A) When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.
B) Portfolio diversification reduces the variability of returns on an individual stock.
C) Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events.
D) The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs.
E) A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio.
G) A) and D)
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A) Portfolio P's expected return is greater than the expected return on Stock B.
B) Portfolio P's expected return is equal to the expected return on Stock A.
C) Portfolio P's expected return is less than the expected return on Stock B.
D) Portfolio P's expected return is equal to the expected return on Stock B.
E) Portfolio P's expected return is greater than the expected return on Stock C.
G) All of the above
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B) False
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A) Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.
B) Adding more such stocks will increase the portfolio's expected rate of return.
C) Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk.
D) Adding more such stocks will have no effect on the portfolio's risk.
E) Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.
G) A) and D)
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A) The expected rate of return must be equal to the required rate of return; that is, = r.
B) The past realized rate of return must be equal to the expected future rate of return; that is, = .
C) The required rate of return must equal the past realized rate of return; that is, r = .
D) All three of the above statements must hold for equilibrium to exist; that is = r = .
E) None of the above statements is correct.
G) A) and C)
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B) False
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A) 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%.
B) 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%.
C) 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%.
D) The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%.
E) The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%.
G) C) and D)
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B) False
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A) Company X has more diversifiable risk than Company Y.
B) Company X has a lower coefficient of variation than Company Y.
C) Company X has less market risk than Company Y.
D) Company X's returns will be negative when Y's returns are positive.
E) Company X's stock is a better buy than Company Y's stock.
G) None of the above
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A) The slope of the SML is determined by the value of beta.
B) The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by its managers.
C) Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well diversified investor, assuming investors expect the observed relationship to continue on into the future.
D) If investors become less risk averse, the slope of the Security Market Line will increase.
E) If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock.
G) None of the above
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B) False
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B) False
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A) An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks.
B) The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
C) It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
D) Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.
E) An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.
G) B) and D)
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A) The required return on a stock with beta = 1.0 will not change.
B) The required return on a stock with beta > 1.0 will increase.
C) The return on "the market" will remain constant.
D) The return on "the market" will increase.
E) The required return on a stock with a positive beta < 1.0 will decline.
G) None of the above
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A) The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.
B) The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
C) The beta of the portfolio is less than the weighted average of the betas of the individual stocks.
D) The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.
E) The beta of the portfolio is larger than the weighted average of the betas of the individual stocks.
G) A) and B)
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A) The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.
B) The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
C) The beta of the portfolio is lower than the lowest of the three betas.
D) The beta of the portfolio is higher than the highest of the three betas.
E) The beta of the portfolio is calculated as a weighted average of the individual stocks' betas.
G) B) and C)
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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, and its 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.
G) A) and B)
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B) False
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A) If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds.
B) If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change.
C) An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk.
D) There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML.
E) Assume that the required rate of return on the market, rM, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF.
Problems
Generally, the SML is used to find the required return, but on occasion the required return is given and we must solve for one of the other variables. We warn our students before the test that to answer a number of the questions they will have to transform the SML equation to solve for beta, the market risk premium, the risk-free rate, or the market return.
G) A) and D)
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A) Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio.
B) The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk.
C) Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios.
D) If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's.
E) The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified.
G) B) and C)
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