deviation will be less than the simple average of

the two portfolios’ standard deviations, 25%.

The combined portfolio’s expected return will be greater

than the simple weighted average of the expected returns of the two

individual portfolios, 10.0%.

The combined portfolio’s standard deviation will be

greater than the simple average of the two portfolios’ standard

deviations, 25%.

The combined portfolio’s standard deviation will be equal

to a simple average of the two portfolios’ standard deviations,

25%.

2 points

Question 7

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

Which of the following statements must be true, according to the

CAPM?

Answer

If you invest $50,000 in Stock X and $50,000 in Stock Y,

your 2-stock portfolio would have a beta significantly lower than

1.0, provided the returns on the two stocks are not perfectly

correlated.

Stock Y’s realized return during the coming year will be

higher than Stock X’s return.

If the expected rate of inflation increases but the market

risk premium is unchanged, the required returns on the two stocks

should increase by the same amount.

Stock Y’s return has a higher standard deviation than

Stock X.

If the market risk premium declines, but the risk-free

rate is unchanged, Stock X will have a larger decline in its

required return than will Stock Y.

Question 8

1. Which of the following statements is CORRECT?

Answer

A large portfolio of randomly selected stocks will always

have a standard deviation of returns that is less than the standard

deviation of a portfolio with fewer stocks, regardless of how the

stocks in the smaller portfolio are selected.

Diversifiable risk can be reduced by forming a large

portfolio, but normally even highly-diversified portfolios are

subject to market (or systematic) risk.

A large portfolio of randomly selected stocks will have a

standard deviation of returns that is greater than the standard

deviation of a 1-stock portfolio if that one stock has a beta less

than 1.0.

A large portfolio of stocks whose betas are greater than

1.0 will have less market risk than a single stock with a beta =

0.8.

If you add enough randomly selected stocks to a portfolio,

you can completely eliminate all of the market risk from the

portfolio.

2 points

Question 9

1. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the

following statements must be true about these securities? (Assume

market equilibrium.)

Answer

When held in isolation, Stock A has more risk than Stock

B.

Stock B must be a more desirable addition to a portfolio

than A.

Stock A must be a more desirable addition to a portfolio

than B.

The expected return on Stock A should be greater than that

on B.

The expected return on Stock B should be greater than that

on A.

2 points

Question 10

1. Which of the following statements is CORRECT?

Answer

A stock’s beta is less relevant as a measure of risk to an

investor with a well-diversified portfolio than to an investor who

holds only that one stock.

If an investor buys enough stocks, he or she can, through

diversification, eliminate all of the diversifiable risk inherent

in owning stocks. Therefore, if a portfolio contained all publicly

traded stocks, it would be essentially riskless.

The required return on a firm’s common stock is, in

theory, determined solely by its market risk. If the market risk is

known, and if that risk is expected to remain constant, then no

other information is required to specify the firm’s required

return.

Portfolio diversification reduces the variability of

returns (as measured by the standard deviation) of each individual

stock held in a portfolio.

A security’s beta measures its non-diversifiable, or

market, risk relative to that of an average stock.

2 points

Question 11

1. During the coming year, the market risk premium (rM − rRF),

is expected to fall, while the risk-free rate, rRF, is expected to

remain the same. Given this forecast, which of the following

statements is CORRECT?

Answer

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.

The required return on all stocks will remain

unchanged.

The required return will fall for all stocks, but it will

fall more for stocks with higher betas.

The required return for all stocks will fall by the same

amount.

The required return will fall for all stocks, but it will

fall less for stocks with higher betas.

2 points

Question 12

1. 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%. The returns on 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

the risk-free rate remains unchanged. Which of the following

statements is CORRECT?

Answer

The required return of all stocks will remain unchanged

since there was no change in their betas.

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.

The required return on 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.

The required returns on all three stocks will increase by

the amount of the increase in the market risk premium.

The required return on the average stock will remain

unchanged, but the returns on riskier stocks (such as Stock C) will

decrease while the returns on safer stocks (such as Stock A) will

increase.

Question 13

1. Inflation, recession, and high interest rates are economic

events that are best characterized as being

Answer

systematic risk factors that can be diversified away.

company-specific risk factors that can be diversified

away.

among the factors that are responsible for market

risk.

risks that are beyond the control of investors and thus

should not be considered by security analysts or portfolio

managers.

irrelevant except to governmental authorities like the

Federal Reserve.

2 points

Question 14

1. Which of the following statements is CORRECT?

Answer

If a company with a high beta merges with a low-beta

company, the best estimate of the new merged company’s beta is

1.0.

Logically, it is easier to estimate the betas associated

with capital budgeting projects than the betas associated with

stocks, especially if the projects are closely associated with

research and development activities.

The beta of an “average stock,” which is also “the market

beta,” can change over time, sometimes drastically.

If a newly issued stock does not have a past history that

can be used for calculating beta, then we should always estimate

that its beta will turn out to be 1.0. This is especially true if

the company finances with more debt than the average firm.

During a period when a company is undergoing a change such

as increasing its use of leverage or taking on riskier projects,

the calculated historical beta may be drastically different from

the beta that will exist in the future.

2 points

Question 15

1. Which of the following is NOT a potential problem when

estimating and using betas, i.e., which statement is FALSE?

Answer

The fact that a security or project may not have a past

history that can be used as the basis for calculating beta.

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 from the “true” or

“expected future” beta.

The beta of an “average stock,” or “the market,” can

change over time, sometimes drastically.

Sometimes the past data used to calculate beta do not

reflect the likely risk of the firm for the future because

conditions have changed.

All of the statements above are true.

2 points

Question 16

1. If a stock’s dividend is expected

to grow at a constant rate of 5% a year, which of the following

statements is CORRECT? The stock is in equilibrium.

Answer

The expected return on the stock is 5% a year.

The stock’s dividend yield is 5%.

The price of the stock is expected to decline in the

future.

The stock’s required return must be equal to or less than

5%.

The stock’s price one year from now is expected to be 5%

above the current price.

2 points

Question 17

1. Which of the following statements is CORRECT, assuming stocks

are in equilibrium?

Answer

The dividend yield on a constant growth stock must equal

its expected total return minus its expected capital gains

yield.

Assume that the required return on a given stock is 13%.

If the stock’s dividend is growing at a constant rate of 5%, its

expected dividend yield is 5% as well.

A stock’s dividend yield can never exceed its expected

growth rate.

A required condition for one to use the constant growth

model is that the stock’s expected growth rate exceeds its required

rate of return.

Other things held constant, the higher a company’s beta

coefficient, the lower its required rate of return.

Question 18

1. Stocks X and Y have the following data. Assuming the stock

market is efficient and the stocks are in equilibrium, which of

the following statements is CORRECT?

X Y

Price

$30 $30

Expected growth (constant)

6% 4%

Required return

12% 10%

Answer

Stock X has a higher dividend yield than Stock Y.

Stock Y has a higher dividend yield than Stock X.

One year from now, Stock X’s price is expected to be

higher than Stock Y’s price.

Stock X has the higher expected year-end dividend.

Stock Y has a higher capital gains yield.

2 points

Question 19

1. Companies can issue different classes of common stock. Which

of the following statements concerning stock classes is

CORRECT?

Question 20

1. The required returns of Stocks X and Y are rX = 10% and rY =

12%. Which of the following statements is CORRECT?

Question 21

1. Which of the following statements is CORRECT?

Question 22

1. Stocks A and B have the following data. Assuming the stock

market is efficient and the stocks are in equilibrium, which of the

following statements is CORRECT?

Question 23

1. The preemptive right is important to shareholders because

it

Question 24

1. Two constant growth stocks are in equilibrium, have the same

price, and have the same required rate of return. Which of the

following statements is CORRECT?

Question 25

1. The expected return on Natter Corporation’s stock is 14%. The

stock’s dividend is expected to grow at a constant rate of 8%, and

it currently sells for $50 a share. Which of the following

statements is CORRECT?

Question 26

1. If in the opinion of a given investor a stock’s expected

return exceeds its required return, this suggests that the investor

thinks

Question 27

1. Stocks A and B have the following data. Assuming the stock

market is efficient and the stocks are in equilibrium, which of the

following statements is CORRECT?

Question 28

1. Which of the following statements is CORRECT?

Question 29

1. For a stock to be in equilibrium, that is, for there to be no

long-term pressure for its price to depart from its current level,

then

Question 30

1. If markets are in equilibrium, which of the following

conditions will exist?

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