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Exam 25: Portfolio Theory and Asset Pricing Models

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Question 1

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You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B.Which of the possible answers best describes the historical betas for A and B? $\begin{array}{l}\begin{array} { l } \text { Years } & \text { Market } \\1&0.03 \\2 & -0.05 \\3 & 0.01 \\4 & -0.10 \\5 & 006\end{array}\begin{array} { l } \text { Stock A } \\ 0.16 \\0.20 \\0.18 \\0.25 \\014\end{array}\begin{array} { l } \text { Stock B } \\ 0.05 \\0.05 \\0.05 \\0.05 \\005\end{array}\end{array}$

A) b_A > +1; b_B = 0.
B) b_A = 0; b_B = -1.
C) b_A < 0; b_B = 0.
D) b_A < -1; b_B = 1.
E) b_A > 0; b_B = 1.

F) C) and D)
G) A) and D)

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Question 2

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

A) True
B) False

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Question 3

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Which is the best measure of risk for an asset held in isolation,and which is the best measure for an asset held in a diversified portfolio?

Stock A's beta is 1.5 and Stock B's beta is 0.5.Which of the following statements must be true about these securities? (Assume market equilibrium.)

Stock A has an expected return r_A = 10% and $\sigma$ _A = 10%.Stock B has r_B = 14% and $\sigma$ _B = 15%.r_AB = 0.The rate of return on riskless assets is 6%. a. Construct a graph that shows the feasible and efficient sets, giving consideration to the existence of the riskless asset. b. Explain what would happen to the CML if the two stocks had (a) a positive correlation coefficient or (b) a negative correlation coefficient. c. Suppose these were the only three securities (A, B, and riskless) in the economy, and everyone's indifference curves were such that they were tangent to the CML to the right of the point where the CML was tangent to the efficient set of risky assets. Would this represent a stable equilibrium? If not, how would an equilibrium be produced?

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

Assume that the market is in equilibrium and that stock betas can be estimated with historical data.The returns on the market,the returns on United Fund (UF) ,the risk-free rate,and the required return on the United Fund are shown below.Based on this information,what is the required return on the market,r_M? $\begin{array} { l c r } \text { Year } & \text { Market }& { U F } \\ 2008& -9 \% & - 14 \% \\ 2009 & 11 \% & 16\% \\ 2010 & 15 \% & 22\% \\ 2011 & 5 \% & 7 \% \\ 2012 & - 1 \% & -2 \% \end{array}$ $\mathrm { r } _ { \mathrm { RF } : } \mathrm { 7.00 \%}$ $\quad$$\quad$$\quad$ $r _ { \text {United } } : 15.00 \%$

Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Talcott Inc.'s beta is 1.00,and (5) its realized rate of return has averaged 15.0% over the last 5 years.Calculate the required rate of return for Talcot Inc.

Security A has an expected return of 12.4% with a standard deviation of 15%,and a correlation with the market of 0.85.Security B has an expected return of -0.73% with a standard deviation of 20%,and a correlation with the market of -0.67.The standard deviation of r_M is 12%. A) To someone who acts in accordance with the CAPM, which security is more risky, A or B? Why? (Hint: No calculations are necessary to answer this question; it is easy.) B) What are the beta coefficients of A and B? Calculations are necessary. C) If the risk-free rate is 6%, what is the value of r_M?

The slope of the SML is determined by the value of beta.

Assume an economy in which there are three securities: Stock A with r_A = 10% and $\sigma$ _A = 10%; Stock B with r_B = 15% and $\sigma$ _B = 20%; and a riskless asset with r_RF = 7%.Stocks A and B are uncorrelated (r_AB = 0) .Which of the following statements is most CORRECT?

Calculate the required rate of return for the Wagner Assets Management Group,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: $\begin{array} { c c c } \text { Stack } & \text { Investment } &\text { Beta } \\\text { A } & \$ & 1.50\\\text { } & 200,000 & \\\text { B } & & - 0.50 \\\text { } & 300,000 & \\\text { C } & &1.25 \\\text { } & 500,000 & \\\text { D } & 1,000,000 & 0.75& \\\end{array}$

In a portfolio of three different stocks,which of the following could NOT be true?

Consider the information below for Postman Builders Inc.Suppose that the expected inflation rate and thus the inflation premium increase by 2.0 percentage points,and Postman acquires risky assets that increase its beta by the indicated percentage.What is the firm's new required rate of return? Beta: $\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$1.50$ Reqquired return $\left( r _ { s } \right)$ $\quad$$\quad$$\quad$$\quad$ $10.20 \%$ $R \mathrm { R } _ { \mathrm { M } }$ $\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$ $6.00\%$ percentage increase in beta: $\quad$$\quad$$\quad$ $20 \%$

If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative,the CAPM would indicate that the required rate of return on Selleck's stock should be less than the risk-free rate for a well-diversified investor,assuming that the observed relationship is expected to continue in the future.

A stock with a beta equal to -1.0 has zero systematic (or market)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.

We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

Which of the following statements is CORRECT?

You have the following data on three stocks: As a risk minimizer,you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.