Multiple Choice Questions
The Capital Asset Pricing Model (CAPM) incorporates several risk measures, including unique risk, beta, standard deviation of returns, variance of returns, and none of the mentioned options.
After diversifying a portfolio, the only risk that remains is systematic risk. This type of risk is quantified by beta.
The level of difficulty is classified as easy.
The Capital Asset Pricing Model (CAPM) classifies the relevant risk into five categories: A. unique risk, B. market risk, C. standard deviation of returns, D. variance of returns, or E. none of the above.
After diversifying a portfolio, the only risk that remains is systematic risk, which can be measured using beta.
Most people can easily reach this level of difficulty.
4. The Capital Asset Pricing Model (CAPM) calculates the rate of return for a diversified portfolio by considering factors like market risk, unsystematic risk, unique risk, reinvestment risk, or none of these.
When a portfolio is diversified, the only risk that remains is market or systematic risk, which directly impacts return according to the CAPM.
Difficulty: Easy
The Capital Asset Pricing Model (CAPM) states that the rate of return for a diversified portfolio is influenced by different risks, such as beta risk, unsystematic risk, unique risk, reinvestment risk, or none of these. However, in a diversified portfolio, only market risk, beta risk, or systematic risk persist. These are the only risks that affect the return according to CAPM.
Difficulty: Easy
According to the capital asset pricing model (CAPM), security X with a beta of 1.2 has an expected rate of return equal to 0.06. Both the risk-free rate and expected market rate of return are mentioned, with values of 0.06 and 0.12 respectively.The options are as follows: B. 0.144, C. 0.12, D. 0.132, and E. 0.18
The earning rate (E(R)) is calculated as 6% plus 1.2 times the difference between 12 and 6, resulting in a total of 13.2%.
Difficulty: Easy
The market portfolio possesses several characteristics: it encompasses all publicly traded financial assets, rests on the efficient frontier, holds securities in proportion to their market values, serves as the tangency point between the capital market line and the indifference curve, and satisfies all of the aforementioned conditions.
The point at which the capital market line and the indifference curve intersect is where the optimal portfolio for a particular investor lies.
The task is of moderate difficulty.
12. The Capital Market Line (CML) has two statements that describe it. Statement A states that the CML is the line from the risk-free rate through the market portfolio. Statement B states that the CML is the best attainable capital allocation line.
The CML, which is also referred to as the security market line, always has a positive slope. Both the Capital Market Line (CML) and the Security Market Line (SML) illustrate risk/return relationships. The risk measure for the CML is standard deviation, while the risk measure for the SML is beta. Therefore, ‘C’ is not true, but the other statements are accurate.
The level of difficulty for this task is moderate.
14. The market risk, beta, of a security can be calculated using different formulas:
A. Beta is equal to the covariance between the security’s return and the market return divided by the variance of the market’s returns.
B. Beta is obtained by dividing the covariance between the security and market returns by the standard deviation of the market’s returns.
C. Another way to calculate beta is by dividing the variance of the security’s returns by the covariance between the security and market returns.
D.
Alternatively, beta can be determined by dividing
the variance of
the security’s returns
by
the variance of the market’s returns.
E. None of these options are correct for calculating beta.
The beta of a security is a Moderate difficulty level measure of how its return correlates with the returns of the market, adjusted for the volatility of the market.
The Security Market Line (SML) is the line that depicts the relationship between expected return and beta for well-diversified portfolios. It is also known as the Capital Allocation Line. Additionally, it is tangent to the efficient frontier of all risky assets and represents the expected return-beta relationship. Furthermore, it represents the relationship between an individual security’s return and the market’s return. The SML serves as a measure of expected return per unit of risk, with risk being defined as beta (systematic risk).
It is moderately difficult.
According to the Capital Asset Pricing Model (CAPM), securities can be considered fairly priced if they have positive betas, negative betas, zero alphas, or positive alphas. Equilibrium and fair pricing for a security with a zero alpha is determined by its level of risk. It is moderately challenging to understand this concept.
According to the Capital Asset Pricing Model (CAPM), underpriced securities can have positive betas, zero alphas, negative betas, positive alphas, or no betas and alphas. However, according to the same model, underpriced securities always have positive alphas.
According to the Capital Asset Pricing Model (CAPM), overpriced securities can be identified by positive betas, zero alphas, or negative betas. However, the correct answer is that overpriced securities have positive alphas. Therefore, the answer is D.
Furthermore, according to the CAPM, overpriced securities possess negative alphas.
Difficulty: Moderate
The Capital Asset Pricing Model (CAPM) asserts that the anticipated rate of return on a security is influenced by different factors, including the risk-free rate, beta value, and alpha value. According to CAPM, when the risk-free rate decreases, the expected rate of return on a security also decreases. Conversely, an increase in a security’s beta leads to an increase in its expected rate of return. Furthermore, a security with an alpha value of zero is considered to have a fair price.
All securities in equilibrium are part of the security market line, and all the aforementioned statements are true. However, although statements B, C, and D remain valid, statement A is inaccurate.
The task is moderately difficult.
The empirical results for betas estimated from historical data reveal several observations. Initially, the findings indicate that betas are not constant over time. Moreover, the results demonstrate that betas of all securities do not consistently exceed one. Additionally, the outcomes illustrate that betas are not invariably close to zero. Nevertheless, the findings do suggest that betas tend to approach one as time progresses. Lastly, the results emphasize that betas always exhibit a positive value.
In summary, these findings imply that betas fluctuate over time and can be negative or less than one. Furthermore, while betas are not consistently near zero, they do seem to regress towards one over time.
Difficulty: Moderate
According to the Capital Asset Pricing Model, an underpriced security is determined by a personal opinion of an expected rate of return of 0.11, a beta of 1.5, a risk-free rate of 0.05, and a market expected rate of return of 0.09.
The different categories for security are as follows:
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.
Through calculations, it is concluded that the security is fairly priced at 11% = 5% + 1.5(9% – 5%).
The task is of moderate difficulty.
The stock should be purchased with a beta of 1.3 if it offers a rate of return of 12 percent, considering that the risk-free rate is 7 percent and the expected market rate of return is 15 percent.
The recommendation is to sell the stock short due to its overpriced valuation.
Selling the stock short is suggested because it is considered to be underpriced.
Buying the stock is proposed because it is deemed to be undervalued.
It is stated that none of the aforementioned options are suitable as the stock is fairly priced.
Based on this calculation: 12% < 7% + 1.3(15% – 7%) = 17.40%; therefore, it can be inferred that the stock is overpriced and should be shorted ( = 12 – 17.40 = -5.40% – overpriced or undervalued).
Difficulty level: Moderate
The security has an expected rate of return of 0.10 and a beta of 1.1. The market’s expected rate of return is 0.08 and the risk-free rate is 0.05. The stock’s alpha is determined to be 1.7%.
The options for the stock’s alpha are:
A. 1.7%.
B. -1.7%.
C. 8%
D .3%.
E.none.
Using the formula alpha = expected return – (risk-free rate + beta(market return – risk-free rate)), we find that alpha = 10% – [5% +1 .1(8% – 5%)]. This equals to 1 .7%.
The task is considered to have a moderate difficulty level.
According to the Capital Asset Pricing Model, it is believed that CSCO is undervalued with an expected rate of return of 0.13, a beta of 1.3, a risk-free rate of 0.04, and a market expected rate of return of 0.115.
B. The security is overpriced.
C. The security is fairly priced.
D. The price of the security cannot be determined from the provided data.
E. None of the above options are correct.
The calculation – 11.5% – [4% + 1.3(11.5% – 4%)] = -2.25% – indicates that the security is overpriced.
Difficulty: Moderate
According to the Capital Asset Pricing Model, Boeing is considered underpriced with an expected rate of return of 0.112, a beta of 0.92, a risk-free rate of 0.04, and a market expected rate of return of 0.10.
The security can be categorized as either overpriced, fairly priced, undetermined from data provided, or none of the above. Based on the calculation, the security is underpriced by 1.68%. Difficulty: Moderate
34. As a financial analyst, you have been tasked with assessing a capital budgeting project using the IRR method and determining the suitable hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company’s beta is 1.0 and the project you are evaluating carries an equal level of risk as previous projects your company has accepted on average. According to CAPM, the appropriate hurdle rate would be ______%. A. 4
B. 7
C. 15
D. 11
E. 1
The hurdle rate should be the required return from CAPM or (R = 4% + 1.0(11% – 4%) = 11%.
Difficulty: Moderate
36. As a financial analyst, you need to assess a capital budgeting project and decide on the suitable hurdle rate using the IRR method. You have been given these details: the risk-free rate is 4 percent, the expected market rate of return is 11 percent, your company has a beta of 0.75, and the project you are evaluating carries the same level of risk as previous accepted projects by your company. According to CAPM, the appropriate hurdle rate would be _____%. A. 4
B. 9.25
C. 15
D. 11
E. 0.75
The hurdle rate should be the required return from CAPM or (R = 4% + 0.75(11% – 4%) = 9.25%.
Difficulty: Moderate
The risk-free rate is 4 percent and the expected market rate of return is 11 percent. If you expect CAT, with a beta of 1.0, to yield a return of 10 percent, it would be most advantageous to purchase stock X as it is considered overvalued.
The recommendation is to sell stock X short because it is considered overpriced. Alternatively, it is suggested to sell stock X short due to its underpricing. Another option is to buy stock X since it is determined to be undervalued. However, there is also a possibility that the stock is fairly priced which would mean none of the aforementioned options apply.
10% < 4% + 1.0(11% – 4%) = 11.0%. Thus, the conclusion is that the stock is overpriced and it is recommended to short it ( = 10 – 11 = -1% – overpriced or undervalued).
Difficulty: Moderate
43. There are two stocks, A and B.
Which security is the better buy and why, given that the expected market rate of return is 0.09 and the risk-free rate is 0.05?
A. Security A would be considered the better buy because it offers an expected excess return of 1.2%.
B. Security B would be considered the better buy because it offers an expected excess return of 1.8%.
C. Security A would be considered the better buy because it offers an expected excess return of 2.2%.
D. Security B would be considered the better buy because it offers an expected return of 14%.
E. Security B would be considered the better buy because it has a higher beta.
A’s excess return is expected to be 2.2%, calculated as 12% – [5% + 1.2(9% – 5%)]. B’s excess return is expected to be 1.8%, calculated as 14% – [5% + 1.8(9% – 5%)].
Difficulty: Moderate
According to the Capital Asset Pricing Model (CAPM), the risk premium an investor anticipates on a stock or portfolio depends on its alpha, beta, and standard deviation. The market compensates for systematic risk, as indicated by beta, which leads to the risk premium of a stock or portfolio changing proportionally with beta. In summary:
45. The risk premium of a stock or portfolio rises along with alpha, beta, and standard deviation.
Difficulty: Easy
47. Both standard deviation and beta measure risk, but they differ in their measurements. A: beta measures both systematic and unsystematic risk.
B: beta only measures systematic risk, while standard deviation measures total risk.
C: beta only measures unsystematic risk, while standard deviation measures total risk.
D: beta measures both systematic and unsystematic risk, while standard deviation only measures systematic risk.
E: beta measures total risk, while standard deviation only measures nonsystematic risk. B is the sole accurate statement.
Difficulty: Easy
48. The Capital Asset Pricing Model (CAPM) recognizes the expected return-beta correlation as a widely accepted assertion, stating that the covariance between stock returns and market returns determines the impact of the stock on the market portfolio’s variability (beta). This assumption is based on investors holding well-diversified portfolios.
D. All of the above are true.
E. None of the above are true.
Statements A, B, and C all describe the expected return-beta relationship.
Difficulty: Moderate
According to research conducted by Jeremy Stein of MIT, the argument regarding the adequacy of beta as a pricing factor has been settled. Stein suggests that managers should utilize beta to estimate long-term returns, while excluding its use for short-term returns.
Stein suggests that beta is appropriate for estimating long-term returns rather than short-term returns. Short-term returns have no correlation with beta, while beta can be utilized to estimate long-term returns. Stein does not endorse options B, C, and D as viable approaches for estimating returns. Consequently, none of the mentioned options (B, C, D) align with Stein’s findings. To summarize, managers should prioritize employing beta for estimating long-term returns instead of short-term returns.
Research on liquidity spreads in security markets has indicated that there are differences in returns between illiquid and liquid stocks. Specifically, illiquid stocks tend to yield higher returns while liquid stocks often have lower returns. This implies that investing in illiquid stocks is more profitable than investing in liquid ones. These findings challenge the belief that both types of stocks generate equal returns or that liquid stocks outperform illiquid ones. Furthermore, the studies suggest that frequent and short-term traders find illiquid stocks particularly advantageous. As a result, options A, B, C, and D do not accurately reflect the conclusions drawn from these studies.
Difficulty: Difficult
54. The risk premium on the market portfolio is determined by either the average degree of risk aversion among investors or the market portfolio’s risk, as measured by its variance. Additionally, it may also be influenced by the market portfolio’s risk, as measured by its beta. Alternatively, both the average degree of risk aversion and the variance of the market portfolio contribute to determining the risk premium.
E. both A and C are true. The risk premium on the market portfolio is directly linked to the average level of risk aversion among investors and the market portfolio’s variance, indicating its risk level.
55. The marginal price of risk for a risky security must be in equilibrium:
A. equal to the marginal price of risk for the market portfolio,
B. greater than the marginal price of risk for the market portfolio,
C. less than the marginal price of risk for the market portfolio,
D. adjusted by its degree of nonsystematic risk.
E. none of the above are true. In equilibrium, the marginal price of risk for a risky security must be equal to the marginal price of risk for the market. If this condition is not met, investors will buy or sell the security until the prices are equal.
Difficulty: Moderate
The statement implies that for equilibrium to occur, it is essential for both the marginal price of risk for a risky security and the market to be identical. If this condition is not satisfied, investors will modify their buying and selling activities until both prices are in harmony.
The capital asset pricing model (CAPM) assumes that all investors are price takers, have the same holding period, and pay taxes on capital gains. According to CAPM, investors are price takers with the same single holding period and there are no taxes or transaction costs involved.
Difficulty: Easy
The capital asset pricing model assumes that:
A. all investors are price takers.
B. all investors have the same holding period.
C. investors have homogeneous expectations.
D. both A and B are true.
E. A, B and C are all true.
The CAPM assumes that investors are price-takers with the same single holding period and that they have homogeneous expectations.
Difficulty: Easy
The validity of the CAPM may be compromised if investors are uncertain about their investment horizons. However, this does not mean that the fundamental assumptions of the CAPM are being violated. As long as pricing does not consider investors’ liquidity needs, the implications of the CAPM remain intact. It is important to acknowledge that removing these assumptions may have consequences, as discussed in the chapter’s section on extensions to the CAPM. Therefore, none of the aforementioned choices can be considered completely accurate. This subject poses a moderate level of difficulty.
62. The amount that an investor allocates to the market portfolio is negatively related to:
- The expected return on the market portfolio.
- The investor’s risk aversion coefficient.
- The risk-free rate of return.
- The variance of the market portfolio
A. I and II
B. II and III
C. II and IV
D. II, III, and IV
E. I, III, and IV
The optimal proportion is given by y = (E(RM) – rf)/(.01xA2M). This amount will decrease as rf, A, and 2M increase.
Difficulty: Moderate
According to the CAPM, investors display myopic behavior. This behavior entails planning for a single holding period, acting as price-takers without affecting market prices through their trades, using mean-variance optimization, sharing the same economic perspective, and not encountering taxes or transaction costs. Myopic behavior is defined by its short-sightedness and lack of consideration for medium-term or long-term consequences.
Difficulty: Moderate
65. The mutual fund theorem is similar to the separation property, and implies that a passive investment strategy can be efficient. However, it does not imply that efficient portfolios can be formed only through active strategies. Additionally, it means that professional managers have superior security selection strategies. Therefore, the correct statements about the mutual fund theorem are I and IV.
B. Options I, II, and IV
C. Options I and II
D. Options III and IV
E. Options II and IV
The mutual fund theorem and the separation property are alike. Professional managers can handle the creation of mutual funds, allowing individuals to combine them with risk-free assets based on their preferences. Investing in a market index fund is an efficient passive strategy.
Difficulty level: Moderate
68. The illiquidity premium on asset i in the CAPM model that analyzes illiquidity premiums depends on the market’s volatility and the correlation among assets caused by shared systematic risk factors.
Factors such as asset volatility, trading costs of security i, risk-free rate, and money supply are all taken into account in the formula for extending the CAPM. This extension allows for considering that trading is not costless. Difficulty level: Moderate.
Assuming the expected rate of return for a security is 0.13 and the market’s expected rate of return is also 0.13, with a risk-free rate of 0.04, the stock’s beta would be 1.25.
B. 1.7
C. 1
D. 0.95
E. none of the above.
13% = [4% +(13% – 4%)]; 9% = (9%); = 1.
