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Exam 7: Risk, Return, and the Capital Asset Pricing Model

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Question 81

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A highly risk-averse investor is considering adding one additional stock to a three-stock portfolio,to form a four-stock portfolio.The three stocks currently held all have b = 1.0 and a perfect positive correlation with the market.Potential new Stocks A and B both have expected returns of 15%,and both are equally correlated with the market,with r = 0.75.However,Stock A's standard deviation of returns is 12% versus 8% for Stock B.Which stock should this investor add to his or her portfolio,or does the choice matter?

A) either A or B, i.e., the investor should be indifferent as to which of the two
B) Stock A
C) Stock B
D) neither A nor B, as neither has a return sufficient to compensate for risk

E) A) and D)
F) B) and D)

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Question 82

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A payoff matrix compares a set of possible rates of return on an investment,with which of the following?

A) the probabilities of occurrence
B) the standard deviation of each occurrence
C) the variance of each occurrence
D) the average return of each occurrence by its squared variance

E) A) and B)
F) None of the above

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Question 83

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The CAPM is built on historic conditions,although in most cases we use expected future data in applying it.Because betas used in the CAPM are calculated using expected future data,they are not subject to changes in future volatility.This is one of the strengths of the CAPM.

Which of the following statements is correct?

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Risk aversion is 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 lower-risk (and therefore lower-expected-return) securities than investors who have more tolerance for risk.

Diversifiable risk is the only risk that affects the required rate of return because nondiversifiable risk can be eliminated.

Consider the following information for three stocks,A,B,and C,and portfolios of these stocks.The stocks' returns are positively but not perfectly positively correlated with one another,i.e.,the correlation coefficients are all between 0 and 1.Portfolio AB has half of its funds invested in Stock A and half in Stock B.Portfolio ABC has one-third of its funds invested in each of the three stocks.The risk-free rate is 5%,and the market is in equilibrium,so required returns equal expected returns.Which of the following statements is correct? $\begin{array}{l}\begin{array}{lll}&&\text { Expected }\\\underline {\text { Stock }} & & \underline {\text { Return }} \\\text { Stock A } & & 10 \% \\\text { Stock B } & &10 \\\text { Stock C } & & 12\end{array}\begin{array}{lll}\text { Standard }\\ \underline { \text { Deviation } }& \underline { \text { Beta } }\\20 \%&1.0 \\10 &1.0\\12&1.4\end{array}\end{array}$

The appropriate measure of risk for all investors is how the return on an individual stock moveswith the returns of other assets in the portfolio.Which of the following best describes thisrelationship?

As investors become ____ risk averse,the market risk premium ____ and SML becomes ____.

Which statement about a stock's beta is correct?

Ripken Iron Works believes the following probability distribution exists for its stock.What is the coefficient of variation on the company's stock? $\begin{array}{lccc}\text { State of the } &\text { Frobability of } &\text { Stock's Expected } \\\text { Economy } & \text { State Occurring } & \text { Return } \\\hline \text { Boom } & 0.25 & 25 \% \\\text { Normal } & 0.50 & 15 \% \\\text { Recession } & 0.25 & 5 \%\end{array}$