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Exam 24: Portfolio Theory, Asset Pricing Models, and Behavioral Finance

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Question 21

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Assume an economy in which there are three securities: Stock A with rA = 10% and A = 10%; Stock B with rB = 15% and B = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0) . Which of the following statements is most CORRECT?

A) The expected return on the investor's portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.
B) The expected return on the investor's portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%.
C) The expected return on the investor's portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%.
D) The investor's risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%.
E) Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%.

F) B) and E)
G) A) and C)

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Question 22

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Which of the following is NOT a potential problem with beta and its estimation?

A) Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.
B) Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the "true" or "expected future" beta.
C) The beta of "the market," can change over time, sometimes drastically.
D) Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
E) There is a wide confidence interval around a typical stock's estimated beta.

F) B) and D)
G) A) and B)

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Question 23

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You are given the following returns on "the market" and Stock Q during the last three years. We could calculate beta using data for Years 1 and 2 and then, after Year 3, calculate a new beta for Years 2 and 3. How different are those two betas, i.e., what's the value of beta 2 - beta 1? (Hint: You can find betas using the Rise-Over-Run method, or using your calculator's regression function.)

You are holding a stock with a beta of 2.0 that is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points) . The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.

The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels) ,

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Data for Oakdale Furniture, Inc. is shown below. Now the expected inflation rate and thus the inflation premium increase by 2.0 percentage points, and Oakdale acquires risky assets that increase its beta by the indicated percentage. What is the firm's new required rate of return?

Consider the following information and then calculate the required rate of return for the Scientific Investment Fund, which holds 4 stocks. The market's required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund's assets are as follows:

You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different common stocks. The portfolio beta is equal to 1.12. You have decided to sell a lead mining stock What is the new beta of the portfolio?

The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.