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Exam 2: Risk and Return-Part I

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Question 31

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

A) the effect of a change in the market risk premium depends on the slope of the yield curve.
B) if the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
C) if the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
D) the effect of a change in the market risk premium depends on the level of the risk-free rate.
E) if the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.

F) A) and B)
G) A) and C)

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Question 32

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Which of the following statements is CORRECTσ

A) the slope of the security market line is beta.
B) any stock with a negative beta must in theory have a negative required rate of return, provided rrf is positive.
C) if a stock's beta doubles, its required rate of return must also double.
D) if a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.
E) if a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.

F) None of the above
G) C) and D)

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Question 33

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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 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECTσ

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?

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

If markets are in equilibrium, which of the following conditions will exist?

Data for Atwill Corporation is shown below. Now Atwill acquires some risky assets that cause its beta to increase by 30%. In addition, expected inflation increases by 2.00%. What is the stock's new required rate of return? $\begin{array} { l r } \text { Inttal beta } & 10.00 \% \\\text { Initial required return ( } \mathrm { s } . & 6.00 \% \\\text { Market risk premrium RP } & 30.00 \% \\\text { Percentage increase in beta } & 2.00 \%\end{array}$

Gretta's 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. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT?

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions.

You are considering investing in one of the these three stocks: $\begin{array}{ccc}\text { Stock } & \text { Standard Deviation } & \text { Beta } \\ \mathrm{A} & 20 \% & 0.59 \\\mathrm{~B} & 10 \% & 0.61 \\\mathrm{C} & 12 \% & 1.29\end{array}$ If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.

Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return?(Hint: First find the market risk premium, then find the required returns on the stocks.)

Stuart Company's manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.) $\text { Economic }$ $\begin{array}{llr}\text { Conditions } & \text { Prob. } & \text { Return } \\\hline \text { Strong } & 30 \% & 32.0 \% \\\text { Normal } & 40 \% & 10.0 \% \\\text { Weak } & 30 \% & -16.0 \%\end{array}$

Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.

Porter Plumbing's stock had a required return of 11.75% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.)

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation.

Which of the following statements is CORRECT?

Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

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