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Exam 13: Return, Risk, and the Security Market Line

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Question 1

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According to CAPM, the expected return on a risky asset depends on three components. Describe each component and explain its role in determining expected return.

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CAPM suggests the expected return is a function of (1) the risk-free rate of return, which is the pure time value of money, (2) the market risk premium, which is the reward for bearing systematic risk, and (3) beta, which is the amount of systematic risk present in a particular asset. Better answers will point out that both the pure time value of money and the reward for bearing systematic risk are exogenously determined and can change on a daily basis, while the amount of systematic risk for a particular asset is determined by the firm's decision-makers.

Question 2

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The common stock of Alpha Manufacturers has a beta of 1.47 and an actual expected return of 15.26 percent. The risk-free rate of return is 4.3 percent and the market rate of return is 12.01 percent. Which one of the following statements is true given this information?

A) The actual expected stock return will graph above the Security Market Line.
B) The stock is underpriced.
C) To be correctly priced according to CAPM, the stock should have an expected return of 21.95 percent.
D) The stock has less systematic risk than the overall market.
E) The actual expected stock return indicates the stock is currently overpriced.

F) D) and E)
G) A) and D)

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E

Question 3

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At a minimum, which of the following would you need to know to estimate the amount of additional reward you will receive for purchasing a risky asset instead of a risk-free asset? I. asset's standard deviation II. asset's beta III. risk-free rate of return IV. market risk premium

If the economy is normal, Charleston Freight stock is expected to return 15.7 percent. If the economy falls into a recession, the stock's return is projected at a negative 11.6 percent. The probability of a normal economy is 80 percent while the probability of a recession is 20 percent. What is the variance of the returns on this stock?

Your portfolio is comprised of 40 percent of stock X, 15 percent of stock Y, and 45 percent of stock Z. Stock X has a beta of 1.16, stock Y has a beta of 1.47, and stock Z has a beta of 0.42. What is the beta of your portfolio?

The common stock of Manchester & Moore is expected to earn 13 percent in a recession, 6 percent in a normal economy, and lose 4 percent in a booming economy. The probability of a boom is 5 percent while the probability of a recession is 45 percent. What is the expected rate of return on this stock?

The _____ of a security divided by the beta of that security is equal to the slope of the security market line if the security is priced fairly.

What is the expected return on a portfolio that is equally weighted between stocks K and L given the following information?

You recently purchased a stock that is expected to earn 22 percent in a booming economy, 9 percent in a normal economy, and lose 33 percent in a recessionary economy. There is a 5 percent probability of a boom and a 75 percent chance of a normal economy. What is your expected rate of return on this stock?

The excess return earned by an asset that has a beta of 1.34 over that earned by a risk-free asset is referred to as the:

Which one of the following is most directly affected by the level of systematic risk in a security?

A stock has an expected return of 11 percent, the risk-free rate is 6.1 percent, and the market risk premium is 4 percent. What is the stock's beta?

The primary purpose of portfolio diversification is to:

What is the standard deviation of the returns on a portfolio that is invested 52 percent in stock Q and 48 percent in stock R?

Which one of the following is an example of systematic risk?

Thayer Farms stock has a beta of 1.12. The risk-free rate of return is 4.34 percent and the market risk premium is 7.92 percent. What is the expected rate of return on this stock?

Suzie owns five different bonds valued at $36,000 and twelve different stocks valued at $82,500 total. Which one of the following terms most applies to Suzie's investments?

You have a $12,000 portfolio which is invested in stocks A and B, and a risk-free asset. $5,000 is invested in stock A. Stock A has a beta of 1.76 and stock B has a beta of 0.89. How much needs to be invested in stock B if you want a portfolio beta of 1.10?

You are comparing stock A to stock B. Given the following information, what is the difference in the expected returns of these two securities?

Which one of the following statements related to risk is correct?