Risk and Return: A look at CAPM

1. Suppose you are an investor that wants to limit your interest rate risk and default risk. Supposing that you want to invest in corporate bonds, which of the possible bonds would be the best to purchase? a. AAA bond with 15 years to maturity. b. BBB perpetual bond. c. BBB bond with 10 years to maturity. d. AAA bond with 10 years to maturity. e. BBB bond with 15 years to maturity. 2. A highly risk-averse investor is considering the addition of an asset to a 10stock portfolio. The two securities under consideration both have an expected return equal to 15 percent. However, the distribution of possible returns associated with Asset A has a standard deviation of 12 percent, while Asset B's standard deviation is 8 percent. Both assets are correlated with the market with r = 0.75. Which asset should the risk-averse investor add to his/her portfolio? a.. Asset A. b. Asset B. c. Both A and B. d. Neither A nor B. e. Cannot tell without more information. 3. The Security Market Line (SML) relates risk to return, for a given set of financial market conditions. If investors conclude that the inflation rate is going to increase, which of the following changes would be most likely to occur? a. The required return on an average stock would increase. b. Beta would increase. c. The slope of the SML would increase. d. The market risk premium would increase. e. None of the indicated changes would be likely to occur. 4. Which of the following statements is most correct? a. When investors require higher rates of return for investments that demonstrate higher variability of returns, this is evidence that is consistent with risk aversion. b. Risk aversion implies that investors will not diversify. c. Risk aversion implies a general dislike for risk, thus, the lower the standard deviation the higher the risk premium. d. In comparing two firms that differ from each other only with respect to risk,

the expected returns on the stock of the firms should be equal. e. All of the above statements are false. 5. Assume CAPM is correct. You are holding a stock, which has a beta of 2.0 and is currently in equilibrium. The required return on the stock is 15 percent, and the expected return on the market is 10 percent. Suddenly due to economic conditions, the expected return on the market increases by 30 percent. If nothing else changes, how much does the expected return on your stock change? a. +20% b. +30% c. +40% d. +50% e. +60% 6. Which of the following is false? a. The definition and measurement of the market portfolio is a controversial topic. b. Several anomalies led people to question the validity of the CAPM. c. The small-firm effect suggests that over the past 70 years, small firms have on average outperformed CAPM estimates. d .CAPM assumes that all investors hold diversified portfolios. e. Fama and French in their 1992 paper conclude that beta is the only measure of risk that is needed to predict future returns. 7. Which of the following is a problem with the CAPM? a. In testing the model we are also testing the reliability of our market proxies and also the market efficiency. b. The model can not describe the higher than predicted returns for small stocks. c. Fama and French found that when size and the MB ratio are included, beta is insignificant. d. All of the above are problems with CAPM. 8 . Beta _______. a. is a measure of firm specific risk. b. is a measure of market risk. c. is a measure of total risk. d. is calculated by regressing the market return on the historical market dividend yield. e. All of the above are true. 9. Firm specific risk is also called _______.

a. Market risk b. Macro risk c. Undiversifiable risk d. Non-Systematic risk e. Unavoidable risk. 10. Which of the following is TRUE? a. A stock with a beta of 3 will always have a higher return than a stock with a beta of 1. b. Testing CAPM must be done after the fact while CAPM measures EXPECTED returns. c. The Beta of a portfolio is the beta of the individual stocks multiplied by the standard deviation of each stock. d. Generally speaking stocks with higher betas tend to have lower total risk. e. all of the above are true. Don't cheat :-) Answers: 1. D 2. B 3. A 4. A 5. C 6. E 7. D 8. B 9. D 10. B