# Fins2624 Past Year Essay

Multiple Choice Questions

1. In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is A. unique risk.

B. beta.

C. standard deviation of returns.

D. variance of returns.

E. none of the above.

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Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta.

Difficulty: Easy

3. In the context of the Capital Asset Pricing Model (CAPM) the relevant risk is A. unique risk.

B. market risk

C. standard deviation of returns.

D. variance of returns.

E. none of the above.

Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta.

Difficulty: Easy

4. According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio’s rate of return is a function of A. market risk

B. unsystematic risk

C. unique risk.

D. reinvestment risk.

E. none of the above.

With a diversified portfolio, the only risk remaining is market, or systematic, risk. This is the only risk that influences return according to the CAPM.

Difficulty: Easy

5. According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio’s rate of return is a function of A. beta risk

B. unsystematic risk

C. unique risk.

D. reinvestment risk.

E. none of the above.

With a diversified portfolio, the only risk remaining is market, beta, or systematic, risk. This is the only risk that influences return according to the CAPM.

Difficulty: Easy

8. The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on security X with a beta of 1.2 is equal to A. 0.06.

B. 0.144.

C. 0.12.

D. 0.132

E. 0.18

E(R) = 6% + 1.2(12 – 6) = 13.2%.

Difficulty: Easy

10. Which statement is not true regarding the market portfolio? A. It includes all publicly traded financial assets.

B. It lies on the efficient frontier.

C. All securities in the market portfolio are held in proportion to their market values. D. It is the tangency point between the capital market line and the indifference curve. E. All of the above are true.

The tangency point between the capital market line and the indifference curve is the optimal portfolio for a particular investor.

Difficulty: Moderate

12. Which statement is not true regarding the Capital Market Line (CML)? A. The CML is the line from the risk-free rate through the market portfolio. B. The CML is the best attainable capital allocation line.

C. The CML is also called the security market line.

D. The CML always has a positive slope.

E. The risk measure for the CML is standard deviation.

Both the Capital Market Line and the Security Market Line depict risk/return relationships. However, the risk measure for the CML is standard deviation and the risk measure for the SML is beta (thus C is not true; the other statements are true).

Difficulty: Moderate

14. The market risk, beta, of a security is equal to

A. the covariance between the security’s return and the market return divided by the variance of the market’s returns. B. the covariance between the security and market returns divided by the standard deviation of the market’s returns. C. the variance of the security’s returns divided by the covariance between the security and market returns. D. the variance of the security’s returns divided by the variance of the market’s returns. E. none of the above.

Beta is a measure of how a security’s return covaries with the market returns, normalized by the market variance.

Difficulty: Moderate

16. The Security Market Line (SML) is

A. the line that describes the expected return-beta relationship for well-diversified portfolios only. B. also called the Capital Allocation Line.

C. the line that is tangent to the efficient frontier of all risky assets. D. the line that represents the expected return-beta relationship. E. the line that represents the relationship between an individual security’s return and the market’s return. The SML is a measure of expected return per unit of risk, where risk is defined as beta (systematic risk).

Difficulty: Moderate

17. According to the Capital Asset Pricing Model (CAPM), fairly priced securities A. have positive betas.

B. have zero alphas.

C. have negative betas.

D. have positive alphas.

E. none of the above.

A zero alpha results when the security is in equilibrium (fairly priced for the level of risk).

Difficulty: Moderate

18. According to the Capital Asset Pricing Model (CAPM), underpriced securities A. have positive betas.

B. have zero alphas.

C. have negative betas.

D. have positive alphas.

E. none of the above.

According to the Capital Asset Pricing Model (CAPM), under priced securities have positive alphas.

Difficulty: Moderate

19. According to the Capital Asset Pricing Model (CAPM), overpriced securities A. have positive betas.

B. have zero alphas.

C. have negative betas.

D. have positive alphas.

E. none of the above.

According to the Capital Asset Pricing Model (CAPM), over priced securities have negative alphas.

Difficulty: Moderate

21. According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false? A. The expected rate of return on a security decreases in direct proportion to a decrease in the risk-free rate. B. The expected rate of return on a security increases as its beta increases. C. A fairly priced security has an alpha of zero.

D. In equilibrium, all securities lie on the security market line. E. All of the above statements are true.

Statements B, C, and D are true, but statement A is false.

Difficulty: Moderate

23. Empirical results regarding betas estimated from historical data indicate that A. betas are constant over time.

B. betas of all securities are always greater than one.

C. betas are always near zero.

D. betas appear to regress toward one over time.

E. betas are always positive.

Betas vary over time, betas may be negative or less than one, betas are not always near zero; however, betas do appear to regress toward one over time.

Difficulty: Moderate

24. Your personal opinion is that a security has an expected rate of return of 0.11. It has a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to the Capital Asset Pricing Model, this security is A. underpriced.

B. overpriced.

C. fairly priced.

D. cannot be determined from data provided.

E. none of the above.

11% = 5% + 1.5(9% – 5%) = 11.0%; therefore, the security is fairly priced.

Difficulty: Moderate

25. The risk-free rate is 7 percent. The expected market rate of return is 15 percent. If you expect a stock with a beta of 1.3 to offer a rate of return of 12 percent, you should A. buy the stock because it is overpriced.

B. sell short the stock because it is overpriced.

C. sell the stock short because it is underpriced.

D. buy the stock because it is underpriced.

E. none of the above, as the stock is fairly priced.

12% < 7% + 1.3(15% – 7%) = 17.40%; therefore, stock is overpriced and should be shorted. ( = 12 – 17.40 = -5.40% – overpriced, or undervalued)

Difficulty: Moderate

27. A security has an expected rate of return of 0.10 and a beta of 1.1. The market expected rate of return is 0.08 and the risk-free rate is 0.05. The alpha of the stock is A. 1.7%.

B. -1.7%.

C. 8.3%.

D. 5.5%.

E. none of the above.

= 10% – [5% +1.1(8% – 5%)] = 1.7%.

Difficulty: Moderate

28. Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the Capital Asset Pricing Model, this security is A. underpriced.

B. overpriced.

C. fairly priced.

D. cannot be determined from data provided.

E. none of the above.

11.5% – [4% + 1.3(11.5% – 4%)] = -2.25%; therefore, the security is overpriced.

Difficulty: Moderate

31. Your opinion is that Boeing has an expected rate of return of 0.112. It has a beta of 0.92. The risk-free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is A. underpriced.

B. overpriced.

C. fairly priced.

D. cannot be determined from data provided.

E. none of the above.

11.2% – [4% + 0.92(10% – 4%)] = 1.68%; therefore, the security is under priced.

Difficulty: Moderate

34. As a financial analyst, you are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company has a beta of 1.0 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. 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 are tasked with evaluating a capital budgeting project. You were instructed to use the IRR method and you need to determine an appropriate hurdle rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent. Your company has a beta of 0.75 and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. 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

39. The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If you expect CAT with a beta of 1.0 to offer a rate of return of 10 percent, you should A. buy stock X because it is overpriced.

B. sell short stock X because it is overpriced.

C. sell stock short X because it is underpriced.

D. buy stock X because it is underpriced.

E. none of the above, as the stock is fairly priced.

10% < 4% + 1.0(11% – 4%) = 11.0%; therefore, stock is overpriced and should be shorted. ( = 10 – 11 = -1% – overpriced, or undervalued)

Difficulty: Moderate

43. Given the following two stocks A and B

If the expected market rate of return is 0.09 and the risk-free rate is 0.05, which security would be considered the better buy and why? A. A because it offers an expected excess return of 1.2%.

B. B because it offers an expected excess return of 1.8%.

C. A because it offers an expected excess return of 2.2%.

D. B because it offers an expected return of 14%.

E. B because it has a higher beta.

A’s excess return is expected to be 12% – [5% + 1.2(9% – 5%)] = 2.2%. B’s excess return is expected to be 14% – [5% + 1.8(9% – 5%)] = 1.8%.

Difficulty: Moderate

45. According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio increases: A. directly with alpha.

B. inversely with alpha.

C. directly with beta.

D. inversely with beta.

E. in proportion to its standard deviation.

The market rewards systematic risk, which is measured by beta, and thus, the risk premium on a stock or portfolio varies directly with beta.

Difficulty: Easy

47. Standard deviation and beta both measure risk, but they are different in that A. beta measures both systematic and unsystematic risk.

B. beta measures only systematic risk while standard deviation is a measure of total risk. C. beta measures only unsystematic risk while standard deviation is a measure of total risk. D. beta measures both systematic and unsystematic risk while standard deviation measures only systematic risk. E. beta measures total risk while standard deviation measures only nonsystematic risk. B is the only true statement.

Difficulty: Easy

48. The expected return-beta relationship

A. is the most familiar expression of the CAPM to practitioners. B. refers to the way in which the covariance between the returns on a stock and returns on the market measures the contribution of the stock to the variance of the market portfolio, which is beta. C. assumes that investors hold 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

50. Research by Jeremy Stein of MIT resolves the dispute over whether beta is a sufficient pricing factor by suggesting that managers should use beta to estimate A. long-term returns but not short-term returns.

B. short-term returns but not long-term returns.

C. both long- and short-term returns.

D. book-to-market ratios.

E. None of the above was suggested by Stein.

Stein’s results suggest that managers should use beta to estimate long-term returns but not short-term returns.

Difficulty: Difficult

51. Studies of liquidity spreads in security markets have shown that A. liquid stocks earn higher returns than illiquid stocks.

B. illiquid stocks earn higher returns than liquid stocks.

C. both liquid and illiquid stocks earn the same returns.

D. illiquid stocks are good investments for frequent, short-term traders. E. None of the above are true.

Studies of liquidity spreads in security markets have shown that illiquid stocks earn higher returns than liquid stocks.

Difficulty: Difficult

54. The risk premium on the market portfolio will be proportional to A. the average degree of risk aversion of the investor population. B. the risk of

the market portfolio as measured by its variance. C. the risk of the market portfolio as measured by its beta. D. both A and B are true.

E. both A and C are true.

The risk premium on the market portfolio is proportional to the average degree of risk aversion of the investor population and the risk of the market portfolio measured by its variance.

Difficulty: Moderate

55. In equilibrium, the marginal price of risk for a risky security must be 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 not, investors will buy or sell the security until they are equal.

Difficulty: Moderate

56. The capital asset pricing model assumes

A. all investors are price takers.

B. all investors have the same holding period.

C. investors pay taxes on capital gains.

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 there are no taxes or transaction costs.

Difficulty: Easy

58. The capital asset pricing model assumes

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

60. If investors do not know their investment horizons for certain A. the CAPM is no longer valid.

B. the CAPM underlying assumptions are not violated.

C. the implications of the CAPM are not violated as long as investors’ liquidity needs are not priced. D. the implications of the CAPM are no longer useful.

E. none of the above are true.

This is discussed in the chapter’s section about extensions to the CAPM. It examines what the consequences are when the assumptions are removed.

Difficulty: Moderate

62. The amount that an investor allocates to the market portfolio is negatively related to I) the expected return on the market portfolio.

II) the investor’s risk aversion coefficient.

III) the risk-free rate of return.

IV) 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

63. One of the assumptions of the CAPM is that investors exhibit myopic behavior. What does this mean? A. They plan for one identical holding period.

B. They are price-takers who can’t affect market prices through their trades.

C. They are mean-variance optimizers.

D. They have the same economic view of the world.

E. They pay no taxes or transactions costs.

Myopic behavior is shortsighted, with no concern for medium-term or long-term implications.

Difficulty: Moderate

65. Which of the following statements about the mutual fund theorem is true? I) It is similar to the separation property.

II) It implies that a passive investment strategy can be efficient. III) It implies that efficient portfolios can be formed only through active strategies. IV) It means that professional managers have superior security selection strategies. A. I and IV

B. I, II, and IV

C. I and II

D. III and IV

E. II and IV

The mutual fund theorem is similar to the separation property. The technical task of creating mutual funds can be delegated to professional managers; then individuals combine the mutual funds with risk-free assets according to their preferences. The passive strategy of investing in a market index fund is efficient.

Difficulty: Moderate

68. For the CAPM that examines illiquidity premiums, if there is correlation among assets due to common systematic risk factors, the illiquidity premium on asset i is a function of A. the market’s volatility.

B. asset is volatility.

C. the trading costs of security i.

D. the risk-free rate.

E. the money supply.

The formula for this extension to the CAPM relaxes the assumption that trading is costless.

Difficulty: Moderate

78. Assume that a security is fairly priced and has an expected rate of return of 0.13. The market expected rate of return is 0.13 and the risk-free rate is 0.04. The beta of the stock is ___? A. 1.25

B. 1.7

C. 1

D. 0.95

E. none of the above.

13% = [4% +(13% – 4%)]; 9% = (9%); = 1.